Institutional investors have been forced to decide whether they will rebalance to their pre-crisis equity allocations, which has thrust the traditional alternative in to the spotlight. “The fixed income asset class is now getting its fair share of attention amongst investment consultants, fund researchers and trustee boards…and about time too!” exclaimed Simon Doyle, Schroder Investment Management head of fixed income and multi-asset, last month. However, this re-assessment of fixed income is not always resulting in new, alpha-seeking active mandates. In fact, many investors seem determined to make fixed income truly ‘defensive’ again, as MICHAEL BAILEY reports.

There has been a bifurcation in the types of fixed income portfolios being demanded by investors, observes Dean Stewart, head of the fixed income division at Macquarie Funds Group. “You’ve got your investors who loaded up on high yield securities and hybrids, who really took on equity-like risk in their fixed interest allocation, then got burnt and now just want a plain vanilla, benchmark-hugging mandate that’s heavy on Treasuries. On the other hand you’ve got the guys who can see the opportunities emerging from the dislocation in credit markets.”

Macquarie being Macquarie, Stewart’s shop is catering to both kinds of fixed interest customer, and his credit boss Brett Lethwaite happily reports the fixed income division has raised more in the last six-month period (“multiple billions”) than it ever has before. In particular, Macquarie’s Debt Market Opportunities Fund No.1 made a name for itself buying Australian mortgage-backed securities about 18 months ago, when many of the offshore banks that had bought the securitised parcels became forced sellers. “We were hoping for 1 or 2 per cent outperformance [of cash] but it’s ended up being 5 or 6 per cent”, Lethwaite says. His team has been flipping the profits of MBS sales into investment-grade credit, where spreads might have come back from 500 bps over bank bills to the mid-200s, but as AustralianSuper’s fixed income chief John Hopper says, still represent “recessionary” pricing.

Hopper concedes “the easy money in credit has already been made”, but Franklin Templeton pointed out in a recent white paper that when a bellwether like the Barclays Capital US Corporate Index has a long term average spread of just 166 bps above government bond yields, there is still a ways for spreads to go. “In addition, corporate bonds may still provide relatively attractive current yields, as tighter spreads have been partially offset by higher government bond yields,” the paper states. However that same white paper highlights the “idiosyncratic risk of individual bond issuers in this uncertain economic environment”, while conceding continuing spread volatility. To an observer like Richard Borysciewicz, the local chief of global bond house Credit Agricole Asset Management, this explains why a certain school of institutional investor “just wants to save money with bonds” and seek active returns elsewhere.

“There was a lot of disappointment with fixed income portfolios that ended up being subject to equity-like risk, so investors now really want their bonds to behave like bonds,” Borysciewicz says. The same phenomenon is observed by the head of PIMCO’s Australian office, John Wilson, who is plainly frustrated that so many institutional investors have been indexing their bond exposure. “You have to ask yourself, in three years do you think interest rates will be higher than they are today? If you think they will be, then why are you buying a Treasuries index with an average 5.8 year duration, and guaranteeing yourself capital loss?” Wilson actually senses a rare occasion where retail investors may be thinking more progressively than the wholesale side, given it is advisers who are driving flows into PIMCO’s shortduration Australian credit portfolio, as exemplified by its Australian Focus Fund.

“Retail investors are playing in the thickest part of the yield curve, they are getting the implicit Government guarantee of paper issued by the banks, plus stable Aussie corporates like Woolies and BHP.” PIMCO’s Australian Focus Fund runs against a 1.9 year average duration benchmark . The UBS Composite benchmark’s average duration is 3.8 years, and Wilson points out “it’s going to get longer as the Government issues more paper, so as interest rates rise you’re going to endure capital loss”. AustralianSuper’s Hopper warns that manager selection is crucial for credit exposures, because “the value has been shifting so quickly between different parts of the market…think back to when bank loans were doing much better than high yield, then that turned on its head. You’ve seen high yield come back by far the strongest in this recovery, CCC securities are up 100 per cent from their lows.”

With greater cross-sectional volatility has come wider dispersion between manager performance. The difference between the top and bottom quartile of active fixed income managers has blown out from “10 to 20 bps to 10 per cent”, Macquarie’s Lethwaite says, with the biggest losers those still working through toxic high-yield and hybrid holdings that had formed part of a “30 per cent [supposedly defensive component] which began to look too much like the other 70 per cent”. Credit Agricole Asset Management’s Borysiewicz says the investors attracted to CAAM’s Global Bond Fund recognise that the volatile fixed income market demands a top-down view.

“We’re finding investors don’t want to be too narrowly focussed – for instance, it doesn’t matter if you have the best bottom-up credit manager out there, you have missed out on what the central banks and governments are doing, the market opportunities that are being created…A top-down, thematic approach will attempt to position you for what is happening in six months time, and you can get alpha from OECD bonds, currency, emerging market debt, as well as credit.” In the year to August 31 the CAAM Global Bond Fund generated a net 20.18 per cent return, against 10.05 per cent for the Barclays Capital Global Aggregate index. However true to his credo that “people want bonds to behave like bonds”, Borysiewicz is stressing that what appears a rather equity-like return was the result of the one-off dislocation in traditional fixed interest markets. “Normally to get a [20 per cent plus return] you would have to leverage or load up on junk bonds, but in 2008/09 it was simply enough for us to be short credit last year and long credit this year,” Borysiewicz says, adding there were numerous other contributors to the windfall return.

While AustralianSuper employs bond managers like Challenger-backed Kapstream Capital with reasonably broad alpha-seeking remits, Hopper monitors his outsourced managers carefully lest they succumb to the temptation to be “overweight investment-grade credit and call it ‘alpha’ when they outperform a composite index”. After a build-up in cash and fixed interest allocations that was “part relative performance and part deliberate strategy”, Hopper has seen some redirection of AustralianSuper’s balanced portfolio back into equities during his four-month tenure at the scheme. The fund is well-disposed towards assets with the most to gain from cyclical economic recovery, which does not include developed market Treasuries and government bonds given the stimulus-sapped fiscal position most find themselves in. Hopper says it’s one of those rare occasions where the fundamentals of some emerging market sovereign and financial issuers are stronger than their developed counterparts, given the lessons they learned from the Asian and Latin American crises.

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