Chris Daily

Central banks could continue pumping money into the economy for decades and interest rates in the United States are set to rise but maybe not this year.

These were some of the conclusions drawn at a recent investment and portfolio construction conference.

According to financial advisers and experts at the Perfecting Investment Portfolios Conference, which was held in Auckland, New Zealand, the current cycle of quantitative easing could easily go on for another 5-10 years with some experts predicting loose monetary policy for even longer. The majority of delegates were convinced that QE had stabilised the financial system, however, they were mixed as to whether rates in the US would increase this year.

With global central bankers focused on avoiding a near-term deflationary environment at any cost, speakers Chris Daily, portfolio manager at Tribeca Investment Partners and Mark Thomas, chief executive and chief investment officer at van Eyk Research urged investors to think like a central banker and remain invested in growth assets.

“Central bankers are focused on reflating the economy to avoid deflation, in which case excessive liquidity is sustainable and investors should stay in equities for longer even though valuations may appear stretched,” Thomas said.

“QE seems to have a shelf space much longer than most are thinking. While there is talk about slowing QE in the US, it’s unlikely that they will remove it until deleveraging is more pronounced in the private sector. Europe has just started and Japan has no other option.”

The Annual Perfecting Investment Portfolios Conference, which is hosted by The Investment Store and Heathcote Investment Partners, focused on two key themes this year: “Bathing in the afterglow of central bank intervention” and “The déjà vu of emerging markets”.

These themes were developed by Shamubeel Eaqub, principal economist at the NZ Institute of Economic Research, who opened the conference. He was joined by other prominent speakers including Jonathan Ramsay, head of strategic research and consulting at van Eyk Research.Clayton Coplestone, director at Heathcote Investment Partners, said he was delighted by the high level of engagement from delegates and their openness to debate thought-provoking themes.

“We were able to stress-test conventional industry thinking, in order to deliver better outcomes for investors,” Coplestone said.

Matthew Mimms, managing director of The Investment Store, added that the conference provided investment professionals with an opportunity to hear a number of expert speakers discuss their views on key investment issues.

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US debt ceiling still impacting markets and currencies.

Thankfully politicians in the US can at least agree on one thing – that America defaulting on its obligations would be a “bad thing”.

And so it was recently at the eleventh hour that an agreement was struck to simultaneously suspend the debt ceiling and reopen the US government. All it took was a sixteen day circus and a glimpse over the abyss but all was finally resolved, at least until early 2014.

While the news has since put the bulls back in charge, the outcome is far from optimal and a long way from a sustainable fiscal solution. But not to worry. Part of the arrangement that helped solve the impasse was the formation of yet another budgetary committee tasked with doing what hasn’t been possible so far, agreement on a long term budget deal.

Perhaps the opposing sides could learn from opinion polls and share the bipartisan call for co-operation but if history is any guide this seems unlikely.  Either way, we’ll find out in mid-December if there is any common ground. Otherwise it’s another shutdown in January and another debt ceiling debacle set for February 2014.

The situation is all the more frustrating as the US economy seemed poised to accelerate and while the extent of the damage has yet to be quantified there’s little doubt the shenanigans have undermined business and consumer confidence.

Taper your expectations

Like the general public the Fed too has been similarly unimpressed. Rather than dialling down QE the Fed is still going full throttle on asset purchases with taper possibly off the table until 2014.  Of course the ripple effects are not confined to the US either.

While the ongoing liquidity is supportive for asset markets, there has also been a sting in the tail on the Australian economy. Coupled with a mildly better China, the Australian Dollar has surged on the belief that QE will be around for a little while yet.

A higher Aussie Dollar makes it harder to rebalance “the growth sources of the economy”. The RBA is surely gnashing its teeth.

Drive your dollar further

From a longer-term perspective, the Australian Dollar remains near historical highs and still provides attractive purchasing power so it is a little surprising that many local investors shy away from global shares. For those worried about the transition taking place in the domestic economy, investors could look offshore to companies benefitting from long term change such as the digital disruption.

We were recently reminded of the dominance of Google in search, advertising and content. With strong growth in mobile, the company delivered results ahead of expectations and put a rocket under the share price moving it past $1,000 for the first time. Not a bad outcome for anyone who bought at the IPO in 2004 for just $85. With audiences continuing to shift to tablets and smartphones, advertisers will be compelled to go with them placing Google in an enviable position.

