The Future of Fixed Income
The fixed income market will continue to experience profound change in 2006, as interest rates move towards "normal" levels in most Western economies, but with corporate and Government bonds still failing to deliver exciting returns, even at these levels. With the weight of money globally looking for a fixed return, well credit rated bonds will continue to trade at premiums to their face value, with the related reduction in running yields that this entails. In Australia, the hybrid security market will not be as attractive for quality corporates to issue into this year and yields for hybrids will continue to be at the lower end of the range. What does this mean for Australian fixed interest investors and advisers?
When prevailing interest rates are at the low end of the range, there are really only two major ways in which fixed interest yields can be enhanced. Fixed interest investors looking for better returns have always been able to take higher levels of credit risk, or participate in transactions which are more structured than traditional corporate bonds. Both pose some risk - as well as opportunity - for investors and advisers. As the hybrid security market illustrates, structured fixed income products can provide fertile ground for investors. Hybrids have been around in various guises in the Australian market since the early 1990s (although the concept behind them has been written about since at least 1959, when Nobel laureates Modigliani and Miller described them and their uses).
The more recent innovation, structured credit or CDO notes, have been in use globally since the late 1990s, and despite pockets of demand from sections of the retail and advisory community, have generally been shunned by the Australian advisory community. Despite this caution, retail CDOs in Australia have generally performed well, with innovations like Managed CDOs answering early concerns about the first generation, "static portfolio" products.
The low interest rate environment flows through to the CDO market, as benign credit conditions reduce the yield pick up available in the structured credit market. Quality portfolio CDOs that would have been able to pay margins of up to 300 points above prevailing interest rates are now more likely to return less than half that margin - and for exotic products like CDOs, this low total return is not sufficient to excite even the most experienced CDO investors. This will increasingly encourage CDO packagers to either move the quality of the portfolio down the credit curve, or to include structural devices which can add yield without directly increasing risk. While both of these areas of innovation can add value, investors need to be aware of the risk/reward trade off which they bring with them.
To date, most CDOs issued in Australia have given exposure to underlying credits which are rated above investment grade, sometimes with the inclusion of a small component of selected names which are just below investment grade. Since portfolio construction is a key to quality CDOs, this will increasingly come under pressure in the search for yield. CDOs with higher levels of structuring have been emerging as a way of building protection around lower rated portfolios, or as a way of boosting yields for higher quality portfolios. Look out for a new wave of capital protected CDOs offering exposure to unrated corporate bonds or secured loan receivables.
For investors who want to keep focused on higher quality portfolios, issuers will increasingly be offering more exotic CDOs with features such as variable maturity dates and mini hedge fund like features such as long/short portfolios. Only time will tell whether issuers can continue to make these products suitable for use by retail clients and their financial advisers, or whether the business and investment risks of the next generation products will restrict clients and advisers to the safety of the lower return environment of vanilla bonds and their managers. As always, scalability will remain a key business imperative, for even the savviest of advisers.
Tony Rumble
