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IN FOCUS
While equity fund managers like to focus on the upside of the securities they invest in, bond fund managers are fixated on the potential downside. Simon Hoyle reports.
FALL THAT’S GONNA YOU KILL
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pare a thought for the fixedinterest investor. When they invest in a bond, the best they can really hope for is to get regular income payments, and then their money back. At worst, they can lose the lot. In investment speak, this is called an asymmetric payoff: the potential downside more than outweighs the potential upside. This contrasts with equity investors, who likewise can lose the lot if things go really wrong, but whose upside is theoretically unlimited. And so it’s hardly surprising that fixedincome managers view the world quite differently from equity managers. It is perhaps summarised by the statement that fixed-income investors focus on what could go wrong; equity investors focus on what could go right. Another issue that differentiates the two world views is that diversification plays a much bigger role in fixed-income investing. When you have 100 per cent of your capital at stake in a particular fixedincome security, and virtually no chance of increasing your capital (assuming it’s held to maturity), you’re naturally more risk averse than someone who might have 100 per cent of their capital at risk in a particular stock, but who might also hold another stock that could increase significantly in value. Jeff Brunton, AMP Capital’s head of credit markets, says diversification of a bond portfolio is therefore even more important than an equity portfolio. “The key difference is that the return pay-offs for bonds are just so asymmetric. We buy a bond at $100 and par, and the best thing that can happen to us is the bond pays our coupons when due and then we
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get the $100 back at the end, at the maturity of the bonds. That is the best thing – that’s the upside. The downside is the bond defaults, and we get nothing back. “Unlike equities, where you might pick one or two dogs out of a 40-stock portfolio and you might lose 20 or 30 per cent on those wrong bets, you’re more able to find one or two that might double your money to compensate; whereas in bonds there’s no way to find one that’s going to go to $200 from $100 to cover one that drops to zero. There’s no way you can find a rising bond to compensate for a falling bond. “That means downside risk management is the focus for a fixed-income manager, compared to equities, where it’s more a matter of what could go right. We’re more about what could go wrong. It’s a very different view of the world. “And so diversification is really a free kick. It’s such a free kick in bonds compared to equities because of that downside risk. Bonds can fall a lot in price, because defaults occur. And defaults, particularly in investment-grade companies – companies that are solid, highly-rated and would sit in most of our fixed-income portfolios – are rare, but they happen without warning, really. “What’s much more likely is an investment-grade company falling out of favour with changing tastes and preferences and becoming a high yield company and trying to turn it around and eventually going into bankruptcy. You’d be thinking about General Motors, Yellow Pages businesses around the world – I mean, who uses Yellow Pages now to do a search, compared to Google? You could be the best company in an industry that just
UNDERWEIGHT BONDS? Cliff Asness, the founding and managing partner of AQR Capital Management, says investors need to pay more attention to where risk resides in their portfolios. Asness says that, put simply, if capital is allocated 60/40 between equities and bonds – not an unusual asset allocation – then many investors will consider it to be balanced. But if the risk of the portfolio is analysed, it will be seen that the risk associated with equities completely swamps the risk associated with bonds. AQR’s research suggests that a portfolio allocated by risk, rather than by capital, can produce better longterm, risk-adjusted returns. A typical portfolio has an over-reliance on equities – which is another way of saying it is underexposed to other asset classes – and as a result is exposed to a disproportionate amount of risk. Equities are something like four times more risky than bonds. “If you think that risk is justified, you have to believe the risk-adjusted return from equities will be eight or nine times that of bonds,” Asness told the AQR University in Melbourne last month. AQR’s latest research suggests that both bonds and equities currently are overvalued, and that an equal allocation of risk to bonds, equities and commodities will provide a superior risk-adjusted return over the long term.
goes out of fashion. Who was the best beta video-cassette manufacturer? Are they still around?” Brunton says changes in preferences and the tastes of consumers, and changes in regulatory environments, are difficult to predict. Bond managers spend a lot of time trying to do just that, though, as a riskmitigation strategy. “But the markets reward you for really diversifying well, and not putting more than 2 to 3 per cent in any particular bond
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– and on average holding much less than that,” Brunton says. “And that’s a free kick, because if you get it wrong and that company defaults, or the bond falls a lot in price, rather than losing a big portion of your money, you’re only losing a little bit.” In an equity portfolio, the bulk of the benefits of diversification can be achieved with just a dozen or perhaps 15 stocks. Not so in bonds, Brunton says. “You look at the concentration that Australian equity managers put up with in the ASX 200, where the biggest six stocks – the four majors [banks] and the two miners – make up 42 per cent of the index. That’s six names. “Maybe that argument holds in equities, but definitely not in bonds.” Jonathan Armitage, acting chief investment officer for MLC Investment Management, says there is currently little evidence of investors reallocating money held in bonds to investments in equities. If anything, he says, money is going the other way, following a reasonable performance by equities over the past 12 months. Investors whose allocation must remain within certain limits are taking profits and reallocating the proceeds. “We haven’t seen real rotation out of fixed-income products,” Armitage says. “But what has been interesting is people have been buying equity-type products, and given the suite of products we have, we have a bit of granularity about that. “What’s also interesting, not just from what we can see internally, but we know [from] competitors, is things like margin lending have picked up. “CommSec, I think, are normally a couple of per cent of ASX flows, and there have been a couple of days [in February] where it’s been multiples of that – four or five times; and that’s quite interesting. “It may be that there are other things going on, and CommSec’s business model is evolving to be more institutional, but I thought that was interesting.” Armitage says that data from the US suggests investors are not bailing out of bond funds.
