Fixed income investors need to be proactive about managing diversification, credit and geographic risk: BlackRock

Global deleveraging and government intervention have produced a challenging new fixed income environment that demands a higher degree of proactivity from investors, says Stephen Miller, BlackRock Australia’s head of fixed interest.

“In the current environment, fixed income investors can not afford to set and forget. They now need to be proactive about managing diversification risk, credit risk and geographic risk,” Mr Miller says.

Responding to this need, BlackRock has launched the Fixed Income Global Opportunities (FIGO) fund in Australia.

FIGO is a flexible global multi-sector fixed income strategy that seeks to achieve a positive total return. While the fund is not tied to a benchmark, it is managed to a target return of 4-6 percent per annum above the UBS Bank Bill Index, net of fees, over rolling three-year periods.

“FIGO was established in response to investors’ desire to diversify their bond portfolios away from traditional fixed income assets, in order to counter the risk to performance presented by a rising interest rate environment over the medium term,” Mr Miller says.

The fund does not focus on just one area of global bond markets. Instead, the underlying investments are a result of collaboration between portfolio managers and over 150 investment specialists globally within the BlackRock group who cover corporate, sovereign, municipal and structured bonds. The underlying strategy also takes active currency positions and can have exposure to equity markets.

“FIGO invests in a mix of traditional and non-traditional strategies that seek to provide superior risk adjusted returns and greater diversification than typical fixed income core or core plus strategies,” Mr Miller says.

“FIGO could appeal to investors looking to enhance return potential from their fixed income allocation without taking on too much risk.”

Although new to the Australian market, the FIGO strategy has been in place in a US mutual fund since 2010 and has a history of attractive returns.

“A modeled return profile for an AUD-hedged version of the US mutual fund strategy outperformed its performance target of the UBS Bank Bill index by 5.3 percent gross each year over three years, and 6.5 percent gross since inception in March 2010,” Mr Miller says.

The fund also showed positive performance during periods of rising bond yields, a consideration for fixed interest investors in the current environment.

“In eight out of 10 periods, the modeled return was positive despite rising US 10 year treasury yields,” Mr Miller says.

FIGO has a minimum investment of $50,000. The fund has no establishment fees, no contribution fees, no withdrawal fees, no switching fees and no exit fees. The annual management fee is 0.7 percent.

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On the contrary, the Omega research has shown that the application of its proprietary risk-controlled methodology is a highly reliable indicator of the likely performance of sovereign bonds issued by a range of nations.

The research is particularly significant because it provides guidance for investors in the face of the dramatic shift in the status of sovereign investing since major world events: the GFC, the actions of major governments in addressing it and the subsequent European sovereign debt crisis. 

“Not so long ago, sovereign debt from major developed nations was considered about as low-risk as you could get,” explained Mathew McCrum, joint head of investments at Omega.  “But post GFC, experience shows us that some of those assumptions no longer apply. The challenge for investors is how to make decisions according to information that’s accurate and relevant in the new environment.”

The desire to pinpoint the factors most relevant to sovereign bond investors in today’s environment has driven this latest Omega research, which back tests the efficacy of the ‘Omega Financial Health Rating’. This is one of a number of risk control tools that’s been used by Omega since its inception in 2008. It is focused on limiting exposure to losses resulting from sovereign defaults and downgrades.

The Omega system assesses both the financial strength and political risks associated with the country it is rating. The financial strength measures focus on a government’s ability to repay debt, and are currently based on the net debt to GDP ratio.  Political risk measures, on the other hand, address a country’s willingness to repay it.

More recently, Omega wanted to explore the potential benefits of enhancing the rating by including additional financial health measures.

“Within a fluctuating financial environment we wanted to see if certain additional measures will help provide a more robust account of a country’s financial health and are therefore a valuable indicator of the likelihood of default,” said Mr McCrum.

Those additional measures include the bonds’ cost based on ten-year-yields; length judged by average maturity; and momentum as assessed bysix-month changes in net debt to GDP.

The research and its findings
The research involved testing the existing Omega Financial Health Rating to see whether it limited exposure to downgrades; and whether it supported improved returns. Proposed additional health measures were also then tested. The benchmark used was the JP Morgan GBI Broad Index.
Ratings downgrades findings: 45 investment grade countries were split into quintiles based on the Omega Financial Health Rating for each year since 1999. The findings show a clear correlation between the resulting rating and future downgrades. For Omega’s investors, this translated to zero exposure to any of the 22 countries that experienced downgrades during the relevant period.

