How to beat the index

Your super money passes through a few hands from the time you tick the box on the form, to the time it finds its way into the account of a corporate bond fund manager.

The superannuation board of trustees appoints an asset consultant who determines how the money will be invested. The asset consultant then goes to work mandating fund managers for various asset classes, including bonds. Once they've won the mandate, the fund manager's job is to make sure they hang on to it. The best way to do that is outperform the competition, and beat the index.

For local fund managers, that index is typically the UBS Composite Bond index. The UBS index comprises of both government and non-government indices which each in turn comprise of two sub-indices, covering the publicly investible domestic bond universe.

Because of the nature of the bond market, replicating a corporate bond index is virtually impossible. Supply of paper is limited and many bond issues are tightly held by large accounts. Outstanding bonds are difficult enough locating and even more difficult buying at a market level in the size required to match the index exposure.

While replicating a bond index is not possible, it can be beaten.

According to Nick Fyffe, executive director, capital markets ANZ, there are a handful of ways for fund managers to beat the index. They can either buy more of the bonds in the index that they expect to outperform or hold less of the bonds in the index they expect to underperform. Another way they can beat the index is to trade in and out of bonds at better levels than the index rate sheets are indicating. Bond fund managers can also source exposure to bonds that fall outside the index but inside their mandates, such as unrated bonds, private placements, foreign denominated bonds, or even credit derivatives.

Another way to beat the index is for fund managers to get in early on new bond issues. Healthy allocation to primary corporate bond deals, often earns the ‘cornerstone' investor good exposure in a similar manner to stocks in an initial public offering.

"For us the best investment opportunities are in primary deals, specifically issuers that have either not issued before or have not issued for some time. Because new issuers must pay a premium to enter the market, this is where we see value,” says a local bond fund manager.

Diversification is also critical for credit investors. A greater spread of exposures is to a large extent an essence of successful lending. Since most fund managers see sectoral diversification as more important than geographic diversification, they are forced to look outside of Australia to build a sound portfolio.

"The large corporates are still not well represented in the corporate bond market. Exposure to the backbone of the Australian economy is still not available to bond investors,” the fund manager adds.

While the corporate bond landscape is shifting, away from the heavy concentration of bank paper, non-financial bond issuance only accounts for less than 3 per cent of this year's supply. While small in percentage terms, the overall amount is not too far off 2006 levels, when companies were most active in debt markets, and signs are next year will see even more supply of non-financials.

Bond investors need to be thorough.

In terms of a percentage of funds under management being committed, for a typical bond fund a $40 million ticket for a corporate bond issue equates to roughly $2 billion of exposure in any of the Big Four bank's corporate loan book. Banks of course survey such an exposure heavily and bond fund managers are no different.

Fund managers also need to demonstrate to their stakeholders that their investment decisions are sound. If a credit goes sour, a trail of investigation and analysis is important to provide evidence that the investment decision was made with maximum insight and knowledge.

Bond fund managers are also well aware that their actions are impacted by external flows. While credit spreads tend to track volatility in equities, a sell-off in stocks can make life tough for bond investors. Ironically, balanced investment funds need to reweight into equities when the value of equities decline. This means fixed income assets must be offloaded so that more shares can be bought.

For this reason, investors will expect to pay a premium for assets that are liquid. It is also the reason why they will sometimes have to sell bonds, which they would have bought at a much higher price.

However, now the market is rising bond fund managers are happier than they have been for a while. The recovery rally in credit spreads has seen the health of their portfolios improve dramatically. With funds flowing back into their coffers, and primary corporate bond markets showing signs of life, beating the index is a whole lot easier.