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.