Safe haven funds disappoint

The bond market proved a reliable safe haven during the 2008-'09 financial year, giving investors a double-digit return that offered some relief from the big fall in the sharemarket. The fixed interest market benchmark, the UBS Composite Bond Index, was up 11.83 per cent for the year to May 31.

But for many investors in bond funds the returns did not flow through. Active bond fund managers have, in recent years, tended to load up portfolios with high-yielding corporate and asset-backed debt securities.

These assets have dragged down the performance of funds that should have given their investors the benefit of strong government, semi-government and highly rated corporate bond returns.

Investors that want secure high-yielding fixed interest returns that give them a better income than cash may need to consider going into the fixed interest market direct and avoiding the managed fund route.

According to researcher Morningstar, while the fixed interest market benchmark, the UBS Composite Bond Index, rose 11.83 per cent in the 12 months to the end of May only five of the 115 Australian bond funds in the Morningstar database beat the index.

Four of the funds lost money, according to Morningstar. They were the Macquarie Income Plus Fund, the UBS Inflation-Linked Bond Fund, the Colonial Inflation-Linked Bond Fund and the Aberdeen Inflation-Linked Bond Fund.

A sub-index of the Composite Bond Index, the UBS Credit Index, fell 1.77 per cent during the past year. Fund managers that loaded up their portfolios with corporate debt at the expense of government bonds suffered.

Morningstar classifies an Australian bond fund as one that invests in "traditional fixed interest securities". These include government and corporate debt with terms to maturity of more than one year and with credit ratings of A- or better.

JUNK BONDS

Morningstar also tracks the performance of other types of fixed interest funds. Diversified credit funds invest in a wider range of credit securities, such as mortgage-backed bonds, and hold securities with lower investment grades. The average rating of securities in diversified credit funds is about BBB. Lower-rated securities offer higher yields but come with higher risk.

Of the 40 diversified credit funds Morningstar tracks, only 13 produced a positive return for the year to the end of May. None beat the UBS Composite Bond Index. Eleven of the funds in this group, with the investment manager BlackRock, reported losses of more than 30 per cent.

High-yield funds invest in similar types of securities but also invest in areas such as emerging market debt and will hold a high proportion of sub-investment grade debt (referred to as junk bonds).

Of the 31 high-yield funds Morningstar tracks, only three produced a positive return. None beat the UBS Composite Bond Index. The AMP High Yield Fund came the closest with a return of 9.7 per cent.

RERATED DOWN

Fund managers have been saying for about 18 months that the blowout in valuations on corporate and structured credit securities that occurred with the onset of the global financial crisis in 2007 would correct at some point and there would then be big gains. What those managers were not able to predict was the long duration of credit market volatility, which continues today.

What is making matters worse is the global recession is causing some of the issuers of the credit securities held in these portfolios to default on their interest payments. In May, AMP Capital Investors reported to investors in its Enhanced Yield Fund that six companies with debt securities in the portfolio were "not performing to expectations".

On June 24, ratings agency Moody's reported it had downgraded the market risk ratings of fixed interest funds managed by Colonial First State and AMP Capital Investors.

Moody's says its market risk rating is an opinion about the degree of volatility of a fund's asset value. A rating of MR3 means the fund is judged to have a moderate sensitivity to changing interest rates and other conditions, MR4 means a high sensitivity and MR5 designates a very high sensitivity.

Moody's downgraded AMP Capital Floating Rate Income Fund from MR2 to MR3, Colonial First State Australian Corporate Debt Fund from MR2 to MR3, the Colonial First State Global Credit Income Fund from MR2 to MR4 and Colonial First State Global Credit Fund from MR3 to MR5.

GO DIRECT

There is a strong case for investors to buy fixed interest securities directly. If they buy and hold the bond to maturity, they get the interest payments along the way and their money back at the end. They are not exposed to the volatility that comes with funds that have to give daily mark-to-market valuations on their holdings. But there are drawbacks to this approach some corporate securities are only sold in large parcels.

The managing director of fixed-interest broker FIIG Securities, Jim Stening, says investors are watching the returns on their cash holdings fall. "The high rates are in the longer-term fixed-term deposits and bonds now. The yield curve has steepened [long-term rates are higher than short-term rates] and that is how it is going to stay for a while."

FIIG sells semi-government bonds in parcels of $50,000. Stening says: "Cash funds and high-interest savings accounts are offering 3 or 4 per cent. We have put some of our investors into five-year Victorian Government debt paying 5.8 per cent. Some banks are offering fixed term deposits up around that level. The difference is that you can sell your bonds if you need to get out.

"The good thing for small investors is there is supply in the market now. Governments are borrowing and some corporate borrowers, Tabcorp and AMP, have packaged recent bond issues for the retail market. It is feasible for investors to develop a fixed interest strategy that involves buying direct, earning almost double the cash rate and holding to maturity to avoid volatility."