(February-2002) Bonds sing to a new tune

Twenty years ago, super funds had a strict diet of Australian sovereign bonds for their fixed income investments. At the time, international investment, especially in fixed income, was a foreign concept to most funds and the Australian bond market was mostly made up of sovereign (or government) bonds. As a result, Australian sovereign bonds dominated most fixed income portfolios.

Due to the homogeneous nature of the market, the sole focus for fund managers seeking to add value in their fixed income portfolios was to successfully position their bond portfolios to exploit anticipated changes in interest rates. For example, a number of fund managers added significant value to domestic fixed income benchmarks throughout the 1990s by taking advantage of the downward trend in inflation.

In the middle of the 1990s, a couple of things changed. Firstly, inflation in Australia fell and, on some measures, became less volatile. This has led some to conclude that interest rates would be lower and less volatile in the future, but the magnitude of this phenomenon is still subject to some debate. Indeed, we continue to believe that value can be added to a specific benchmark by anticipating movements in the direction of interest rates.

In any case, as Australia’s inflation performance began to match that of most other industrial countries, super funds began to diversify their fixed income portfolios. In the middle of the 1990s, these funds started investing in sovereign bonds from other countries, primarily Japan, Europe and the US, alongside Australian sovereign bonds. This not only reduced risk through diversification but could also enhance returns over the long-term.

A more recent but related trend has been the move to non-sovereign bonds. As their name suggests, non-sovereign bonds include all fixed income securities not issued by a government. They include debt issued by corporations, local authorities and international authorities, such as the World Bank, and bonds issued by independent government-owned agencies, such as Australia Post or Fannie Mae in the US, as well as collateralised debt, such as mortgage backed securities.

One of the key drivers of the increasing emphasis on non-sovereign debt has been the move by governments around the world to run budget surpluses and to retire debt, thereby reducing the supply of sovereign bonds available for investors. At the same time, the growth in super funds and their international equivalents has fuelled the demand for fixed income investments.

The supply of non-sovereign bonds is also increasing. In the US, corporate bonds and mortgage backed securities have led the charge. Corporations are increasingly turning to debt as a funding tool, in part to fill the gap created by the shrinking supply of sovereign bonds and also to diversify away from traditional sources of debt, such as bank loans. Consistently low interest rates have also given corporations an incentive to lock in interest rates by issuing long-term corporate bonds.

The mortgage backed securities market grew out of a desire by banks and other mortgage financing entities to move their loans off their balance sheet.

Over the long-term, we expect the trend towards non-sovereign bonds to continue. But over the next two or three years, the growth in supply of these bonds will slow relative to government bonds. In the US, for example, the recent terrorist attacks may drive the government to temporarily push the budget into deficit, which will boost the supply of sovereign bonds at least in the short-term.

The growth in non-sovereign bonds has left its mark on the fixed income investment landscape. One of the changes is the increasing popularity of diversified bond indices, such as the Lehman Global Aggregate Index. As our charts show, the index covers more than 6,600 fixed interest securities and contains roughly half sovereign and half non-sovereign bonds.

It has also altered the make-up of other indices. In Australia, about 30 per cent of the benchmark UBS Warburg Australian Composite Bond Index is now made up of non-sovereign bonds.

All of this is good news for superannuation funds. A mix of sovereign and non-sovereign bonds has the capacity to reduce the volatility of a fixed income portfolio. For example, over the past 10 years, average returns for the Lehman US Aggregate Index have been similar to the Lehman US Treasury Index, which is exclusively made up of sovereign bonds. But the Lehman US Aggregate Index has been less volatile.

This doesn’t mean it would be prudent to move all fixed income investments into non-sovereign bonds. Non-sovereign bonds have disadvantages as well as advantages. For a start, non-sovereign bonds are often less liquid than sovereign bonds. This means that it is not as easy to adjust a portfolio using non-sovereign bonds as it is with sovereign bonds during times of upheaval, such as the Asian/ Russian/ Long Term Capital Management crisis in 1998.

There also needs to be a clear distinction drawn between investment grade bonds and high yield or emerging market bonds. Although they are less well-researched, lower grade bonds probably do not reduce volatility to the same extent as investment grade non-sovereign bonds. However, indices such as the Lehman Global Aggregate Index only include securities rated investment grade.

At the same time, investing in non-sovereign bonds requires different expertise to investing in sovereign bonds. Researching corporate debt and mortgage backed securities can take significantly more human effort than government bonds. For example, around three quarters of the 101 fixed income professionals who help manage the BT Global Diversified Bond Fund focus on the non-sovereign part of the portfolio. Expertise in credit analysis, sector rotation between the various non-sovereign sectors, the allocation between sovereign and non-sovereign bonds, and the more traditional top-down skills focusing on anticipating changes in interest rates are all necessary tools for fund managers to add significant value to a diversified bond fund.

But whatever the relative merits of sovereign and non-sovereign bonds, we believe the combination of the two can reduce volatility in a fixed income portfolio, while maintaining long-term returns.

We expect the superannuation industry’s ability to adapt to changing market conditions to drive the continuing rise of global diversified bonds into the future.

— Stephen Miller is the head of Australian and diversified fixed interest at BT Funds Management.