A divergence in the performance of economies around the world is creating fresh opportunities for active management of fixed income portfolios, the Investment Magazine Fiduciary Investors Symposium has heard.
But even as that happens, it is creating new challenges in creating products for superannuation fund members.
New Capital senior portfolio manager and head of fixed income Michael Leithead told the symposium that “we’re at an interesting point in time”.
“I can see room for global divergence,” he said. “And I think in terms of benchmarks, there are opportunities for active management.”
Now, in a more normalised interest-rate environment, Leithead said, the main change to managing fixed income is that “higher yields bring new opportunities and bring back asymmetric risk”.
“There’s quite a lot of opportunity that’s emerging from the divergence in economies,” he said.
“That means that when it comes to portfolio construction, don’t think about benchmarks as being your portfolio construction tool, think about them as being your risk framework.
Leithead said if investors follow global bond benchmarks they would be “essentially 40 per cent allocated to the US where there’s an argument…that, actually, fiscal stimulus is pretty inflationary; you’re 10 per cent allocated to Japan, which is really struggling with monetary policy and yields are low; [and] 10 per cent to China, where arguably, we’ve seen a decoupling in terms of global cycle [and] there’s not been that synchronization with the global cycle, and inflation has been is very low”.
This means 60 per cent of a global fixed income allocation is sub-optimal, Leithead said, which presents opportunities for active management and deviation from benchmark, and a chance to rethink the role of fixed income in multi-asset portfolios.
Leithead said that for the past five to 10 years investors have operated in a “very credit-driven environment”.
“What’s changed in the last four years or so – and it’s been very challenging for fixed income managers – is the interest rate environment, and where we lie in terms of the volatility spectrum there.
“If you look at the past four years, really fixed income, in the conservative sense of the word, has been a return-free source of risk. But I think we’re at a point now where yields are that much higher, and volatility is likely to come down, that fixed income has a place in a multi asset portfolio.”
“And finally, I would say from an active management perspective, there’s plenty of opportunities both in terms of the asset allocation level and from the selection basis.”
Rethinking fixed income
Leithead said when an investor takes a multi-asset-class view of the world “and you’re trying to diversify your growth risk, actually this is where fixed interest can play a bit of a bit of a role within your portfolio”.
“What’s changed in the last four years Is it really that we’re now in potentially a more normalised interest rate environment. We’ve seen interest rates go to more restrictive, more normalised levels. That means central banks have much more room to cut rates going forward [and] I think fixed income becomes a more predictable asset class than it was under, say, a QE environment.”
As the fixed income environment normalises, it’s causing a re-think among asset owners about how they create products – or investment options – for their members.
The traditional characteristics of fixed income – as diversifier, providing core yield and low volatility – and its correlation with inflation meant the asset class has “ended up in the low-risk products at the bottom of the investment menu”, Brighter Super chief executive and former bond fund manager Kate Farrar said.
“And people were really happy to put that into something that was nominally multi-asset-class, but actually had a lot of fixed income in it, and despite that still took on CPI-plus investment option targets,” she said.
Farrar said the Your Future Your Super performance test made credit, in particular, an important part of how funds built up relatively low-risk buffers over time.
“You could have short duration – was great for rates at the time; very stable credit margin, really, over the long run; didn’t have its own sub-asset class so it could be part of fixed interest; and you could just get the core yield and build up your buffer,” she said.
But two years on, and in the shadow of the performance test, “most portfolios have worked out how to be managed against the test and have built up a lot more buffer than they ever had before”.
“If we roll forward to this new environment, and we look at the question are traditional bonds really back, I’m going to take a leaf out of [an earlier panel discussion] and say yes, and no.
“First of all, I think there is a case for yes. And that is really that people are actually unwinding the significant shift towards illiquid credits that had occurred a couple of years ago, because you’ve got…much better yields. You can get really good yield for much better credit quality, and it also helps with your liquidity.”
In that sense, there is “a real argument that traditional bonds are back”, Farrar said.
