10 February 2010
Capital stable fund managers have ditched the exotic hybrids that typified the bull market.

A trend that will please conservative investors with money in capital-stable superannuation portfolios is that investment managers are taking a much more cautious approach to the management of their funds. Capital stable fund managers have ditched the exotic hybrids that typified the bull market.

A trend that will please conservative investors with money in capital-stable superannuation portfolios is that investment managers are taking a much more cautious approach to the management of their funds.

It is back to basics as the hybrids, structured assets and high-yield corporate securities that were the cause of big losses in fixed-interest portfolios in 2007 and 2008 are tossed out in favour of high-quality liquid assets.

Many investors found to their cost that being in capital-stable funds was not the haven from the fallout of the global financial crisis they hoped it would be. Government bond and investment-grade corporate credit markets performed well in 2008, as equity markets collapsed, but investment managers could not deliver these returns to their investors because they had loaded up on exotics.

The investment director at Omega Global Investors, Mathew McCrum, says: "During the heady pre-crisis days an appetite for increasingly leveraged versions of fixed-income securities took root. Many investment managers began avoiding traditional fixed-interest investments as unfashionable.

"The result was that many investors had no part of their portfolio generating positive returns throughout the crisis period. Investing in defensive assets should be based on controlling the downside risks by investing in investment-grade bonds and being highly diversified."

The UBS Composite Bond Index, the benchmark for securities traded on the Australian fixed-interest market, rose just 1.7 per cent in 2009. It was a sharp decline from the 2008 result, when the index rose 15 per cent and was the top-performing asset that year.

Despite these sharp fluctuations Australian fixed interest has been a sound investment over the long term. According to Russell Investments, the average return has been 10.4 per cent a year over the past 30 years and the average risk has been 7.1 per cent. Risk is measured by calculating standard deviation, which is the level of movement above or below the average return in any year.

According to Russell, Australian shares have returned 14.9 per cent a year over the same period but the average risk has been 23.6 per cent. Cash is the most stable asset, with an average return of 8.9 per cent a year and an average risk of 4.2 per cent.

According to SuperRatings, median return for capital-stable superannuation funds was 8.9 per cent last year and the top-performing funds produced returns of between 10 per cent and 15 per cent (see accompanying table). Capital stable funds have a high proportion of fixed-interest assets in their portfolios.

Intech head of fixed income and currency, Brad Bugg, says investors can expect a better return from fixed interest this year. Bugg says the 2009 result was driven by the bottoming of the interest-rate cycle and bonds coming under pressure as investors anticipated the next round of interest-rate increases and a return of rising inflation.

Bugg says: "At first glance it would appear that there are many factors that point to further pressure in 2010, most notably the prospect of further rate rises by the Reserve Bank over the next 12 to 18 months. Increasing issuance of debt securities by the Commonwealth and the states will put further pressure on yields.

"But the markets have largely pre-empted the RBA's course of action and we do not expect any more dramatic repricing. The scale of demand is in question but we see two potential sources of new or increased demand.

"The first is the removal of interest withholding tax, which was brought into law in late 2009 and is expected to bolster demand for Australian bonds offshore. The second is the Australian banking regulator's proposed changes to bank liquidity, which will require banks to hold more government bonds.

"If we factor in slightly higher yields from now, we think 2010 Australian bond total returns are set to show a significant improvement on 2009."

Omega's McCrum says he is investing in high-quality corporate credit securities, which provide a higher yield than government bonds but still have low volatility. He says the key with such securities is to be well diversified.

The chief executive of Pimco Australia, John Wilson, says the investment outlook favours bonds over growth assets. Wilson says: "The new normal includes lower and slower economic growth, higher risk premiums and ongoing volatility."

In fixed-interest markets Wilson expects that default risk will increase (the risk that corporate credit issuers will not pay interest on their debt securities). He says this will require constant monitoring if investors are holding corporate credit.

He agrees with McCrum that corporate credit will produce better returns than government bonds, which are likely to underperform because of the high level of new government borrowing prompted by the crisis.

How bond portfolios are made up

The term bond portfolio is a bit of a misnomer. Bonds are debt securities issued by governments, while credit is the term used to describe the debt securities issued by companies. Credit dominates most fixed-interest portfolios these days.

The benchmark for fixed-interest fund managers is the UBS Composite Bond Index.

Its make-up includes: Government bonds, about 20per cent. Semi-government bonds, about 30 per cent. Corporate credit, about 40 per cent. The balance is made up of sovereign fund assets and non-investment-grade corporate debt securities.

Source: John Kavanagh, Sydney Morning Herald