Indeed some 40% of traffic to YouTube now comes via mobile. A perfect way to stay in touch on the debt ceiling and other dysfunctional debates on Capitol Hill over the coming months.

By Pat Noble, Senior Investment Specialist, Zurich Financial Services Australia Limited

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This general information is dated 23 October 2013, is given in good faith and is derived from sources believed to be accurate as at this date, which may be subject to change. It does not take into account the personal investment objectives, financial situation or needs of any person. Investors should consider seeking advice from their licensed financial adviser. Past performance is not a reliable indicator of future performance. Zurich Investment Management Limited ABN 56 063 278 400 AFSL 232511, 5 Blue Street North Sydney NSW 2060 (Zurich Investments). No part of this document may be reproduced without prior written permission from Zurich Investments.

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Federal Reserve building, Washington DC.

Stan Druckenmiller, a star US hedge-fund manager, slams the Federal Reserve for “running the most inappropriate monetary policy in history”. But what seems to scare investors more is the prospect that the Fed’s quantitative easing will end soon.

Financial markets wobbled after Fed Chairman Ben Bernanke on May 22 said the Fed could wind down the unorthodox monetary tool, whereby a central bank, having already slashed its cash rate to close to zero, conjures liabilities on its balance sheet to buy financial assets. The aim of the policy is to lower long-term interest rates to encourage consumers to spend and businesses to invest.

The policy, first tried in Japan in 2001, has helped the world avoid the deflation and depression that dogged the 1930s. While the ability of quantitative easing to spur economic growth is more debatable, for it has failed to stir a lasting recovery, it’s clear the practice carries side effects, including beneficial ones for financial assets.

Druckenmiller and others say the Fed’s asset-buying misallocates resources (hard to prove) and will unbuckle inflation expectations (no sign of that happening). Other alleged spin-offs are so-called currency wars (inadvertent) and inequality because the practice favours asset owners (as the Bank of England admits). The asset-buying has certainly propelled bonds to record low yields, even Netherland bonds that were first issued in 1517, and boosted stocks to fresh peaks.

A definitive assessment of quantitative easing must wait until the practice ends. Many worry it will finish badly. They fret that the great monetary experiment of our time is yet to be halted seamlessly in any country as its economy reignites. Japan has conducted bursts of quantitative easing over the past 12 years (thus temporarily ending it), but without revitalising its economy. But there are no reasons why quantitative easing can’t end smoothly enough for the US as its economy rebounds. It may, however, prove more troublesome for other parts of the world.

The intentions

The declared Fed policy is that it will reduce its asset purchases worth US$85 billion (A$90 billion) a month in steps any time now, if economic, especially jobless, readings justify a less-promiscuous policy. The Fed expects that by mid-2014 it will have stopped the asset-buying that has swelled its balance sheet to US$3.7 trillion from US$894 billion at the start of 2008. By then, the Fed expects the jobless rate to be under 7%, from a four-year low of 7.3% in August.

The Fed can alter, even reverse, its actions at any time if the economy changes beat. Bernanke, aware that policymakers wrecked recoveries in the 1930s by braking too soon, says he won’t allow “a premature tightening”. But such comments to Congress have failed to soothe investors and speculators. Since the end of May, these “feral hogs”, as Richard Fisher, the President of the Dallas Fed described them to the Financial Times, have walloped bonds (thus boosted interest rates) and driven up the US dollar while undermining stocks, especially emerging ones, and commodities.

The financial reaction surprised Bernanke. Perhaps he failed to realise how addicted market players have become to their central-bank fix – so much so that promising reports on the US economy now trigger turbulence for they reinforce that the Fed’s asset purchases will slow soon. Another problem, though, is that some people see so-called tapering as a squeeze on credit, the scourge of the Great Depression. But tapering is not a tightening of monetary policy. If the Fed spends one dollar buying assets, it is easing monetary policy. Once the Fed stops buying assets, then monetary policy is in neutral.

The reason why the ending of quantitative easing is unlikely to be threatening to the US is that the central bank doesn’t need to sell the assets purchased under the program (outside of its normal trading of securities on the money market to control the cash rate). The central bank can hold the bonds to maturity, for, under a system of fiat money (when notes and coins are backed by nothing), the size of a central bank’s balance sheet is peripheral. The dimensions of the monetary base (notes and coins in circulation and bank reserves held at the central bank) have no influence on the Fed’s ability to control the cash rate and thus inflation. When central banks in the 1990s moved to a system of announcing cash-rate targets, they snapped the link between the money supply and the cash rate.

