Traditional Australian bond managers, who seek to beat the market through duration bets on interest rates, have been losing favour with investors for several years, but, like Mark Twain, reports of their death may be premature. Ross Gustafson, head of fixed interest for Tyndall Investment Management, says that duration management is still the dominant source of alpha in most specialist bond portfolios.

He also says that because opportunities for alpha generation from duration management have declined, with declining volatility of financial markets, some investors have been tempted to switch to pure credit-based fixed interest portfolios to maintain a higher yield. This would have served them well in the past three years. “But, be warned, this is not a continuous game,” Gustafson says. “The level of risk premium (yield spread above government bonds and the yield difference seen between low and high-grade corporate borrowers) in corporate bonds is currently very low and, by definition, cannot keep on contracting to provide a boost to total returns. “Indeed, our view is that these yield spreads are more likely to widen and drag back the higher returns these securities offer from their coupons alone. In this respect it can be seen that funds confined by mandate to invest solely in corporate credit-based securities may indirectly have a narrower opportunity set than, say, a fund that has discretion to both over and underweight exposure to the credit sector as opportunities for excess returns from that area wax and wane over the economic cycle.” Gustafson says that the fall in volatility across financial markets in recent years has been particularly evident in global bond markets. Combined with this historically low level of volatility, the range of interest rate variation in mid-to-long-term bonds has also been very low relative to past years. “Accordingly, the opportunity for bond managers to add value through duration management, that is shifting portfolio average term-to-maturity risk based on guessing forward movements in interest rate direction, has fallen as a consequence. “Five to 10 years ago the Australian investment grade fixed interest market was made up mostly of government and semi-government bonds. Over those years we would have likely seen, say, 70 per cent of the total excess return in our bond portfolios being attributed to duration risk management, with the remainder coming from correct yield curve positioning and active management of the portfolio allocation between government and semi-government bonds. “Over the past three years however, in Tyndall’s experience, the proportion of alpha attributable to duration management alone, has fallen to around 35 per cent. “Despite this, we think it is too simplistic to state that this has led to duration managers falling completely out of favour. Duration management still is the dominant source of alpha generation in most typical bond specialist portfolios. “What has occurred however, is that the sharply changing composition of the fixed interest investment market over recent years has empowered the adept manager to diversify the sources of alpha generation. Indeed, the substantial growth in corporate bond issuance and the emergence of new financially engineered products (such as CDOs, CLOs, CDSs, ABS’s, etc.), has clearly widened and deepened the investment field for fixed interest portfolio management.” Tyndall’s Australian bond fund is restricted to investment grade securities but is able to manage exposures across a range of sub-sectors. The firm’s attribution analysis shows that, on average, duration management has generated 35 per cent of alpha, yield curve position has generated 20 per cent, tilting portfolio sector weightings has generated 11 per cent, security selection 12 per cent and portfolio construction for higher income returns a further 18 per cent. Gustafson says that a superior return over the past three years at least would have been delivered through a mix of Australian and international bonds. For instance, Tyndall’s Australian bond fund returned an average 6.62 per cent for the past three years, against the Australian composite index return of 5.72 per cent. The Tyndall international bond fund averaged 8.52 per cent return over the same period. “The average alpha generated from, say, a 50 per cent investment mix in each (Australian and international) fund would have been 1.85 per cent, or 0.95 per cent more return each year than an investment portfolio confined solely to investment grade Australian bonds,” he says. The Australian bond market universe for investment, in investment grade corporate securities, is a bit thin when it comes to representing the full range of economic sectors, Gustafson says. Banking, finance and property and telecommunication sectors (Telstra) are disproportionately overweighted in the manager benchmarks that represent the range of securities authorised for investment. “The greater diversity achieved across corporate borrowers (from international bonds) is complemented by the opportunity to lower risk and increase returns through enabling the manager to access differing country debt markets which yield curves may be both of different shape and value and move differently to varying degrees from Australia’s. “Indeed, at times some of the alternative international sovereign debt markets, like Japan’s for instance, may exhibit negative correlation for a period in that they sometimes show a tendency for interest rates to move in the opposite direction to Australia and the US market. “These type of variances amongst country debt markets offer a wider range of opportunities to the manager to add value (import alpha) without necessarily increasing the overall riskiness of the portfolio. It is likely that the overall riskiness of the portfolio may be significantly reduced relative to one confined solely to comparable term risk Australian fixed interest.” The argument that Australian and most western government bond markets are likely to dry up because of fiscal surpluses into the future is also sometimes advanced for a reason to reduce allocations to bonds. However, Gustafson says investors should be wary about being too complacent on the forecasts for government surpluses, “given the known history of governments regularly shifting from surplus to debt in large swings for a wide range of reasons, including political party transition, economic cycle needs and fundamental shifts in population”. In any case, investors will benefit in terms of overall risk and return, he says, as long as they confine their investments to a prudently constructed portfolio which maintains dominant exposure to investment grade securities and has reasonably defined limits on exposures to lower-grade securities.

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