Fixed income is about more than yield
It is difficult to pen a one-liner to explain why people invest. A good place to begin is the desire to accumulate wealth over time. An investor wants the money he or she tucks away for retirement today to be worth more when it is needed 30 to 35 years he
Investors, financial advisors and asset managers rely on four basic asset classes to achieve their investment goals, namely bonds, cash, equity and listed property. The mix of these assets within a portfolio varies depending on the requirement of the investor or advisor and the mandate of the asset manager. In each case the investment decision is a trade off between risk (to the capital) and return (capital growth and yield). We can explain this trade off by considering categories in South Africa’s Collective Investment Schemes industry. Average Joe can choose his unit trust fund from four domestic fund categories, ranked from highest to lowest risk as follows: equity, asset allocation, real estate and fixed interest (income).
The art of generating fixed income...
South African investors are generally risk averse. At 31 March 2012 some 41% of the domestic unit trust industry’s R977 billion in assets were invested in fixed interest funds, which include bond, income and varied specialist sub-categories. To find out how flexible income fund managers generate income in excess of the additional capital risk they take on, we attended a presentation by Conrad Wood, Head of Fixed Income at Momentum Asset Management. He told the audience at the recent Momentum Investments’ Independent Multi-Manager Conference (held 15 May 2012) that fund managers in the flexible fixed income space could not focus on yield alone. He also observed that it was more difficult to generate yield in the current economic climate due to continued global financial repression and central banks’ high tolerance for inflation, among other factors.
“Inflation is one thing that will help governments to manoeuvre out of the leveraged debt conundrum – they will maintain interest rates at record low levels for longer than they should and engineer policies that will generate higher inflation,” he said. South Africa’s interest rate policy mirrors that of its developed world peers, with our prime rate “stuck” at 30-year lows. The challenge for fixed income portfolio manners is to mix and match the five fixed income building blocks for maximum performance under this “lower for longer” environment. “The five instruments mentioned below all offer reasonable yield and income – unlike cash which currently offers negative real returns,” observed Wood.
The cornerstone of most fixed income portfolios is the nominal (or government) bond. “Nominal bonds are trading at fair value at their current 8% yield,” said Wood. He noted that Momentum Asset Management believed a fair range for government paper was between 7% and 9%! Bond yields have come under pressure thanks to unprecedented buying of domestic bonds by foreign investors – with the result the asset class yielded some 8.8% through 2011. Although bonds must make up part of a fixed income portfolio there are a number of headwinds building up in the market. As soon as the yield on 10-year US Treasuries corrects to between 4% and 5%, where they should be trading, local bondholders can expect sharp capital losses.
Introducing bonds on steroids!
The second fixed income building block mentioned during Wood’s presentation was inflation-linked bonds. “These bonds offer diversity, hedging and correlation benefits that are extremely useful to fixed income portfolios,” said Wood. The only drawbacks are that they exhibit extreme capital volatility and are highly sensitive to moves in real interest rates. Inflation-linked bonds perform optimally when real yields are falling. This explains the 15% return generated by this fixed income class over the past year. “We are in a perfect storm thanks to global financial repression (which will keep real rates low for some time) and high inflation – the two factors that drive return on inflation-linked bonds,” he said. A diversified fixed income portfolio should include a healthy “slice” of inflation-linked bonds.
Fixed income fund managers include credit (the third building block) in their portfolios too. Wood opined: “Barring event risk we expect credit spreads to remain range bound. You can generate 120 basis points more than government paper – a fair risk / return trade off.” He admitted that the group used quite a lot of credit and yield enhancements in their portfolios. But Momentum is not keen on the fourth fixed income building block, listed property. Although this investment category boasts solid defensive properties Wood was not enthusiastic about backing a product showing a 14.3% annual compound return for the five years ending 31 December 2012. Listed property delivered a staggering 26.9% total return in 2010!
The fifth and final building block available to fixed income specialists is preference shares. “There is no strong incentive for us to include preference shares as a tax-uplift in our portfolios,” said Wood. He said this mechanism was best utilised by individual investors pursuing a buy-and-hold after-tax investment strategy. Investors must take cognisance of the fact preference shares are floating rate products that exhibit massive capital volatility. If you buy this product at the wrong point in the interest rate cycle you can easily lose 10% or more of your invested capital!
A waiting game
The massive liquidity injected into global markets in the wake of the credit crisis has created an abnormal underpin for the fixed income market… Although it is acceptable to take risks in the current market flexible income fund managers must take note of the capital risk posed by the looming rising interest rate cycle. “When the cycle turns – and it will – flexible income portfolios will have to position more carefully than they have in recent years,” concluded Wood.
Editor’s thoughts: One of the themes repeated at the Momentum Investments Multi-Manager Conference was “cash is trash”. There are plenty of fixed income investments that offer better total returns than that on offer in cash investments such as money market funds (which currently offer negative real returns). Are you concerned about the possible capital destruction in fixed income products when the next rising interest rate cycle begins? Add your comment below, or send it to [email protected]
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