Returns findings: The yearly quintiles created from the Omega Financial Health Rating were compared with the one year forward total returns. The findings show that countries with a superior Omega rating had both larger average returns and reduced volatility of returns. For Omega’s investors this translated to increased return of 9% which was 1.10% over the performance benchmark.

Additional health measures findings:  The next step was to back test performance in relation to each of the proposed additional financial strength measures. For all four measures, the countries with the superior financial health rating tended to have lower volatility of returns, with all but the maturity measures also delivering higher average returns.

“One of our real concerns at Omega was that the current extreme risk aversion in the market would result in an approach that placed all sovereign debt into one basket, irrespective of its quality – and that investors would miss out as a result,” said McCrum.

“However our research clearly shows that using a comprehensive risk-control tool that’s built on a strong platform of objective economic and political measures gives us an accurate picture of the true risks that apply, and helps us make investment decisions accordingly. We’ve had some very good results in our funds this year and one of the key motivations for undertaking this research is that we are keen to maintain the high performance.

“We want to stay in front of changes to help us continue offering investments that deliver both maximum upside potential and protect on the downside. Because that’s what fixed income investing should be all about.”

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• The past week has seen some good news on the Greek debt front with the Greek Government surviving a parliamentary confidence vote, the EU and IMF endorsing Greek austerity plans and EU leaders pledging to head off a Greek default. However, there are still several hurdles to clear before Greece gets a new bailout package. First, the Greek Parliament needs to approve the latest austerity package in order to receive new loans in a vote scheduled for June 28th and then an emergency Eurogroup meeting is scheduled for July 3 to finalise a second bailout package. Reflecting the threat from Greece to the European financial system, ECB President Trichet described financial risk signals in Europe as “flashing red”. Against this background and with signs European growth is slowing, the ECB would be completely crazy to follow through with its threat to raise interest rates again next month.
• In the US there were no surprises from the Federal Reserve’s post meeting statement or press conference by Chairman Bernanke. While the Fed revised down its growth forecasts it committed to maintaining currently easy monetary conditions rather than endorsing hopes for a third round of quantitative easing (ie QE3). Right now its clear that the hurdle for QE3 is high as the Fed regards the growth slowdown as largely driven by temporary factors and the US no longer faces the risk of deflation as it did when QE2 was announced. While Bernanke indicated a preparedness to take action if conditions warranted it is clear economic indicators will have to get a lot worse before this occurs. This only added to market nervousness.
• In Australia, the minutes from the Reserve Bank’s last rate setting meeting offered nothing new from what Governor Stevens told us just over a week ago – that the RBA thinks that if it is right on the economic outlook then interest rates will need to rise “at some point”, but that right now there is no urgency to move. It makes sense for the RBA to sit back and wait for clear evidence of a reduction in global uncertainty and more evidence that Australian economic growth is strengthening or inflationary pressures picking up. This suggests August at the earliest for the next interest rate hike, but we believe there is a growing risk that it may come later and maybe not even this year at all. Outside of the mining sector the Australian economy is very soft. Anecdotal evidence of this abounds: one of my best friends who has a couple of golf shops in Sydney’s west has been complaining for some time about how tough things are. Even my skin specialist told me when I was having my regular skin cancer check that there has been a cutback in discretionary spending on cosmetic skin treatments, like Botox. Things must be tough if Australian’s can’t afford to keep up Botox treatments!
• However, it’s not all doom and gloom. US transport giant FedEx beat earnings estimates and said it saw the soft patch in growth as temporary and a further sharp fall in oil prices is positive for global growth. So if Greece gets another bailout and global economic data improves in the second half as parts supply from Japan returns to normal and as the negative impact of the oil price surge falls out then shares could have a decent rebound.