“But from a product construction perspective, I also do think that there’s a case for no,” she said.
“Because of the extra duration, because of the extra volatility and because in historic standards, even though…forward returns [are] still only moderate at best [and] even though it’s the peak of the credit cycle, the standard risk measures have actually gone up for all of our products.”
Farrar said it is very difficult to explain to a member why their supposedly low-risk investment option has lost money.
“Secondly, because fixed interest has actually not performed well over the medium-term historical horizon against CPI-plus [objectives], in fact, people are looking at their CPI-plus inflation-linked objectives and making some changes – we’ve just done this throughout our low-risk product – to market linked objectives,” she said.
Farrar said in this environment it is doubtful whether a market-based fixed-interest benchmark will deliver what members need and expect, and there’s an argument for considering other assets – like infrastructure – to deliver the required risk and return characteristics.
“Whether you think traditional bonds or traditional fixed income is back, there is a case for yes, and I think there’s a case for no,” Farrar said.
“As always, it’s much more nuanced than you expect. As a former bond fund manager, I have got to say I’m pretty excited to be thinking about all these very interesting things in the asset class.”
Changing risk profile
Australian Retirement Trust senior portfolio manager Greg Hall said the majority of fixed income allocation is in products or options supporting members approaching or in retirement, or post-retirement when they’re looking for stable, reliable income.
He said the post-COVID ART went through a phase “where standard risk measures did have to be reviewed, and to a degree the objectives as well”. He said ART was created from two legacy funds that had both, at times, “offered conservative options with a cash-plus objective, and we did have a very hard think about that in the last review of objectives”.
“Certainly in a basis-risk sense, I think it makes more sense to couch some of those conservative options against a cash-plus objective [rather] than CPI,” Hall said.
“The interesting challenge you get [and] some of the testing and feedback we got back was well, yes, you can offer a cash-plus option, but the rest of your suite, particularly MySuper, is couched in CPI-plus [terms], and so how are you going to help members make those comparisons, and is it worth better communicating your conservative option, but also making it more challenging for them to evaluate that against others?
“That’s, that’s not an easy decision to make, ultimately, and we ended up with a low CPI-plus objective continuing. Neither is perfect. As an objective, CPI-plus is a large basis risk for any option and it’s a guide more than it is an objective, but that’s not how it’s couched by those who set the standards.”
Avant Mutual chief investment officer Craig Lamb said the firm doesn’t treat fixed income as a discrete asset class in its portfolio, but rather is “a total-portfolio investor”.
Lamb manages about $2.2 billion in insurance companies regulated by APRA, and in other companies – Avant is a mutual organisation owned by doctors – but unlike ART and Brighter Super, adopts an asset and liability matching (ALM) strategy that focuses on risk premia and “what sort of risk premia do we want across both our portfolios?”.
“We also have top CPI-plus objectives in the [APRA-regulated] insurance company,” Lamb said. “It’s an ALM return objective of CPI plus 1.75 per cent. For our unconstrained non-regulated portfolio, it’s CPI plus 4 per cent.
“When we’re thinking about fixed income, it’s important to remember that there are different aspects of fixed income, different decisions one has to make. You’ve obviously got the distinction between public and private debt instruments. Then you’ve got fixed, floating, inflation-linked. On top of that, you’ve got risk-free or sovereign bonds, and credit. And then within fixed, you’ve got different duration; and within credit, you’ve got different credit duration. It’s actually quite a complex issue.”
From a risk perspective, Lamb said, “fixed Income is risky”.
“If you look at volatility of fixed income at the moment, relative to long term averages, it’s actually very elevated,” he said.
“You look at volatility in equity markets relative to long term averages, it’s actually probably below average. In a relative sense, fixed income is actually quite risky in that regard.
“We don’t certainly see fixed income as a great diversifier. But we can certainly see the attractiveness of fixed income in terms of the yields it offers.”
This article was edited on 26 May 2024 to clarify the regulatory status of Avant group entities.