The political reality, though, (and Fed officials are attuned to that) is that the puffing up of the Fed’s balance sheet has sparked warnings of inflation, asset bubbles and economic imbalances. Bernanke admitted to such risks on May 22 when he told Congress the Fed’s loose policies could “undermine financial stability”. Fed officials want to shrink the balance sheet for they anticipate blame for any financial mishaps while it stays bloated. The Fed can be expected to sell assets to trim its balance sheet, and if it does, it’s tightening monetary policy. The Fed will only do this if the economy is humming enough to stoke inflation beyond its 2% limit. By selling assets, the Fed wouldn’t need to raise the cash rate as much as otherwise to keep inflation benign. This will help the recovery for it will receive fewer Fed-raises-rates jolts.

A bond surprise

Amid the tapering talk, US 10-year Treasury yields have risen about 130 basis points from 1.67% on May 1. (They peaked 2.99% on September 5.) The ending of quantitative easing may have a less-dramatic effect on US yields over the rest of the year, though. Investors have priced in the Fed’s intentions and the economic data is modest. (The US economy expanded at an annual rate of 2.5% in the second quarter). Investors are reassured that the Fed will be flexible about curtailing its asset-buying if circumstances demand and they think the central bank is determined to keep the cash rate low. Analysts only expect one 25-basis-point rise in the US cash rate in the next 12 to 18 months.

The biggest risk with ending quantitative easing is that even small increases in borrowing rates could torpedo the US recovery. The US economy’s rebound is wobbly as it is battling reduced fiscal stimulus, stricter bank-lending practices, a feeble eurozone recovery and a slowdown in China. Another risk to the Fed in shrinking its balance sheet is that it will realise losses on bond sold, if interest rates are climbing. That will force a de facto tightening of US fiscal policy. These concerns can be offset by the fact that any dip in economic growth could lead to a renewed loosening of monetary policy.

Investors can expect endless speculation about how and when the Fed will act. The jobless rate will be the best guide but the official rate fails to capture the intricacies of the labour market. The better official employment numbers shroud that many of the jobs created are low-paid and part-time and that many people have dropped out of the workforce. The gains in jobs may not empower the economy that much. The Fed could remain a bond buyer until the official jobless rate is well under 7 per cent\.

The reactions on financial markets to every economic release or Fed utterance can be considered a cost of slowing or reversing quantitative easing. The Fed should worry about bond yields for higher interest rates threaten the recovery. The Fed’s job is to control US inflation and promote US economic growth. It can ignore gyrations on currency, commodity, property and stock markets that have no obvious consequences for the US economy.

It’s hard to see how the ending of quantitative easing can ignite inflation when it will only boost interest rates, which would subdue inflationary pressures. The threat of deflation dispels notions of a bond bubble so it’s not likely that Bernanke will trigger a 1994-style bond crash. The big surprise of the ceasing of quantitative easing could well be how little disruption this causes in the US.

Trouble elsewhere

The ending of quantitative easing, however, may be more complicated elsewhere. The widespread use of the US dollar in trade and in pricing assets and the fact that many currencies are linked to the greenback ensure that US monetary-policy shifts are transmitted around the world. The problem is that while the US economy is recovering many other countries are struggling. Those with currencies tied to the US dollar are losing their export competitiveness as higher US interest rates are boosting the greenback.

The region most at risk is Europe, even with a free-floating euro. The ending of the Fed’s asset-buying may trigger a rise in global bond yields that, however gentle, hampers Europe’s economy, while exposing the limits of the European Central Bank’s bond-buying promise to save the euro. Investors may discover that the ECB can’t keep bond yields of troubled sovereigns at low-enough levels to keep governments solvent, just as a slowdown shoves more pressure on public finances.

Emerging markets are vulnerable in a different way. When quantitative easing started in 2009, US money fled to emerging markets to seek higher returns. The US-sourced capital may gush home if US yields rise. Investors fret that more emerging countries might need to raise interest rates, and thus curb growth, to attract capital to offset current-account deficits and protect their currencies from a slump that triggers inflation via higher import costs. Central banks in Brazil, India, Indonesia and Turkey lifted key rates and took other steps in recent months to prop up their currencies and balance their balances of payments. (India’s moves included capital controls).

