In today’s fund manager interview we turn our attention away from the share market and towards an equally important part of most successful investment portfolios.
Namely, fixed income investments.
To gain a top insider’s perspective into this market, the Motley Fool reached out to Darren Langer and Chris Rands. Darren is the head of Australian Fixed Income at Nikko Asset Management and both he and Chris are co-portfolio managers of the Nikko AM Australian Bond Fund.
Nikko AM has 20 years’ experience managing fixed income assets. Rather than passively track an index, the team engages in actively managed, high conviction investing.
Nikko AM’s Australian Bond Fund only invests in investment grade securities (a BBB- rating or above), and generally holds between 70 and 130 securities. The fund requires a minimum $10,000 initial investment and pays quarterly distributions.
Launched in July 2000, the fund has delivered a per annum return, net of fees, of 5.6% over 10 years, 7.3% over 2 years and 4.3% over the past year (as at 31 October and assuming the reinvestment of distributions).
With that background covered, read on for the Motley Fool’s exclusive interview with Darren Langer and Chris Rands.
Let’s start things off with a ‘bond investing 101 question’. Why invest in fixed income as part of your wider portfolio?
Darren: I’ll start off with one thing and that’s obviously not all fixed income is the same. So do your research on what you’re actually looking for.
We’re more at the conservative end of the spectrum. Our role in a portfolio is generally a defensive one against risk assets. We’re really in the game of delivering consistent income for investors.
Fixed income provides a buffer against equity volatility and also provides consistent income over time. Bonds generally give you a positive outcome in most conditions. There are certain times when you book a slight negative, but you’re never really likely to get big drawdowns.
So it provides a nice steady income and a conservative place to park money if things are very volatile or just to diversify your portfolio.
What sets Nikko AM’s Australian Bond Fund apart from your competitors?
Darren: There are a couple of things that we do a little differently. One is that we try very hard not to add volatility to a portfolio. So we tend to invest fairly conservatively. We’re not trying to take really big macro bets. We’re really analysing how things currently look in the market and trying to put bonds in our portfolio that deliver a better performance than the index.
We’re aiming for about 70 [basis points] over the index, which is the Bloomberg [AusBond] Composite Index. And we try to get that year in and year out, to consistently add value over time and for a reasonable fee.
Volatility is really the main difference between us and our competitors. Some will take a lot more credit risk in their portfolio, or they’ll take a lot more interest rate risk. So their returns are much more volatile.
Chris: We try to introduce a lot of little bets rather than one big bet. It reduces the volatility and if you win more often than not, the small bets add up to that consistency through time.
Darren: The other thing that’s different from some of our competitors is that we spend a lot of time on technology. We’ve found that most people do the same thing in fixed income. The bond market is the bond market. So they’re all doing the same kinds of investments.
We use technology to try to capture opportunities more regularly and more consistently. We spent a lot of time building a toolkit that we can use to identify and filter lots of different opportunities and to invest in the best ones. We’re ploughing through thousands of ideas every day. We can go through large amounts of data very quickly and then distil what opportunities are there.
What type of mix of bonds does the fund invest in?
Darren: We’re a composite fund so we use a combination of all the investment grade universe. That covers government markets, the state governments, offshore sovereigns and it covers the corporate credit market and banking.
Our process is to rotate into the sector opportunities that have the best relative value and we’ll use different maturities in our portfolio and try to find the best ideas all along the yield curve. And that’s what we’re really talking about when we talk about relative value. We can’t control the level of interest rates but we can buy the best set of assets in each part of the market. And that’s what we think gives us the edge over what some of the funds do.
Chris: We use mortgage-backed securities and asset-backed securities as well, which tend to provide a slightly higher return for a similar risk as bank bonds.
Do you predominantly operate in the primary or secondary bond markets?
Darren: We’re active in both.
Companies come to the market all the time. Because bonds have a fixed maturity, at the end of which they pay you back money, we then have to invest in something else. New bonds are always coming onto the market, so there’s quite a big primary market. But we’re active in the secondary market as well.
Generally, we have a 3 to 6-month time horizon when we set something in the portfolio. But that doesn’t mean we sell bonds every 3 to 6 months. That’s when we review our ideas. The average duration of our portfolio is around 5 to 6 years.
