By Tim Hewson
18 March 2009
With the global recession expected to deepen throughout 2009, investors continue to seek safe-haven investments to protect their portfolios against further downside risk.
So it's no wonder many investors continue to check their rear-view mirror when it comes to analysing last year's best performers to help them navigate the perils of the year ahead.
According to Morningstar data, Australian Bonds generated 14.95% for the 2008 calendar year and outperformed the worst performer, Australian Listed Property (A-REITS), by more than 70%.
But a word of caution, whilst Fixed Income managed to deliver double-digit returns, not all funds generated the types of returns you would expect from this traditionally overlooked asset class.
What's in a name?
Fixed Income is really nothing more than a generic term used to describe a very broad range of securities that share a common characteristic.
The Fixed Income funds available via RaboPlus buy, sell and trade public debt securities, such Bank Bills, Commercial Paper (CP), Treasury Notes (T-Bills), Australian and Global Bonds (Government and Corporate), Floating Rate Notes (FRNs), Asset Backed Securities (ABS), Mortgage Backed Securities (MBS - including RMBS and CMBS), Convertibles, Hybrids, Preference Shares, structured debt, such as Collateralised Debt Obligations (CDOs), and derivatives, such as Credit Default Swaps (CDS), as well as private debt securities, such as those in infrastructure.
Ultimately, the more aggressive investors are in their quest for returns, the more complex and sophisticated the securities are required to be in order to deliver the types of returns investors have become accustomed to in recent years.
Fixed Income is no longer the boring asset class it was once perceived to be. It now performs the vital tasks of protecting capital, diversifying a portfolio and dampening volatility, creating exposure to assets that are unattainable in other asset classes and generating income.
Putting it into context
The first thing you notice when you look at the Fixed Income funds available via RaboPlus is that there is a broad mix of funds covering Australian Bonds, International Bonds, Diversified Fixed Income (Australian and International), Credit, Income, Mortgages, Diversified Credit and Multi-Strategy funds.
Importantly, the investment management strategies and the assets invested in may vary dramatically from fund to fund.
Looking at the performance table below, there was more than a 55 % difference between the best and worst performing funds for the 12 months to 31 January, 2009.
Table 1: Fixed Income funds offered through RaboPlus
Source: Morningstar
Performance data effective 31 January 2009
*Funds currently On Hold
Whilst some of the variation in performance can be attributed to income generated by the fund assets, the majority of the variation has occurred as a result the fluctuating capital value of the underlying securities.
Higher yields have led to higher prices and the end result is a daily marked-to-market security that suffers from a significantly reduced capital value the lower the credit rating and the higher the credit risk.
About Aussie Bonds
The UBS, Tyndall, BT and Schroder Australian bond funds predominantly invest in Australian Government and high grade corporate bonds, but may also invest in ABS and MBS, structured debt securities CDS, hybrids as well as US and European bonds.
Each fund differs in strategy, benchmarks, and return objectives, and this explains why overall performance diverges.
Of course, the more conservative and 'high grade' the investment focus of the fund, the better the performance was during 2008. The Tyndall Australian Bond Fund is one example.
But funds with a slightly broader mandate, which invested into sub-investment grade debt, hybrids, emerging market debt as well as US and European bonds, under-performed.
What about Global Bonds?
The UBS, Tyndall, BT, and AMP international bond funds exhibited a 23.52% gap between the best and worst performing funds.
Again, conservative funds which focused on high-grade credit were less vulnerable to widening credit spreads, compared with those investing further down the credit curve.
Funds that also hedged their global exposure, tended to do better as the Australian dollar slumped from a high of 98.49, to 60.04 in USD terms during 2008.
In this category, the UBS Diversified Fixed Income Fund ranked the best, maintaining a 70 % allocation to domestic Fixed Income with the balance allocated globally and hedged back to Australian dollars.
In contrast to Australian Bonds, global bond funds derived the majority of their return from the income returned on the underlying assets as the value of global assets typically under-performed and generated negative returns.
There's no place like home!
Mortgages funds had a reasonable 2008, despite widening credit spreads, the collapse of the securitisation market, increasing defaults and restricted liquidity.
