The review covered funds offered in four peer groups of cash, enhanced cash, fixed interest, and credit. 

There has been very little rating change in this year’s review. AMP Capital’s corporate bond fund was upgraded to five stars reflecting our highest opinion on the investment team, in particular portfolio manager Jeff Brunton, the firm’s investment process, and their approach to risk management. Our other five-star ratings were for the PIMCO Australian Bond Fund and Australian Focus Fund, Tyndall’s Australian Bond Fund, and Colonial First State’s Cash Fund. 

Performance across the Australian bond fund universe has been mixed with the key driver of outperformance, or in the majority of cases significant underperformance, being duration positioning. 

“The divergent views on the path of interest rates were unparalleled in my time covering this asset class,” said S&P fund analyst David Erdonmez. 

“The fact that we had managers presenting views that would lead to maximum long or maximum short duration positioning highlights the different approaches managers take in forming their macro views. The bias of the majority was to the short side with very few managers positioned long,” said Mr Erdonmez.

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As fears of a sell-out of fixed interest assets build, investors should look beyond large developed bond markets, to Asia and to Australia, for less volatility and potentially higher returns, according to Legg Mason affiliate Western Asset.

During the GFC, many investors fled to the safe haven of fixed interest , but concerns are now surfacing as to whether there could be a sell-off in developed markets like the US, Europe and Japan.

According to Western Asset, not only do Asian and Australian bond markets represent good value in their own right, they are also less susceptible to global events causing market jitters, such as a potential US double dip.

“If you are concerned about global uncertainty, such as the possibility of a US double dip recession, then Asian and Australian bonds are the place to be,” said Rajeev De Mello, head of Singapore fixed income at Western Asset. “During the last quarter of 2008, for example, Asian bonds proved resilient to the global sell-off.”

Why Asian bonds for Australian investors?

A decade ago the Asian region was considered an emerging market, but economic fundamentals have improved for many countries. Several regional bond indices have been created in recent years and bond funds can provide ready access for foreign investors.

“There are still a lot of myths around about Asian bonds being risky and illiquid, but with governments across the region putting their houses in order, and yield rates attractive, the risk/return equation is looking really good,” said De Mello.

As well as representing good value and stability, Asian bonds are also attractive as a currency play. China’s recent change to its exchange rate regime is likely to lead to faster appreciation of Asian currencies in the medium to long term, while increased investment in the region will also support currencies.

“Foreign ownership of local currency bonds across Asia has already begun, with around 27% of Indonesia’s bond market held by foreign owners. Singapore has around 20%, while Thailand has less than 10% but China and India have less due to entry barriers for foreign investors”, said De Mello.

Korea has also been one of the main beneficiaries of cross investment within Asia and is one of the most liquid and highly rated bond markets in the region.

De Mello adds bonds provide good diversity for a portfolio, for an Australian investor, but are also more straightforward than some other more structured/indexed fixed interest products available.

The ‘kangaroo effect’

Australian fixed interest has also been attracting the attention of foreign investors, due to its good yields and positive outlook.

However the so-called ‘kangaroo effect’ is also taking hold, with many foreign corporates now choosing to issue bonds in the Australian investment grade market.

“It is now possible to issue long-dated bonds, with terms of up to 10 years, bringing Australia into the ‘big league’ of bond issuers like the US. This is a sign that the local market is really developing,” said Anthony Kirkham, head of investment management for Western Asset Australia.

“Australia is now becoming a destination of choice for corporate bond issuance, and we predict many more entrants will come.”

Kirkham recommends that investors target a fixed interest fund that offers a diversified selection of companies and sector allocations when looking to invest in Australian bond markets.

“It is also important to look for stable returns, and having a globally integrated research capability helps,” Kirkham said.

The Legg Mason Australian Bond Trust is ranked as the top performing Australian (Core) Fixed Income fund over one year in the Mercer August 2010 Survey.

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The classification of term deposits as cash by 50% of advisers highlights the need for greater education, according to the world’s largest bond manager PIMCO, which surveyed more than 200 financial advisers in July 2010.

Peter Dorrian, Head of Global Wealth Management at PIMCO, said 47% of advisers’ clients had little or no idea about the illiquid nature of term deposits, which incur hefty break fees when capital is accessed early. Moreover, on average, advisers allocate close to one third (29%) of their client’s fixed income portfolio to term deposits.

“As billions of dollars sit in term deposit accounts, the perception that they are cash indicates advisers are failing to understand the significant limitations of the term deposit structure,” Mr Dorrian said.

“Locking your cash up in term deposits not only means investors can’t access their money when they need to without incurring costs, it also means they’re potentially missing out on higher returns in a rising interest rate environment,” he said.

Mr Dorrian said term deposits were also not defensive assets, despite perceptions they play that role. “Although term deposits provide capital stability, they are technically not defensive assets. A defensive asset will perform better when riskier assets perform poorly, while term deposits will not change due to their illiquid nature. This is in contrast to other fixed income products such as bonds, which capture upside performance when other risk assets are performing poorly,” he said.

Half of the advisers surveyed rated their knowledge of fixed interest markets as average. For advisers’ clients, 53% believed fixed interest products were too technical with 39% highlighting that education material by product providers was inadequate.

“The results from the survey shows there is a gap in the market for simple and easy to understand material explaining the advantages of fixed interest products. With advisers only having an average knowledge of fixed interest, the challenge is to provide easy to digest materials which highlight the benefits of this asset class,” Mr Dorrian said.

Advisers favour actively managed fixed interest funds

Despite misperceptions surrounding term deposits, advisers are favouring actively managed fixed interest funds (42%) compared to term deposits and other fixed interest products. Of those in actively managed funds, 79% said the opportunity for higher returns was the main reason for this exposure followed by the ability to avoid high risk debt (41%).

On the flipside, when advisers were asked about the major risks they perceive in passive fixed interest funds, 65% were concerned about low returns and only 36% believed sovereign risk was an issue.

“Advisers should be aware the real strength of active management in current market conditions is the ability to avoid risky debt. PIMCO’s fixed interest funds outperformed the benchmark this year and actively avoiding high risk debt played a part in achieving this outcome,” he said.

In a New Normal world where global growth is slower and investment returns from higher risk assets will be lower, a greater allocation towards fixed interest products will become crucial to ensuring returns, according to Dorrian.

“We need to work with advisers and their clients to educate them on the benefits fixed interest allocations can have on portfolios in the ‘New Normal’ environment,” Mr Dorrian concluded.

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