Chris: Government bonds are a huge, very liquid market, so you can shift in and out of those at very low cost. Corporate bonds are less liquid and might only issue $200 million and you might never see the bond again once it’s issued. When you buy corporates, you have to have the mentality that this could be in your portfolio for the full period.
Typically, in our portfolios, the government sector will turn over a lot more than the corporates. While we don’t always hold them to maturity, we would be buying corporates with the expectation that the credit quality is good enough that we can hold them to maturity.
So the yields that you’re getting are a combination of the coupon payments and some capital gains from selling them as well?
Darren: Yes, there is a combination of both. Over the long run, the income on a fixed income portfolio is the main driver of return, but there are opportunities to add value through moving bonds around and trading and picking up capital gains. But it’s really more about income over the long run.
What factors would determine whether you decide to exit a bond position before maturity?
Chris: We’re really what you would call relative value managers. If we’re going to sell something, it’s because it’s outperformed relative to its peers. A lot of our process is designed in ticking off the things that have deviated from their peers. The reason that works in fixed income is because it’s a very correlated market.
For example, a 2026 and 2027 bond should have a pretty similar yield, but at certain points in time, those things can deviate. Our process is designed around picking up those deviations. And once those deviations close, that’s when we look to move out of those positions and get into something else.
Darren: The main reason you have that grouping is because interest rates are a commonality across all bonds. Where with equities, different companies have different drivers. So equities will move a lot more independently. But with fixed income, interest rates all move together. You do have some idiosyncrasies within each bond, but in general the government bond yield is the driver for most bonds. That’s why we’re a much more highly correlated market than equities.
What types of risk management strategies do you employ?
Darren: There are two ways of making returns in fixed income, particularly in a low yield environment.
You can either keep your risk relatively constant, like we’ve always done, and just accept that interest rates are low, and then try to add as much active return as you possibly can.
The other alternative is you dial the risk up to get higher returns. We try not to do that. We try to do the same things day in and day out. We just have to accept that at the moment, yields are very low, and try to add something to that. For us, it’s about only taking enough risk to get our returns and delivering what we say we’ll deliver.
We don’t see any dramatic change in interest rates for some time. But we expect the returns from other asset classes are likely to come down a bit.
Chris: From the portfolio perspective, there’s limits around how far we can go away from the benchmark on interest rate exposure and credit. We don’t invest below BBB-, which is the lowest rating in investment grade.
Darren: The other thing we do is not take too much concentration risk. A lot of fixed income funds that have higher returns are generally very concentrated in credit markets. We use credit in our portfolio, but we don’t overuse it. Credit tends to be very correlated to equities, because generally the same sorts of risks drive credit markets as equities. We don’t want to become the same as an equity portfolio, because we’re supposed to be a diversifier.
Speaking of low rates, what are your thoughts on negative rates, like the German 5-year Bund which is yielding minus 0.72%?
Darren: Negative cash and negative bond rates require a slightly different answer. We don’t think we’re going to get negative cash rates here because the RBA is very anti-negative cash rates. That doesn’t mean bond rates here couldn’t go negative, but it’s not likely.
However, we are at the bottom of a rate cycle. Rates can’t go much lower without going negative. So if we hit another rough patch where they need to stimulate the economy, negative rates are still possible.
Fixed interest funds can handle that. As we’ve seen in Europe, where they’ve had negative rates for some time, the banking system and bond markets are still functional. It’s just not going to be a great income-producing situation. But the style of investing that we do, by switching between the best value assets, we can still eke out a return in that environment.
Chris: Part of what the ECB has said about negative rates is that it hasn’t actually hurt the banking system as much as people make out. That’s mainly because it also improves credit quality by pushing borrowing costs lower.
Are there any investments that really stand out as top performers and any you wish you’d avoided?
Darren: Most of our ideas are around themes rather than individual bonds. Unlike in equities, we are not trying to pick specific companies that will do well but we concentrate on broad sectors and areas of the yield curve that look attractive and then target the bonds in those areas.
Recently we have had a strong view that state governments have been relatively cheap compared to credit markets and also the federal government. For the last year or so, we’ve been heavily invested in various state government bonds. With the RBA doing quantitative easing and changing some banking rules around state bonds as part of their liquidity, that’s done very well.