The Fed’s actions, however, might be less of a concern than the other causes of economic slowdowns already underway in much of the emerging world. Brazil confronts falling commodity prices, sluggish growth and inflation. China is battling excessive lending. Inflation-prone India is heading to its biggest balance-of-payments crisis since 1991 because politics have stymied reform. Central European countries such as the Czech Republic, Hungary and Poland are largely untouched because their economies are better balanced. Heightened US economic activity sucking in imports may offset some of the short-term damage of the tapering, which will probably prove a hiccup for emerging countries rather than trigger a crisis. Most of the capital directed at the emerging world in recent years was for long-term investment and many countries have low foreign-debt-to-income levels and enough reserves to cope with the whims of speculators. The emerging world’s favourable demographics, abundant raw materials, rising middle class, pro-business policies, large savings pool and low labour costs will nurture its industrialisation for years to come.

Australia is better placed to cope than most countries from any Fed-induced buffetting. Australian bond yields will tick up to some extent with US yields but not fully as China’s slowdown is crimping growth and containing inflation. While rising local yields will slow the economy and steeper global interest rates will add to foreign-debt repayments, the Australian dollar will probably slide to more competitive levels and help our economy overcome the sag in the resources boom.

Over in Washington, the US-taxpayer-funded Fed should just focus on managing the US economy. It should ignore the global repercussions of its policies unless they will hurt the US. Authorities elsewhere should just better brace their economies for a less-lax US monetary policy.

Financial information comes from Bloomberg unless stated otherwise.

By Michael Collins, Investment Commentator, Fidelity Worldwide Investment

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  © 2013 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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The future of fixed income.

Roger Bridges, Head of Fixed Income and Anita Daum, Head of Portfolio Management and the portfolio manager for the Tyndall Australian Bond Fund have provided their answers to AdviserVoice on fixed income and the future for bonds.

Roger has 30 years’ experience in the fixed income market, and has overall responsibility for managing and implementing the strategy for Tyndall’s fixed income portfolios. Anita has 11 years’ experience in the fixed income market and has been managing the Tyndall Australian Bond Fund for four years.

Why did bonds take such a hammering in June?

Roger:  The June reaction of bonds was due to the market’s expectation for the reversal of quantitative easing or QE in the US. Bonds prices surged to record highs in recent years, in part due to central banks such as the US Federal Reserve and Bank of England buying them under QE programmes. The intention – and the effect – was to push down bond yields, which move in the opposite direction to prices.

Low bond yields tend to cause interest rates to fall. This helps to reduce the cost of borrowing for consumers and governments and boost the prices of other assets such as shares. These effects can help pull a country out of recession and assist economic recovery.

But as the recovery gathers momentum, central banks try to curtail and then reverse QE, sending the previous trends into reverse. Announcements by the Fed in June that it planned to scale back its QE programme sparked fear among investors, sending bond prices in the US sharply lower and yields higher. Our bond market is strongly affected by the movement of US bonds, particularly longer-dated bonds such as the 10-years. As a result, we also saw a sell-off here with yields rising and bond prices falling below fair value.

Following this upset, the Fed was forced into a partial retreat and tried to calm market fears over QE tapering, which caused bond yields to fall back to more normal levels. In fact, July saw Australian bond market indices post modest positive returns as bond yields fell.

Can we expect more volatility in the short term?

Roger:  In our view, September seems to be a likely start date for the US Fed’s tapering of its bond-buying programme. The Fed indicated back in June that it may start tapering next month and recent strong economic data makes this all the more likely. In the past week or two, we’ve seen strong US employment and consumer price data.

Given the strong correlation between the movement of US government bonds and Australian government bonds, bond market volatility remains a strong possibility as the market tries to work out what the effects of tapering QE will be.

As growth improves in the US and this tapering of QE comes into effect, how likely is it that we will see another 1994 with bonds experiencing negative returns?

Roger:  It is possible, though unusual, for bonds to deliver negative returns. In general, this only occurs when either the cash rate unexpectedly increases by a large amount or the bond market tries to price in unexpectedly large rate increases and adjusts these expectations quickly. If these market expectations are slowly priced in, then the market value of bonds may fall but they don’t experience negative returns, only lower returns.

