Jeff Brunton
Head of Credit Markets

So much for the ‘great rotation’ from cash to equities: 81% of institutional investors plan to remain in fixed income this year, according to the latest AMP Capital Institutional Investor Report (May 2013). The challenge is not to rotate out of fixed income, but rather to identify and switch to the best returns on offer from this proven asset class.

Economic conditions remain uncertain and governments around the world continue to adopt monetary policy that is supportive of low interest rates. With continued troubles in Europe, as recently exemplified by Cyprus, European fixed income investors are increasingly looking abroad.

Investors such as institutions with set pension liabilities, or insurance firms need to invest in assets that have a steady rate of return with stable capital – such as fixed income.

So, rather than a move out of bonds we are seeing a shift in the type of fixed income that is in demand.

One reason is that the economic environment has seen spreads compress on many fixed income products to historic lows. For instance, several government bond rates are at levels below the rate of inflation. This means investors are losing money in “real” inflation-adjusted terms from investing in these bonds. Consider that a US 10-year bond is offering 2%, inflation could be higher than that. As soon as you buy that bond you are arguably paying a tax to the government for the privilege of owning their paper.

The market term for this phenomenon is “financial repression”; a method used by indebted governments to cut their deficits, as they are able to hold down their borrowing costs while rising prices reduce the “real” size of their debts. This means that the government bond markets today are distorted actions of central banks and finance ministries.

This demonstrates how the objectives of fixed income investors and those of central banks may diverge in the short-term. Most central banks are aiming to boost growth and employment, and low interest rates are one way to do this.

Some sovereign wealth funds and central banks can only hold high-quality bonds, while banks and insurance companies are required by regulators to hold government securities. No matter how low the yield, these investors are compelled to buy bonds - and they are looking for places to diversify into.

There are a few markets that are offering these sovereigns and insurance firms positive returns.

BLOOMBERG 13 March 2013

Credit markets are in uncharted territory as the global recovery is threatened by a mismatch between companies hoarding cash and record government debt, said Australia’s top-ranked bond manager.

“It’s pretty clear that the credit cycle is still broken,” Jeff Brunton, head of credit at AMP Capital Investors, said in an interview in Sydney this week.

....The AMP Capital Corporate Bond fund has delivered the best return among Australian fixed-income peers over the decade to Jan. 31, offering an average annual gain of 7.2 percent, according to Morningstar Inc. rankings. Over the same period, investors in Aussie corporate notes earned an annualized 7 percent, a better performance than any other developed market tracked by Bank of America Merrill Lynch indexes.

....Brunton has been head of credit at AMP since January 2008. The fixed income team manages more than A$44 billion out of the company’s A$128 billion in assets. Brunton previously worked at Queensland Investment Corp. in Brisbane as head of global credit and as head of Australian fixed interest and cash.

AMP Capital’s corporate bond fund also delivered the best return over a three-year time horizon and the secondhighest in the year to January, according to Morningstar. It handed investors an 11 percent return over the 12 months, behind only the 11.3 percent gain on the Macquarie Core Plus Australian Fixed Interest Fund, the data show.

AMP beat its competitors in recent years by buying debt sold by UK, French and Swiss banks, and going overweight into 5- to 10- year notes sold by Australian property companies and utilities.

The case for corporate bonds

We are currently in a ‘de-synchronised’ credit cycle: sovereigns in Europe and the US are beset by rising debt and deficits. In contrast, most corporate borrowers are in the “recovery” stage of the credit cycle, in which debt is falling and profits are positive.

While governments and banks are displaying high debt levels, corporates have much healthier balance sheets. However, corporate issuers are not being rewarded for their healthier balance sheets, and credit spreads (the excess yield offered by corporate bonds over government bonds) have subsequently remained higher than normal. Because a number of governments are yet to go into ‘repair’ mode, they are effectively contaminating the strong parts of the market (corporates), which means that these issuers are offering superior yield for risk.

The excess yield on corporate bonds over government debt is likely to remain elevated for the next three to four years, largely due to perceived risks generated by ongoing global government debt issues. The European sovereign crisis is expected to take many years to resolve. In a number of European countries, such as Greece, Spain and Italy, debt to gross domestic product ratios remain high, signalling that these governments will continue to run up debt for at least the next two to three years. Despite the largest cuts to government spending in a generation, the US is still faced with a large debt that it needs to reduce.

The excess yield on corporate bonds will provide an ongoing source of income for investors. And while we believe total returns from corporate bonds will be muted compared to previous years, they should still be higher than the return an investor can expect to achieve from government bonds and term deposits.

Again, Australia has been favoured by investors, due to the high yields on corporate debt issued by companies with good credit ratings.

To take advantage of a regular income stream from bonds, as well as reduce the risk of capital loss, investors should look towards an actively managed bond fund as opposed to investing directly in bonds.

Which markets offer the best fixed income returns?

If you look at all the developed bond markets, the higher returns over the past year have come countries including Australia, Belgium and New Zealand (year to 31 March 2013 according to Bloomberg).

In fact, Australian corporate bonds have outperformed any other developed market tracked by Bank of America Merrill Lynch indexes over the past decade - returning an annualised 7% a year (over the past 10 years to 31 January 2013).

Should you be looking at fixed income from down-under to increase your fixed income returns?

Australia is one of the few developed bond markets where investors are not being “repressed” and remains one of the last vestiges of value in sovereign markets. The bond rate and the rates bank pay on cash are above Australia’s inflation rate of 2.2%.

One reason for the strength in Aussie bonds, as they are known, is that Australia avoided recession during the Global Financial Crisis and Moody’s recently described its credit rating as one of the strongest in the world. Australia is one of only seven countries with a coveted AAA-rating with stable outlook from all three global rating agencies.

Foreign central banks are the most important investors in Australian fixed income, with a 27% market share. This is up from about 10% a decade ago. And they hold over 75% of commonwealth government bonds.

But most investors aren’t restricted to government bonds. They can also invest in corporate bonds which have tended to provide a greater return than government bonds over the past few years.


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