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“You have not seen sales of bond funds, you’ve just seen the amount of money has been slowing down,” Armitage says. “Equity market mutual funds have really picked up, but a lot of it just seems to be coming out of cash.” Armitage says there are institutions reallocating from equities into bonds. “There’s a couple of organisations that have fixed allocations for equities and bonds and so on, and given the very strong performance you’ve seen out of equity markets, if anything the readjustment will be out of equities into bonds,” he says. “There are a number of big institutions in Europe and the US where they’re pretty much mandated to keep those allocations within set parameters. “Their own systems are going to be saying that they need to sell equities to buy bonds.” Those who are quick at mental arithmetic will have worked out that if a fixed-income manager is not putting more than about 2 per cent of their portfolio into any single security, they must hold at least 50 securities in their portfolio. Brunton says AMP typically holds between 50 and 100 securities in a portfolio, which suggests a substantial research effort behind the scenes. And bear in mind that earmarking a security as fit for investment is only part of the job. There’s the ongoing job of monitoring and regularly reassessing each and every security in the portfolio. Brunton says fixed income analysts “need to follow the company”. “That means going to see the company at least once a year, listening in on earnings calls, every morning walking in and surveilling all of the news that has happened overnight and during their day to make sure that that particular company hasn’t made an announcement or there hasn’t been an announcement made by a relevant peer company that will impact upon that company,” he says. “All of that information is obviously very important to understanding and predicting how the financials of that company will perform while we own the bond.”
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YOU HAVE NOT SEEN SALES OF BOND FUNDS, YOU’VE JUST SEEN THE AMOUNT OF MONEY HAS BEEN SLOWING DOWN. EQUITY MARKET MUTUAL FUNDS HAVE REALLY PICKED UP, BUT A LOT OF IT JUST SEEMS TO BE COMING OUT OF CASH
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Brunton says the point is to try to pick up changes in a company’s strategy – things like merger and acquisition activity, sales in major business segments and management changes. “There might be the loss of a major client or there might be a joint venture, costs might be rising or falling in the company,” he says. “There’s a whole lot of stuff that can happen that is really a combination of bottom-up factors - factors that are relevant to that individual company or industry; and there’s a whole range of topdown factors that need to be surveilled. Is the credit cycle changing? What do monetary and fiscal policy mean for the overall level of growth or inflation in the economy? How will that impact on the spreads of all credits?” Brunton says an individual fixed-
income analyst will typically cover more companies than an equity analyst, and AMP’s analysts actively cover 35 to 40. “Then they’d have another 10 to 20 names that are being surveilled, but less closely because we don’t own them, but they’re relevant for comparing the companies that we do currently own,” Brunton says. “Equity analysts would do 10 to 15 companies, know them in a lot more detail, and would be more focused on the profit and loss statement, in terms of the financial statements that are relevant, because they’re more focused on trying to think about the future earnings of the company and what multiple the market will pay for those earnings. “We’re more focused on cash-flow statement and balance sheet – interest coverage ratios, gearing ratios, the amount of free cash flow generation.”
WHY ADVISERS MAY NOT BE BEST FOR DIRECT INVESTMENT Stuart Piper, debt portfolio manager for MLC Investment Management, says his company would be “the last people to denigrate financial planners”, but he seriously doubts whether many – if any – are properly equipped to offer direct fixed-interest investment options to clients. “The difference between…equity markets and fixed-income markets is that the fixed-income markets are over-the-counter markets,” Piper says. “They are not visible, apart from just very vanilla government bond markets, and they’re not very transparent. “For your average SMSF [self-managed super fund], they are not in a strong position to know [what’s what]; whereas if you’ve got a listed stock like BHP or something, you’ve got [a large] amount of information. “Hybrids are probably the best example of what you’re talking about. We’ve got nothing against hybrids, and financial planners recommending hybrids, except it’s even more the case among hybrids that not all hybrids are created equal. “Some hybrids can have a final legal term of 30 years. The assumption is that they’re going to be called and pre-paid within seven years, but not necessarily. They have got to refinance, and if the refinancing requirement happened to coincide with the GFC [global financial crisis], all of a sudden these things become a very long credit instrument, and
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they’ll behave like equity, and they’ll become illiquid. So you’ve got to be careful about hybrids. “So my view is that they are better off encased in a well-managed bond fund, properly described, et cetera, et cetera. I think that’s a better solution – just assuming fees and all that are OK. That’s what I would do. So I’m very sceptical about how successful [direct investment] can be.” Piper says another issue facing individual investors is that they struggle to achieve genuine diversification in the fixed-income part of their portfolio, because each individual investment requires so much capital. “A lot of these people would have very concentrated portfolios as a consequence,” Piper says. “They’d buy their $100,000 of AGL or hybrids or whatever, and it would be a big chunk of their portfolio, absolutely. “So I’m very sceptical about [direct investment]. I think if someone wants to go and buy NSW Treasury Corporation, or walk up to the Reserve Bank and fill out the forms and say give me an inflation-linked bond, no problem. What you see is what you get. “Once you go outside of the vanilla government – as in high-quality government – liquid markets and you go into credit or credit-related stuff, it’s a different kettle of fish.”
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