This is what happened in 1994: The Fed and its chairman Alan Greenspan were worried about inflation following the 70s and 80s and so decided to take swift action to avoid a spike in inflation. The market was surprised by the sharp rate hikes that the Fed introduced and US bonds didn’t respond until the rate hikes occurred since they were not well telegraphed in advance. The market then panicked and bond yields jumped, while prices fell. 2004-2006 also saw rate hikes in the US but because the Fed was more transparent and took action more slowly, the market had time to react to avoid bond losses.

The current situation is likely to be a repeat of 2004-2006. The Fed is telegraphing its moves in advance so the market shouldn’t be taken by surprise, although there might be brief periods of panic, like in June. But in the longer term, QE unwinding and rate hikes will be slow, measured and telegraphed in advance which shouldn’t lead to bond losses even though the trend will be for yields to rise.

Focusing back on the domestic economy, what’s the likely impact on our bond market of the upcoming Federal election?

Roger:  There is unlikely to be much of a reaction. In general, investor confidence should improve if there is a clear-cut outcome, with one party obtaining a decent majority. A hung parliament will be a negative for confidence and add to uncertainty.

Whichever party wins, if they intend to achieve a fiscal surplus, then obviously that will have an effect on bonds due to the reduction in bond issuance. If there are fewer bonds on issue, it should help to support pricing and keep yields lower.

With prices surging to record highs in recent years, is it fair to say that Australian bonds have had their day?

Roger:  Given historically high prices and low yields, investors have been questioning whether bonds have had their day. I don’t think this is the case.

Australian 10-year bonds have fallen from around 15% in 1982 to record lows below 3%.  The decline in bond yields has been largely the result of a structural decline in global inflation expectations, partly due to QE from central banks around the world and partly to slowing population growth and an aging population.

But in the shorter term, there are three main reasons why Australian bonds should remain attractive.

1)     Foreign investment. Even though this has started to drop off, it is still historically very high. Before the GFC approximately 20-30% of our bonds were held offshore, but by this year, it had jumped to just under 80%. This is largely due to other central banks wanting to diversify away from currencies such as the US dollar.

2)     QE globally. For Australia, this artificial suppression by other central banks means that there is increased demand for our higher yielding assets. Although interest rates are at record lows, our cash rate of 2.5% is still much higher than the zero or close to zero rates seen in Europe, the UK and the US.

3)     Our AAA rating. Australia is one of only 8 countries that has a AAA rating with a stable outlook from all 3 major rating agencies (Standard & Poor’s, Fitch, Moody’s).

So, in a world with a still highly volatile macroeconomic backdrop, the combination of very loose monetary policy in other countries and foreign demand for our debt due to its yield advantage should help to support the bond market in the medium term. We don’t envisage many catalysts that would suddenly push bond yields upwards for a sustained period.

Anita, why should an investor maintain a bond allocation in their portfolio?

Anita: Australians have traditionally invested in shares rather than bonds. But bonds are a valuable component in a diversified portfolio. Bonds tend to perform relatively better in market downturns and when deflation is a major risk. Diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns and reduce overall risk.

Although equities can offer the potential for greater returns more quickly, they involve considerable volatility and the potential for capital losses. Fixed income, on the other hand, offers regular, predictable income with a greater likelihood of capital protection and much more stable returns over the long term. It’s the non-correlation to equities that’s important – bonds should outperform when equities are underperforming and vice versa. So it’s important to have some of a portfolio invested in bonds.

What do you think an investor should look for when choosing a bond fund to invest in?

Anita:  If an investor wants a core bond holding to diversify their portfolio, then they should look for a traditional “true-to-label” bond fund to offset the volatility of other market sectors and provide that non-correlation to equities risk.

A fixed income fund should perform well in market downturns, providing the consistency of performance and regular income that investors expect. However, it’s important to note that not all bond funds are the same. For example, some funds are able to allocate large portions of their portfolio to credit. This gave investors in some of those funds a nasty shock during the GFC. Instead of the fixed income portion of their portfolio doing its job and being the outperformer during that time, funds that were very overweight credit actually performed badly and in some cases actually delivered negative returns during that period.

Our flagship bond fund did very well during the GFC because it is a true-to-label fund that is highly risk-aware and designed to deliver consistent performance even through serious market dislocations, when equities are doing badly.

So, it’s important to consider what an investor wants from fixed income and choose a fund accordingly. If it’s a non-core holding and the investor is looking for a higher return and is prepared to take on extra risk, then a fund that is able to invest in riskier securities could be appropriate. But if the investor is looking for a core holding, then they want a conservative true-to-label fund that won’t give them any nasty surprises at a time they can least afford them.