Major global economic releases and implications

• US economic data remained pretty soft consistent with sub-par growth. Existing and new home sales fell in May, although bad weather probably played a role, weekly jobless claims rose, weekly mortgage applications fell and weekly retail sales data were soft. There was good news on house prices which rose.
• European manufacturing and services sector conditions indicators (or PMIs) fell further in June adding to signs of a soft patch in the global economy.
• The Japanese economy continues to recover from the March earthquake with gains in exports in May and a strong rise in an industrial activity index in April.
• Chinese economic data was consistent with a continued moderation in growth with a further softening in a preliminary manufacturing conditions index for June and an ongoing softening in house price growth in May to an estimated 4.3% year on year, down from a peak late last year of nearly 12% year on year. While inflation looks like it will head up to over 6% in June taking it to the highest this cycle and another rate hike is likely, the softening in growth and its likely flow on to lower inflation through the second half suggests that the tightening cycle in China is nearly done.

Australian economic releases and implications

• It was a quiet week on the data front in Australia, with the big news being a slowdown in population growth last year to 1.5%, it’s slowest in five years. On the face of it, this is a dampener for housing demand and negative for labour supply, but note that its still above the 30 year average population growth rate of 1.4%and in any case since last year the Government has acted to push immigration levels back up to help alleviate skill shortages. Meanwhile, the Westpac leading index rose again in April suggesting growth should pick up.

Major market moves

• Share markets had another volatile week with better news on Greece but poor economic data. This left global markets pretty mixed: up slightly in the US, Asia and Australia but down slightly in Europe.
• Commodity prices were weighed down by ongoing evidence of slowing global growth. In particular oil prices fell further on news that International Energy Agency member countries, mainly the US, would release 2 million barrels per day from oil stockpiles for 30 days. One can question why this wasn’t done earlier this year. It’s mildly bearish for the oil price in the short term, but unlikely to have any medium term impact though.
• Falling commodity prices, a stronger $US generally and reduced expectations for an RBA interest rate hike saw the $A fall slightly.

What to watch in the week ahead?

• The key focus globally in the week ahead will be the Greek Parliament’s scheduled vote on its latest austerity package, the support for which is required for Greece to get the next tranche of loans. While the Greek Government won a confidence vote, public opposition is intensifying and it only needs to lose the votes of five out of 155 governing PASOK party members to lose the vote on the austerity package.
• In the US, the key focus will likely be on the ISM manufacturing conditions index for June due Friday which various regional surveys suggests is likely to fall below the supposed boom/bust level of 50.While this is likely to have been temporarily depressed by Japanese supply chain disruptions and should reverse in the months ahead, another fall in the ISM may add to investor nervousness. Meanwhile, consumer confidence data due Tuesday is likely to rise helped by lower gasoline prices and a strong 15% or so bounce is expected in pending home sales data for May, due on Wednesday. Data for personal spending and income, house prices, construction spending and vehicle sales are also due for release.
• Japanese industrial production data for May due Tuesday is likely to show a solid gain confirming that recovery from the earthquake is underway.
• Chinese manufacturing conditions indexes (PMIs) due Friday are likely to show a further mild softening in the Chinese economy, based on an advanced PMI already released.
• In Australia, expect soft readings for May job vacancies, private credit and dwelling prices which are all due for release on Thursday and similarly soft readings for a manufacturing conditions index and new home sales due on Friday. A speech by RBA Assistant Governor Debelle on Tuesday will also be watched for any clues on monetary policy.

Outlook for markets

• While the news on Greece has become a little better it is still not yet out of the woods and more broadly the worry list remains long with ongoing issues regarding Europe, weak growth readings in the US, the end of QE2 in the week ahead, ongoing uncertainty around the US Government’s debt ceiling and worries about a hard landing in China all likely to contribute to ongoing volatility in shares and possibly more weakness in the September quarter.
• However, beyond the uncertain short term outlook we remain of view that the medium term fundamentals for shares are reasonable. Shares are very cheap again, some of the temporary factors weighing on global growth are abating (such as Japanese supply chain disruptions, the surge in oil prices and bad weather in the US) and monetary conditions globally remain very easy. This all points to an eventual rebound in shares into year end.
• Australian shares are likely to continue under performing their global counterparts, on the back of the strong Australian dollar and the prospect of higher interest rates.
• While the Australian dollar remains vulnerable to a further short term correction, it should remain strong on the back of high commodity prices and a high interest rate differential to the US.
• Softer economic data has helped sovereign bonds in key countries perform well over the last few months as yields have fallen. However, if as we expect global growth re-accelerates during the second half then government bonds are likely to perform poorly over the medium term.

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