What's driving fixed income?
Q. Michael, how have the Euro and US government debt problems affected fixed income markets?
A. Fixed income markets had become more stabilised following the global financial crisis (GFC) but over the past year have been undergoing some fundamental changes.
The status of US and Euro bonds, that were previously considered to be risk-free assets, has been brought into question – and these questions will continue for years to come.
Historically, the main risk investors had to consider with these assets was interest rate risk. Now investors are having to factor in the previously unthinkable – that these governments could potentially default. Just as destructive in its own way, they could simply print more money and inflate their way out of their debt burden – in the process degrading their currency and the value and status of their bonds.
Financial markets have awoken to the fact that not only do many western governments currently have very heavy debt burdens, their fiscal policies are unsustainable over the longer term, given their ageing populations.
Ironically, during the US gridlock over its debt ceiling, US government bonds rallied strongly – indicating that while their risk free status has been called into question there is essentially nowhere else to go at this stage, except into gold, and there is simply not enough gold in the world to underpin the financial system.
Overall, the world is going through a massive de-leveraging to unwind the debt bubble that grew over decades and burst spectacularly with the GFC. Debt is being called in, it is harder to borrow, and you are paying more for it. This means the return hurdles for all investors – in shares, bonds, property and infrastructure – have been raised.
Q. What does all this mean for other fixed income securities?
A. Previously 'risk-free' government bonds, US treasuries in particular, always served as the base pricing points for other income securities, and ultimately most other investments from equities to property.
Whatever the short-term remedies in the US and Europe, financial markets are now well aware that the underlying problem has not been solved; that it is not just the current unsustainable levels of debt – but the unsustainable fiscal policies for the long term with ageing populations exacerbating the problem.
So this is changing the fundamental relationship between government bonds and corporate bonds. For example, some US corporate bonds backed by strong businesses with solid balance sheets, have been trading at lower risk premiums to US treasuries for the first time in living memory. Although previously unheard of, this is now logical given the circumstances.
The fear over the quality of government bonds and paper money generally has continued to fuel the rally in gold, as an enduring physical store of wealth that provides a hedge against inflation.
Given Australia's limited government bond market due to our Government's strong fiscal position, the spill-over effect has been to boost the attractiveness of the Australian corporate bond market to international investors.
By comparison to the US and say Britain, Australia has low government debt, although high private debt. More importantly, our economic fundamentals are pretty strong, with high export revenue derived from our rapidly growing Asian trade partners.
This is changing Australia's status from a pure risk currency to somewhat of a safe haven. Given that our low debt means our government bond market is fairly shallow, there is increasing interest in our corporate bond market.
Q. How are you responding with your investment strategies?
A. In the short term, the government debt crises and general mood of risk aversion have actually been good for the sort of high quality corporate bonds in which we invest.
Longer term, if the risk premium increases for the reference instruments that underpin the pricing of the whole market, then that raises the floor for all fixed income instruments.
On a risk benefit analysis, globally, interest rates are at historically low levels so the only way is up, in response to inflation. To protect investors against inflation, or rate increases aimed at stifling inflation, we tend to focus on floating rate securities with short durations.
Q. What does the changing world of fixed income mean for investors?
A. I think it means that investors should probably take a closer interest in fixed income and better understand what they are invested in, and the nature of the various risks – default, liquidity, capital stability and the effects of inflation on the real value of money.
Pre-GFC, fixed income was taken for granted. The risk premium essentially disappeared and investors put a large proportion of their life savings in it, while paying little attention to it. In fact it was an era that rewarded many investors, as they received high returns and rarely had to pay for their risks.
The credit crunch that triggered the GFC was very sudden and dramatic, whereas what is happening now is a slow grinding process of realignment. The global economic recovery, de-leveraging and realignment of economies, currencies and risk relativities, will take years to play out and investors will rightfully remain cautious for quite some time.
In the new world, we need to be very patient and very careful in assessing all of the underlying risks behind a fixed income security and ensure investors are receiving a suitable reward for the risk undertaken.
We are now in an era where not all fixed income is the same, where none is entirely risk free, but one that will reward the diligent and patient.
This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. The views expressed in this article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor's capital.
This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of the Fund or the return of an investor’s capital. An investment in the Fund is not a bank deposit, nor is it a liability of the Perpetual Group. It is subject to investment risk, including loss of some or all of an investor’s principal investment and lower than expected returns.