The overall disparity between the best and worst performing funds was only 6.41%.
In this category, the Challenger Wholesale Howard Mortgage Fund managed to generate a return of 7.71% and out-perform cash.
The worst-performing fund was the CFS Income Fund, which is diversified into mortgages (60%), global corporate bonds (28%), and Australian corporate bonds (12 %). The fund generated a reasonable income return of 7.08%, but the underlying assets under-performed by 5.78%, pushing the overall return down to just 1.03 %.
The CFS Income Fund maintains a relatively low exposure to income-generating residential mortgages, and is principally exposed to the retail sector (39%) - a segment which has come under increasing pressure as a technical recession looms.
Hybrid Income
Funds in this category include the AMP Enhanced Yield Fund, the Schroder Hybrid Securities Fund, UBS Hybrid Income Fund, and Challenger's High Yield Fund.
This category typically operated against the backdrop of uncertain equity and debt markets, but also suffered from widening credit spreads, depressed equity markets and conflicting global macro anomalies.
The AMP Capital Enhance Yield Fund was the only fund to generate a positive return, while the worst-performing fund (Challenger High Yield Fund) generated a return of -26.18%.
Problems for these funds include liquidity restrictions, continuing volatility in the equity and debt markets, the current historically wide credit spreads, forced asset sales and ongoing deleveraging.
Diversification remains crucial in these portfolios, and investors always need to be mindful of the impact of defaults, credit risk and equity market volatility.
And onto Diversified Credit...
Diversified Credit funds invest across a broad range of corporate securities, including ABS, MBS, bonds, swaps and structured securities, with the key objective of actively managing credit exposure to generate income.
The investment strategies of both the CFS Global Credit Income Fund and the BlackRock Monthly Income Fund aim to generate 'consistent monthly income' returns above the cash rate by investing in investment grade corporate securities.
'Investment grade' simply refers to securities with a rating from Standard & Poor's of 'BBB' or above. In looking at actual allocation of these funds, both these funds are predominantly invested in BBB and A rated securities.
Of course unprecedented volatility, significant deleveraging, tightening credit conditions, a severe lack of liquidity, and a rush to safe-haven securities has hit these funds reasonably hard, especially given changing credit conditions. Both these funds also maintain more than 10% exposure to sub investment grade assets which has resulted in significant capital losses on these allocations.
The BlackRock Monthly Income Fund generated a return of -40.25%and was exacerbated by a -45.3% capital value loss of the portfolio.
The CFS Global Credit Income Fund generated a return of -8.99% over the same period, but was not subject to the same degree of capital losses.
Any good news?
Well, if you're already invested in funds focused on the more conservative Government and high-grade corporate bonds, then this segment is expected to perform reasonably well. But for anyone invested further down the curve, your bumpy ride is likely to continue as the market readjusts to further changes.
Take a look at the Risk Ratings published on the RaboPlus Fund Selector.
These ratings provide a relative measure of a fund's standard deviation (volatility) against the 10-year performance of the asset class.
However, these ratings are only a guide, and should be used in conjunction with the risks outlined in the Product Disclosure Statement (PDS) for individual funds.
What the...?
Yes, six funds are currently 'On hold' out of 17 Fixed Income funds offered through RaboPlus.
The worst affected funds are those with mortgage exposure which have suffered severe constraints on liquidity, or those invested into structured credit securities, such as CDOs, which returned considerable losses last year.
Subsequently, many investors fled these funds as capital values deteriorated and liquidity worsened.
More recently, several fund managers have limited investors' ability to withdraw in order to prevent further outflows, which could lead to distressed sales of assets.
Of course, any change in a fund's redemption policy impacts different investors in different ways.
The key is to ensure that your fund continues to meet your long-term investment objectives.
It's important to take a three, five and ten-year view because all investments will continue to be buffeted by the global financial crisis.
Diversification is always prudent, and Fixed Income should only represent a portion of a well-constructed portfolio.
For more information on investing in Fixed Income, check out last month's Positive Interest Newsletter article on Fixed Income and Portfolio Construction and a recent Confident Investor blog on How to select Fixed Interest Funds.
Happy Investing!
