AFR: Best bond funds of the last three years

AFR: Smart Money, October 2011

Over the last three years Australian bonds have done just what people wanted from them – and then some. In a volatile environment they have steadily paid out good returns, have done so reliably, and have in many cases exceeded long-term expectations. While shares have floundered, several of the best bond funds have recorded double digit returns – five of the best are described in detail below.

Is the outlook still good for Aussie bonds or have the best opportunities passed? Like so much else, the answer depends on what’s happening elsewhere in the world. “In the immediate term we’re subject to the vagaries of what’s happening in Europe and the globe,” says Steve Miller, Australian fixed income head at BlackRock. The impact of those developed-world problems on Asia will have major implications for Australia – but if the world continues to turn sour, Australian bonds are better positioned than most. “Australian bond yields are relatively high compared to all other core developed economies,” Miller says. “If the world gets uglier, the Reserve Bank has a lot more room to cut rates; there is room for yields to fall and to provide positive returns to investors.”

Australian bonds are distinct from others in the world for more reasons than just yield. Key benchmarks like the UBS Composite, which most Aussie bond funds follow, are high quality and secure, populated by a high-grade mix of government, semi-government, supranational and corporate securities. Crucially, even the corporate end – usually the riskier end – is very solid in Australia. “Those corporate bonds are generally fairly high quality and are concentrated in banks,” Miller says. “That appeals, because in a world where growth is challenged and banks are deleveraging, the best bonds to be in are high quality and high yielding ones; for Australia-domiciled investors, our bonds offer precisely that.” There are times when that can be difficult for portfolio managers: in happier economic climates they will seek greater diversity in bonds. “But in the world today, it’s favourable.”

Best funds of the last three years

We asked Morningstar to provide details of all Australian bond funds and then selected the five best performers over the three years to September 30, after removing duplicates (for example, the Pimco Australian bond fund can be bought wholesale, or in the retail-accessible version through Equity Trustees; each has slightly different post-fee returns, but is essentially the same fund).

Depending on how you accessed it, the Pimco fund would have brought you between 10.82 and 11.1% per year over the last three years – and it is truly outstanding to have received consistent double-digit returns from an asset most invest in for safety.

The Pimco fund was one of the ones we profiled in last week’s study of bond fund factsheets, so we won’t get into a great deal more detail here except to say that it has made the vast majority of its returns in distributions rather than growth; it is a fairly conservative fund with an average credit quality of AA and an average bond maturity of 5.1 years; and that at the moment it is emphasising government guaranteed bonds, which pay a higher yield than pure government bonds yet are safe and provide liquidity.

Two Aberdeen funds come next on the list. The Aberdeen Income-Focused Bond Fund is, as you would expect, a bond fund focusing on income rather than growth – which is, effectively, what has worked so well for Pimco too. It’s driven by relative value and credit strategies – so it looks to find inefficiencies in the market, where something is valued too low for its fundamentals, and invests in the hope that they will correct themselves so the bonds go up in value. It’s also pretty safe, focusing on government and investment grade securities; Aberdeen ranks its volatility and risk as “low to medium”, which suggests that the funds that have thrived in recent years have actually been the safest ones. Just under 76% of the fund was in top-rated AAA securities as of September 30.

The other Aberdeen fund is the Aberdeen Australian Fixed Income Fund, which is a little more diversified than its sibling. With about half the fund in government and semi-government securities – a lower proportion than the benchmark UBSA Composite Bond Index by more than 10% – it has 37.53% of its money in corporate debt (including banks and asset-backed) as well as 11.75% in cash. 61.58% of this fund is in AAA securities and 16.49% in AA, making it pretty risk-averse, but there is room for a little exposure in riskier, lower-rated securities.

The Perennial Fixed Interest Trust looks very different. As of September 30, only 0.1% of the fund was in government bonds, and 28.7% in semi-governments; instead 49.9% was in credit, such as corporate bonds.  “Solid corporate fundamentals, good levels of profitability and adequate risk premiums for investors make corporate debt an attractive investment option,” said portfolio manager Glenn Feben in his September report to investors. He is also overweight bank guaranteed and semi government bonds, “on the basis of the attractive yield advantage they offer relative to government bonds.”

Rounding out our top five, the Optimix Australian Fixed Interest fund is the only multi-manager product on our list. A complicated story, this one: It invests in a diversified portfolio of Australian fixed interest securities through a range of underlying managers, and until recently did so through ING. However, since the ING business was sold to UBS earlier this month, Optimix is now under UBS – at least until it ends up being owned by ANZ, as many expect, since ANZ owns OnePath, which is the custodian of the Optimix fund. Anyway, at the moment Aberdeen Asset Management and Western Asset Management are the underlying managers, but watch this space.