How fixed-interest funds fare in the money trap

If you've ever taken a passing interest in share-based managed funds, you'd know there is often a big gap between the best and worst performers - particularly over shorter periods such as one year. Fund managers have different investment objectives, different investment styles, and can operate in different sections of the market. And, frankly, some are just better than others.

If you've ever taken a passing interest in share-based managed funds, you'd know there is often a big gap between the best and worst performers - particularly over shorter periods such as one year. Fund managers have different investment objectives, different investment styles, and can operate in different sections of the market. And, frankly, some are just better than others.

But fixed-interest funds are not like that. They invest in bond and similar debt securities where the return is largely dictated by interest rate movements. They're boring, not flashy, which is why you won't see the average fixed-interest manager making the gossip columns or being asked for their investment tips.

In short, while share funds provide lots of scope for fund managers to prove their value (whether they do or not is a whole different topic), fixed-interest funds tend to be a "vanilla" product providing similar returns.

Until this year. One of the more unusual features of this year's performance figures is the wide disparity between the top and bottom bond funds, particularly those operating in global markets. According to research company Morningstar, there was a difference of almost 6 percentage points between the best and worst-performing retail Australian bond funds last year. The best performer, Equity Trustees' Premium Bond Fund, returned a solid 6.42 per cent; ANZ's Fixed Interest Trust a mere 0.74 per cent. Look at global bond funds, where the DDH Global Fixed Interest Alpha Fund returned 8.34 per cent, but the Invesco Global Fixed Interest Fund lost 6.45 per cent. And the blended Australian-global funds where Australian Unity's Vianova Core Plus Trust was up 9.31 per cent, but an ANZ/ING diversified fixed interest offering lost 1.77 per cent.

It's clear something out of the ordinary has been happening.

The global credit crisis has undoubtedly presented fixed-interest managers with an unusual set of challenges. It's not every day major banks run into problems and whole sections of the debt market dry up.

But the extent to which this has hurt fixed-interest funds goes back to the boom when funds were under pressure to provide higher yields, and many took on added risks to do so.

The problem for bond funds in the earlier part of this decade was that interest rates were low. They had fallen dramatically through the 1990s as inflation was brought under control and provided bonds funds with some tidy capital profits - as bond prices rise when interest rates fall. At one stage in the late 1990s, bonds were delivering better long-term returns than shares with less risk. That couldn't last, but it set high expectations.

But with interest rates low, the easy flow of capital profits dried up, and the yields from mainstream fixed-interest investments had little appeal. The flow of money into bond funds slowed and fund managers were facing a stagnant or declining business.

To make matters worse, their traditional mainstay, government bonds, had become harder to get as governments, particularly in Australia, wound back debt. In this environment, it was inevitable that fixed-interest funds would take on greater risks to provide the yield investors wanted.

The gap left by government bonds was more than filled by companies taking advantage of low interest rates. In 1994, corporate bonds comprised just 2 per cent of the Australian bond index; today that figure is around 50 per cent.

But Vianova senior portfolio manager, Michael Swan, says in the lead-up to the subprime crisis, investors were not being adequately compensated for the extra risks they were taking on. The interest rate spread between government-guaranteed debt and corporate debt had narrowed so much that some fund managers felt the extra yield offered was not high enough to justify the extra risks.

The subprime crisis and resulting credit crunch put an end to all that. Since the problems in the US emerged, we have seen a global re-rating of debt investments, with yields on corporate and semi-government debt lifted. It was a classic flight to quality, and as Swan points out, in such flights all non-top-grade assets get lumped together, regardless of their underlying merits.

Funds exposed to lower grade debt assets have been hit by this re-rating, even if those debt securities are still sound. Some may also have been hit by defaults, but a fund manager didn't need to be loaded up with subprime investments to have their returns cut over the past financial year.

As if that wasn't enough, Australian interest rates have been rising, which reduces the value of existing fixed-interest investments, and the Australian dollar has also been going up, eroding the value of unhedged overseas bond investments. Some funds have been hit by a double whammy of rising local rates and the subprime crisis.

Some enhanced cash funds - a spiffed-up version of the old cash management fund - have also suffered in this market. Morningstar says AMP's BlackRock Income fund was down more than 7 per cent.

Swan says the "fracturing" of credit markets over the past year is responsible for the unusual disparity in bond fund returns, and funds that are based around the index will have suffered from a high exposure to non-government paper. Those funds that have performed better tended to be more conservatively invested.

The fallout from the credit crisis is by no means at an end, and investors in bond funds anticipate further volatility. What this year has shown is there's no such thing as a free lunch. Higher yields inevitably carry higher risks.


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