Inefficiency is driving an opportunity in this market

Since the 2008 Global Financial Crisis, central banks around the world have used quantitative easing (QE) to stabilise investment markets and boost risk-taking, allowing investors to reap rewards with little capital risk. 

As central banks end QE, inflation globally starts to ease, and we enter a more normal economic cycle, income portfolios with high-risk exposure or passive index-tracking strategies will face diminished profitability and periods of underperformance. Further, as interest rate bets continue to show signs of peaking, term deposit interest rates are also showing signs of peaking.

In this article, we discuss why the same can’t be said for an actively managed fixed-income portfolio.

Bonds are an inefficient opportunity

The fixed-income market has a greater diversity of market participants regularly buying and selling a significant number of different bonds which can differ by sector, coupon, optionality, and liquidity. All this makes that asset class far more inefficient than its equities counterpart. 

Pricing inefficiency infers that the prevailing market price of a security may not match its intrinsic value. But inefficiency is not always a bad thing. As active managers, we seek to profit from that inefficiency by buying bonds that we view as underpriced and selling bonds we deem to be overpriced. 

But buying bond ETFs doesn't solve the problem

A passively managed portfolio is intended to replicate the exposures and the performance of a benchmark index. Those indices don't tend to represent the best ratings, sector, curve or country opportunities. Even so-called "risk-free" government bonds are not all equally risk-free. 

For these reasons, indices are also more prone to systemic risk. The biggest risk to bonds generally arises from a default. This risk, even in lower-rated bonds, is still fairly low; however, in a systemic event (such as the GFC), it increases dramatically.

Index funds generally own the largest-issue bonds in the market, not the whole market. This behaviour leads to overbidding for the larger issues, driving prices beyond fair value. This means the passive investor ends up paying more than they need to. 

Understanding the true cost of your passive fund

While index funds may appear cost-effective at first glance, their impact on returns relative to the benchmark over the long term is often considerably lower after accounting for fees. This is particularly true when compared to active bond managers (refer to Table 1).

Table 1: Cumulative returns of index funds (net of fees) over a 10-year period

Bonds outperform term deposits over the long term

In addition to investors shifting towards passive ETFs, there is a noticeable increase in their allocation to term deposits (TDs), driven by concerns about ongoing market uncertainty and a higher interest rate environment. 

In our view, investing in fixed-rate active bond funds helps to deliver a more efficient portfolio outcome, particularly as we approach the cash rate peak. For one, TDs are generally only best in short-term investing time frames. TDs are also less flexible than ETFs and bond funds as the only secondary market is the bank that issues them and there is a penalty for breaking the deposit. In contrast, bond funds offer capital stability and a diversity of assets.

Most importantly, as illustrated in Chart 1, bonds have significantly outperformed term deposits over the long term.

Chart 1: Bonds outperform TDs over the long term (10 years)

Fixed rate bonds provide capital gains benefits that term deposits lack

Fixed rate bonds offer capital gains benefits that term deposits cannot provide. Similar to TDs, fixed rate bonds provide a known return (at maturity) from the investment date. However, TDs lack the potential for capital gains, which can increase the potential return to an investor when interest rates fall. It is essential to note that while the market value of fixed rate bonds can fall as rates rise, holding them until maturity ensures realising the initial yield without incurring any capital losses. Few other asset classes can offer such certainty.

While the past two years have been difficult for fixed income investors, it is important to recognise that these years are abnormal. Negative bond returns are still rare. Analysis of 1-year bond returns versus TDs demonstrates that, for the majority of time periods, bond returns have outperformed TDs (refer Chart 2).

Chart 2: Bond prices increase as yields fall

It's a good time to own active fixed rate bonds

The outlook for fixed income has become more positive, meaning now is an opportune time to hold active fixed rate bonds. The September consumer price index report suggested inflation may have peaked (a suggestion that has been further supported by the recent October release). 

As the economy slows and different sectors and issuers diverge in navigating the contraction, disciplined active managers can successfully separate the winners from the losers, dynamically adapting to new information and conditions. 

Bonds currently offer more attractive yields than they have in several years and are well-priced. Importantly, higher yields mean greater potential returns for investors.

Managed Fund

Yarra Australian Bond Fund

Australian Fixed Income

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