(August-2001): Invasion of the bond snatchers – corporate credit drives Aussie bond dollars offshore

Is your super fund an investment pioneer or luddite, and more importantly, how can you tell the difference?

Investments in hedge funds, private equity, and any number of other fashionable asset classes will earn you points as a groundbreaker, but the real test could be your position on defensive assets. Yes, boring old bonds.

Here is a simple test: If your fixed interest portfolio is still heavily weighted towards domestic bonds for none other than historical reasons, then, chances are, your investment philosophy belongs somewhere on the road between an isolated backwater and Amish country.

If not, then you may have been, at one stage, a pioneer, but you are now about to be a part of probably the clearest and most discernible trends in the asset allocation of superannuation funds.

While the growing acceptance of international equities markets by super funds has made headlines for some time, the rapid acceleration in the amount of fixed interest mandates heading offshore has been less well documented.

Figures supplied by Rainmaker Information show that international fixed interest rose from around three per cent to just over five per cent of the total asset allocation of an average super fund between December 1997 and December 2000, while Australian fixed interest fell steadily from 16 per cent to 14 per cent over the same time frame - in strategic terms, a direct swap.

But while the figures are compelling, they are likely just the prologue to a much longer and far more dramatic story.

Many superannuation funds that have recently reassessed their fixed interest portfolios have moved to a 50/50 split between international and domestic bonds, with many consultants predicting that the majority of funds will be investing as much in international fixed interest as Australian fixed interest within a few years.

Even that, however, could be just the beginning. Some funds are already beginning to consider defensive assets from a much more global perspective, and investing in Australia only so much as it fits into an international bond portfolio.

The push is largely a reflection of the Australian fixed interest landscape.

For one, while bond yields in Australia were traditionally very competitive, they are now much more closely correlated to yields in other markets. So, from a purely performance point of view, there is probably less reason at this point in time for a relatively high exposure to Australian fixed interest.

But more importantly, government debt has dried up over recent years in Australia, leaving corporate debt to make up 23 per cent of the domestic fixed interest market, up from just over three per cent in 1996.

The growing scarcity of government debt is set to continue, with the Federal Government using its latest budget to announce plans to retire another $5 billion of debt in the next financial year, reducing net government debt from around 6.4 per cent to 5.4 per cent of GDP.

But why should the emergence of corporate debt to fill the vacuum left by shrinking government issuances drive Australian bond dollars offshore?

The concern by superannuation funds, and their consultants, is that the Australian corporate debt market lacks the size, diversity and liquidity of offshore markets.

Australia makes up only one per cent of the world corporate bond market, compared to 57.4 per cent for the US and 16.9 per cent for Europe.

The 10 largest corporate issuers in Australia also account for 50.7 per cent of the entire debt market, whereas the top 10 issuers make up only 16 per cent of the market in the US.

Put simply, the Australian market does not have enough corporate debt, issued often enough, by a wide enough variety of companies to justify a significant defensive investment.

The nature of the local market is forcing superannuation funds to spend fixed interest dollars offshore, and particularly North America, where they can not only benefit from an exposure to a range of countries, but also to deeper and much more sophisticated corporate debt markets.

“It is a bit hard these days to argue why you would even have half your bond portfolio invested in Australia,” Frontier Investment Consulting managing director Fiona Trafford-Walker says.

“The big issue for us is that fixed interest is a risk play, and if you can reduce the overall risk of a portfolio by having a meaningful amount of fixed interest invested offshore, you are freer to take risk elsewhere in your portfolio.”

But the concern by superannuation funds is not only over the degree of depth and liquidity in the domestic corporate debt market, but also over the lack of experience in the sector by local managers.

The predominant view is that domestic managers, to a large extent, have not yet been able to keep pace with the rapid growth in corporate debt in the Australian fixed interest market.

“When we assess some international managers, particularly those operating in the US market, there is quite a material difference in their ability, compared to the average manager here,” Trafford-Walker says.

The median Australian credit manager has produced returns generally in line with the index over the last few years (-20 basis points over one year, 70 basis points over two years) — a level of performance widely regarded as having been affected, to some degree, by poor portfolio construction technique.

Of course, not everyone agrees with that assessment of domestic debt managers, or of the wider Australian corporate debt market.

Some investment managers, like Macquarie’s Michael Korber, argue that where investment grade credit is concerned at least, the local market offers enough opportunities and sufficiently skilled managers for super funds to put together an adequately diversified portfolio.

However, the argument (and Korber agrees) drops off when the discussion turns to below investment grade corporate debt, where the issue of diversity becomes even more critical and managers’ skill in bottom up type assessments of individual companies is the key to competitive returns.

The inability of the domestic market to meet the needs of super funds when it comes to more lowly rated debt has attracted the attention of global debt managers.

Loomis Sayles, a US$70 billion US-based debt manager with a specialty in lower grade debt — anything from emerging market to US high yield debt — is one of them.

The group set up an office in Australia last year after it was, according to Australian marketing director Karen West, constantly being sought out by superannuation funds looking for “more bang from their fixed interest buck”.

And that sums up the situation in Australia. As long as funds keep flowing into superannuation, and a proportion of those funds are invested in fixed interest, then super funds will have to look increasingly offshore for a more diverse exposure to both fixed interest markets and products. Or essentially, for more bang from their fixed interest buck.