In terms of the other side, we underestimated a bit going into COVID-19 just how aggressively markets would move. We probably underestimated how powerful the whole quantitative easing thing offshore was for credit markets. We probably didn’t have as much exposure to credit as some of our competitors, so that was a bit of a detractor for us. For us, the sector allocation is more important than individual bonds or companies.
Chris: For us, the past 5 months has been one of our strongest performing periods, so it’s hard to say that anything was ‘a dog’. But when I think back to the start of this year, the area that annoyed me was that we had some inflation bonds in the fund. They protect you against rising inflation and when we came into COVID, and the oil price tanked, that was negative for performance because inflation got killed. So that was probably the most frustrating single position.
Nikko AM has been certified as carbon neutral (after entering into a carbon offset program with the UK-based international organisation Carbon Footprint Ltd). Has your carbon neutral certification impacted your investing metrics?
Darren: For us, in fixed income, we’re not an ESG [environmental, social, and governance] fund. We don’t try to be pure ESG, but we use that as part of our credit process and part of our filtering process and it’s an important part of our process.
Chris: We revamped our ESG process over the past 12 months. We now focus on a negative screen, so we’re removing any kind of ESG companies that we think don’t fit the criteria that meet our investment standards. The idea there is that we’re trying to take out the risk that you get poor practices from a corporate that can destroy the value of that company. For a company to make it into our fund, they need to be solid in E, S, and G… all of those practices.
Now it’s generally big corporates we’re looking at. And most of them do those things anyway. But a few things do get screened out. A lot of the auto manufacturers have poor governance and issues like that. It won’t necessarily be that the carbon footprint is too large. It will be that our assessment is that this company is not quite up to scratch. But in Australia that’s quite rare. The miners don’t issue many bonds.
Darren: We don’t own anything. We’re just a lender. We can’t function like activist investors. What we can do is avoid lending to companies that we don’t think do the right thing. That’s why we use that negative screen. It’s about ultimately getting repaid and we want to avoid lending to companies that might not repay us because of various environmental or social conditions.
The inverse relation between bonds and shares have historically helped to offset portfolio volatility; some are saying this relationship is breaking down. Do you agree?
Darren: Normally it’s been the case that when equities have a bad run they’re able to cut interest rates, and fixed income markets then perform well. Now that we’re close to zero, it’s much harder to do.
Our feeling is that fixed income does still provide a defensive roll. It may not give you an offsetting return, and I don’t believe it’s ever really given a perfect offset. Equities can sell off 20-30%. Bonds rarely ever have that kind of return, unless you’re taking significant risk.
If you want to park your money somewhere to avoid volatility, we think fixed income still provides that. But if you’re looking for something that might give you a perfect offset, that’s going to be less likely with interest rates already very low. Some investors may have heard about risk parity as a way of protecting portfolios but this is actually increasing risk on the fixed income side with leverage, and may introduce other risks.
Chris: Part of the scare people get is that interest rates go up and that rising rates cause economic stress and then the market falls. And then you could have both bonds and equities doing poorly at the same time. I caution against reading too much into that. If interest rates rise relatively quickly, we’ll see the central banks move in to stop it so that higher rates don’t kill the economy.
What’s the biggest opportunity and threat for fixed income investors in the year ahead?
Darren: Starting with the threat, the main thing that hurts fixed income is rising interest rates. We don’t see a huge probability of this. But large interest rate hikes are the biggest risk. Though generally if you do have a hike, the next couple of years deliver pretty good returns for fixed income, so it tends to correct itself.
The other thing that could hurt fixed income, depending on the style, is some sort of economic downturn that hurts credit markets. For funds that have a lot of credit, it’s a similar sort of outcome that you’d get with equities.
There’s no real massive upside in fixed income. Generally, you get paid your money back plus some income. Rates falling can help generate capital gains, but we don’t see much opportunity for that with where rates are at the moment. Stable income and capital preservation are probably the main opportunities for the next couple of years.
Chris: Fixed income is meant to be a defensive asset. People are still concerned about how we’ll make it through this crisis. Some protection makes sense. Long government bonds still give you some of that protection. If things go wrong, they will probably perform quite well. And if things go well, then your equity portfolio is probably doing quite well. Diversification matters.
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Motley Fool contributor Bernd Struben has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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