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Disclaimer

This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Bond Fund ARSN 098 736 255 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”).  Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.  TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.

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In the first half of 2013, developed market equities have outperformed emerging markets, while fixed income has performed poorly, except for high yield bonds, which have benefited from their shorter duration characteristics. After a strong first quarter, risk assets rose through to mid-May before an aggressive bout of profit taking hit most financial markets. The trigger for this was the US Federal Reserve (Fed), which commented that it may ‘taper’ its bond purchase programme if economic data remains strong.

In this regard, the news is good for the US economy, but not so good for those who had expected quantitative easing (QE) to continue indefinitely. On the data front, US car sales have picked up markedly in the past two years and, importantly, housing starts have also improved – indeed, housebuilding is seeing a material uptick, having been a serious drag on the US economy over the past five years. As a result, US growth should continue to outperform the rest of the developed world. The fiscal cliff has also been less of a drag than feared, while the tax take has been better than expected.

The market now expects a US interest rate rise in 2015, about a year earlier than was forecast a few months ago and prior to the comments on ‘tapering’. It is worth emphasising that ‘tapering’ does not mean tightening (as shown in Figure 1 below), but rather making policy ‘less loose’. It is understandable that the Fed wants to begin to unwind QE, given the strength of the US economy compared to the rest of the developed world, and we expect this to happen in $20bn chunks, starting later in 2013. Further support for the ‘tapering’ argument comes from the fact that US inflation is very subdued, despite the pick up in economic growth.

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Beware the risks associated with benchmarks.

In an uncertain market, an absolute return focus rather than a benchmark driven one is more likely to protect fixed income investors – as disappointing financial year returns from many benchmark driven funds have already indicated.

According to Susan Buckley, Managing Director of Global Fixed Interest for investment manager QIC, there are inherent risks associated with benchmarks – and the current environment serves only to exacerbate those risks.

“Benchmarks have long durations, meaning they are sensitive to interest rate movements. Security selection is about issuance not investor return profiles, because the biggest debtors make up the largest component.”

Ms Buckley went on to explain that QIC has a different approach, focusing on building a portfolio which manages interest rate, credit and inflation risk separately according to what is influencing markets at any particular time. The returns of the QIC Inflation Plus Fund, compared with those from the UBS Government Inflation Index, support this approach.

The index returned -1.45% for the year to 30 June 2013, compared with a return of 5.36% from the QIC fund for the same period.

“No one will be surprised to hear me say that the rally we’ve seen in fixed interest from the end of the global financial crisis until late last year is unlikely to continue. But as interest rates inevitably rise, many of the benchmark driven investment approaches will disappoint investors.”
Moving on to discuss the themes in fixed interest markets for the 2012/13 financial year, Ms Buckley said that for the first time since 1994, the Australian Government Inflation benchmark produced a negative result.

“The result wasn’t entirely unexpected because the dominant risk associated with investing in these benchmarks is their sensitivity to interest rate movements. Returns fall sharply when yields rise in the aggressive manner we saw in May and June this year,” she said.

Ms Buckley then explained that yields began rising on the back of comments from the Chairman of the US Federal Reserve, Ben Bernanke. He intimated that the recovery in the US economy had progressed to a point where the program of quantitative easing (QE) might be wound back. This prompted a flurry of activity in May and June. Yields on both US 10 Year Treasuries and Australian 10 Year Bonds rose by 1% in 8 weeks – sending returns into free-fall.

In fact, uncertainty about the effect of the US Federal Reserve’s policies decimated returns from some of the biggest benchmark driven bond funds globally. One example of this impact was seen in the PIMCO Total Return Fund, the world’s biggest bond fund managed by fund manager Bill Gross. Mr Gross had been investing on the basis that quantitative easing would ultimately fuel inflation, and yet the fund fell 4.7% between May and June this year as markets disagreed.

In conclusion, Ms Buckley reminded investors that a rising tide lifts all boats, and that this has been the case in fixed interest until recently. Everyone wanted to go long on bonds as they rallied on aggressive buying from central banks. However, the world is looking different now. The yield cycle has likely troughed and, as liquidity injections from central banks diminish, yields are likely to return to more ‘normal’ levels.

“We understand that moving from a benchmark approach to absolute return is big decision, but I firmly believe a diversified portfolio with no bias to a benchmark or any particular risk factor is a superior solution for investors,” Ms Buckley said.

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