The debate about whether equities outperform bonds over the long term is being overshadowed by the suggestion that we are about to see a fundamental change of attitude towards fixed income investments. There are risks attached to such claims, which normally occur when the bottom is about to fall out of a market. In this case, it does appear that a ready supply of debt of varying quality has coincided with a demand for more stable returns than equities seem able to offer.
Advantages of the fund approach to bonds are fairly straightforward. Bond funds offer a degree of diversification, a spreading of the credit risk where a portfolio may be exposed to elements of low-grade debt. A managed bond portfolio will also carry access to some of the larger, or more limited issues. The funds provide for automatic reinvestment of interest payments. One of the more reliable aspects of bond fund investment is the consistency of returns within a given sub-sector. So, for example, there are many good consistent performing funds in the European corporate bond sector. The funds are available from all of the major funds houses and many of the smaller ones. Their returns are very comparable, reflecting the similarity of quality and duration of their portfolios. Now though, compared with the global investment universe, the European bond market is regarded as overvalued.
Bond funds are either defined by the type of debt instrument they focus on, such as government/sovereign bonds, corporate bond or municipal bonds. Or they are defined by region. The table shows the comparative performance of the different geographic fixed income sectors. Within each of these categories, there are differences in quality (from high-grade to high-yield) and duration (from short-term to long-term). Different issuers, sectors, credit ratings, coupons and maturities are all represented in a diversified portfolio.
There is a profusion of portfolios either devoted to European bonds or denominated in euros. Outside of this sector, some funds to highlight would include two funds from Aberdeen, Sovereign High Yield and Exotic Debt. Both these funds have produced solid results over various periods out to three years. Sovereign High Yield Bond fund manager Julian Adams comments that: “So far US growth hasn’t been too impacted by the Iraq effect, and in fact for emerging markets, there have been major oil beneficiaries. Venezuela came through the two-month general strike maintaining civil order and increasing oil production. Ecuador is on the point of signing a new IMF agreement. The purchase in Russia by BP of TNK / Sidanco underlines the new importance of Russian oil for Western companies keen to increase their reserves, and has led to a substantial rally across all Russian assets.
“Argentina continues to recover well and the cheapness of both the Argentine peso and Brazilian real augur well for export-led recoveries that have turned around the external accounts dramatically. As uncertainty over Iraq recedes, the market will be encouraged.”
Ashmore Investment Management have made their name managing funds invested in emerging country debt markets. The core of the $1.4trn emerging debt market consists of dollar-denominated bonds issued by developing country governments. According to Ashmore, investment in emerging market debt capitalises on credit improvement in developing countries, is highly liquid and transparent (with an annual turnover of $3.5trn) and can be invested without significant foreign exchange risk. Over three years, the Ashmore Russian debt fund has a capital return of 280%, and a more modest 44% over one year. Its Local Currency Debt Portfolio has produced a 163% return over three years.
The Fortis L Bond Europe Emerging fund has an impressive track record. For sheer breadth of research, it is hard to overlook PIMCO, the world’s largest fixed income manager. The PIMCO Global Bond Fund is a solid performer. Man IP Diversified Bond Fund from Swiss-based alternatives manager Man Investment Products is another worthy of closer inspection. The group has a variety of event-driven strategy funds in its stable.
The most common event-driven investment styles are distressed securities and merger or risk arbitrage. Distressed securities managers commonly buy the under-valued securities, or bank debt, of companies in financial distress or bankruptcy proceedings. Distressed securities strategies generally perform best during times of economic recovery. A variation on a theme is the Sarasin CI Income Portfolio. Thematic investing pioneer Sarasin has taken the concept into the corporate bond arena. This portfolio, launched last year and domiciled in Guernsey, has a typical asset allocation of 70% fixed income, 20% equities and 10% cash.
Corporate bonds are likely to remain less volatile than equities, adding decent yield and ballast to a diversified portfolio. There is certainly a huge latent demand for more stable returns than equity funds seem able to provide. And while the European debt market looks to have topped out, there is still plenty of opportunity in other areas.
It’s not all plain sailing though. Clearly, high-yield bond funds are harder to manage for consistent returns. At UBS the high-yield bond team explains: “With fair spreads over government, the euro high-yield bond market offers some value for long-term investors. Yields of 10.5% in the fund protect the investor against declines in nominal value and compensate for market risks (ie, defaults, lack of liquidity, 10% concentration in telecom issuers, volatile fallen angels). However, volatile stock markets, high default rates and the absence of investors can lead to further market volatility.”
The perception that junk bonds are more likely to default lowers their prices, detracting from the heady interest rates. The T Rowe Price High Yield Fund, for example, has a tempting 10% yield (that’s the average interest rate of securities in the portfolio). But it produced a modest 1.1% return for 2002. The high-yield sector has suffered from the overall investment market depression of the past two years but, outside of Europe, the fund managers suggest there are still good opportunities. Sarasin’s chief investment officer Guy Monson suggests that investment clients have become more averse to the risks of equity investment and that portfolios like this may be the way of the future. The element of doubt in the argument for a new dynamic in the equity/bond relationship comes from Merrill Lynch, in a recent strategy note: “In our view, this is not the right time to allocate more money to the fixed income class. Although we are not forecasting above-average equity returns in the immediate future, we believe the prospects for better relative performance versus bonds and cash have improved significantly. Will stocks continue to be priced for failure and bonds priced for perfection? We do not think so. A disciplined rebalancing approach to asset allocation makes sound investment sense at current levels. A disciplined approach to asset allocation will be even more important in the next few years.”