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AFR, October 2011

In difficult economic times, investors tend to show more interest in bonds: safe, stable, steady, and not generally subject to the same volatility as stock markets.

There is a multitude of bond funds available in Australia: domestic and international, simple and structured, high grade and high yield. So how does one choose between them?

To explain, let’s take a close look at some of the available information for major bond funds sold in Australia. To start with, take the fact sheet issued by PIMCO EQT Australian Bond Fund. Pimco is one of the world’s biggest fixed income managers, and its fund is sold to retail investors in Australia through Equity Trustees; you can get its latest fund factsheet from the Equity Trustees site (www.eqt.com.au).

At the time of writing, the most recent fact sheet covers the period to September 30 2011. Right at the top, it tells you the basics of the fund: its investment objective, the sort of things it invests in, the date it started, the management costs, funds under management (Pimco calls this investment pool size), minimum initial investment, and the buy/sell spreads on the fund when you buy in or sell out. All of these things may be relevant to you in deciding whether to invest in a fund: perhaps the amount you want to invest is below the minimum accepted, or the management costs are higher than you’re comfortable with.

What’s particularly appealing about the Pimco fact sheet is that it tells you not only the fund’s return, but where it’s coming from. A bond fund will get returns from two sources: distributions, from the bonds it holds, and growth in the value of the bonds themselves. Pimco breaks these down, and also compares them to the index, so you can see how it’s doing compared to its benchmark. Over the last year, that makes rather solemn reading for Pimco, though you can see it is beating the benchmark over the longer term.

Another interesting part of the Pimco factsheet is the way it breaks down the funds by duration, yield and quality. It is very important to understand that all bonds are not equal – indeed, they are as different from one another as stocks are. The highest rated bonds in the world are rated AAA (such as Australian government bonds – but not, any more, US Treasuries) and they then fall one notch at a time as the strength of the issuer falls. AAA is better than AA, which is better than A, and between each of these classes is a plus and a minus to provide further differentiation (so AAA- is one notch above AA+). BBB is considered the lowest level of what fund managers call investment grade; by the time you get to BB, you’re in to what is variously called sub-investment grade, high yield, or junk. Here, you’re getting big returns, but at a much higher risk.

Bonds also vary enormously in duration, from periods that can be measured in days (these are normally called money market securities) up to as much as 100 years, though in practice most bond funds will tend to focus in durations between one and 20 years. Pimco’s fund, for example, has an average maturity of 5.1 years, and an average asset quality of AA. We can also see the estimated yield of the portfolio (6.5%), which should give us some guidance about expected returns. Pimco goes so far as to provide a chart of when the portfolio matures, and what sectors it is typically in.

Pimco’s is a fairly safe and steady fund – just 3% of its holdings are sub-investment grade, while 81% are AA or higher. So for comparison let’s look at something with a different risk profile. The Schroder Credit Securities Fund is sold in Australia (directly as a wholesale fund, but you can access it through platforms) and its fact sheet can be found on the schroders.com web site. A look at the latest factsheet (August 2011, at the time of writing) shows a markedly different range of credit ratings: only 9.5% of holdings are AAA, compared to the majority in the Pimco fund, while more than 20% are sub-investment grade, and some rated as low as CCC. Additionally, although this fund has two thirds of its assets in Australian securities, it can invest in global assets too, so shows regional allocations, top holdings, and the split in bond type.

In a fund like this it’s easier to see just how widely fixed income securities can vary from one another. This fund puts 36% of its money into hybrids and convertibles, which are a sort of halfway house between debt and equity: for example, they might start out as bonds but in certain circumstances convert into shares. Australia has long been fertile ground for these securities, and a look at the top 10 holdings shows many of them, from issuers like Orica, Woolworths and Southern Cross Airports. Like many funds, the Schroders product offers a monthly commentary on how risk assets are doing, what was added to or taken away from the portfolio in the previous month, and what the outlook is; many people find this a very appealing consideration when deciding whether to invest. Incidentally, while the mix of holdings in the fund is very different between the Pimco and Schroder funds, the experience has been similar: outperforming the benchmark in periods over one year, underperforming more recently.

Monthly reports like these tell you a lot about a fund and help you to make a decision on whether it’s right for you. Of course, look at returns – and focus on the long-term end of that chart – but also be clear on the level of risk, the expected time horizon, where the money is coming from, if it is heavily concentrated, and generally if you understand what it does. If all those things tick the right boxes for you, you’re probably going to be a happier investor going in.

BOX: What’s it mean?

DURATION: Each bond matures in a certain period of time; generally, for any one issuer, the longer the duration, the higher the rate of interest. Average duration gives you a snapshot of the whole fund’s holdings.

CREDIT RATING: Most bonds are rated by an agency such as Standard & Poor’s, Moody’s or Fitch. These ratings are meant to reflect the ability of a borrower to pay back the bond: AAA is the strongest, and below BBB you’re into what’s called junk territory. A fund should tell you the split of credit ratings among its holdings.

YIELD: Some managers will express a yield for their entire portfolio – the expected return assuming the bonds in the portfolio stay the same and continue to do what they’re meant to.

Chris Wright
Chris Wright
Chris is a journalist specialising in business and financial journalism across Asia, Australia and the Middle East. He is Asia editor for Euromoney magazine and has written for publications including the Financial Times, Institutional Investor, Forbes, Asiamoney, the Australian Financial Review, Discovery Channel Magazine, Qantas: The Australian Way and BRW. He is the author of No More Worlds to Conquer, published by HarperCollins.

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