Fixed interest is more volatile than you think! Yes, it can be. Certainly the daily marked to market value means returns can move quite visibly in both directions.
There are three distinct periods for interest rates in Australia since the 1980s:
n 1980s high inflation, large amplitude in interest rate cycle.
n 1990s — transition to a low inflation economy.
n Late 1990s to today — smaller amplitude of cycle, but still much volatility.
A few observations about the current environment:
n Interest rates continue to display cyclical behaviour consistent with trends in inflation and economic growth.
n Over recent years a series of one-off events have added to that volatility, generally resulting in periods of heightened risk aversion and low bond yields.
n There is much greater transparency in RBA policy, which gives confidence in monetary policy actions.
We believe this volatility gives active managers (via interest rate management) a great opportunity to add value for investors and importantly do this in a risk-efficient way.
However, the market still over-reacts to news with excessive optimism or pessimism.
The interest rate environment in June 2003 had markets gripped by fears of deflation and worry that the US economy would remain depressed for an extended period, in spite of the massive amount of stimulus being directed against this risk.
Despite the strong performance of the Australian economy interest markets had priced in further monetary easing by the RBA and thereafter a long period of very low cash rates. This resulted in bond yields falling to their lowest level in 40 years.
Contrast this to December 2003. Deflation fears have all but receded, the global growth outlook brightened considerably and interest rates are around 150 basis points higher than they were only five months before.
This situation provided a tremendous opportunity to add significant value from adopting a defensive interest rate stance in what was a major overshoot in bond yields.
By way of example a portfolio positioned at half a year below the benchmark over this period would have exceeded the benchmark return by approximately 75 basis points.
It is this over-reaction that gives active managers the opportunity, provided they have a sound valuation process, and have the conviction and patience to let their strategies succeed.
So we think that traditional active strategies continue to have a key role to play in fixed income. If you look at the performance of active managers, two key points emerge:
The first graph shows the median manager performance from 1994 to date on a rolling three year basis. As you can see it has been on a steadily improving from around 1999.
What tells a more compelling story, however, is the right-hand graph which shows the quartile performance distribution of active managers over the past three years. As is evident, the majority of managers are above the benchmark return while first quartile managers are achieving what we consider to be quite significant excess performance.
So, prima facie, this suggests sufficient inefficiencies exist to provide active managers with opportunities to add value.
So why do we think this improvement has occurred?
n We perceive there has been a conscious change in the risk taking behaviour of managers, n They have recognised that their long-term survival is dependant upon them being able to generate a meaningful level of alpha on a consistent basis over a sustained period,
n The further development of the corporate market has created additional opportunities at both a sectoral and security level, and
n Managers are becoming more adept at managing in a lower growth and inflation environment.
— Glenn Feben is head of fixed interest with Perennial
