Why Fixed Income Matters

Valtwies: Brett, 2010 has been a tough period with so many themes sending the markets on an erratic journey. How have you dealt with this period?

Lewthwaite: Well, 2010 has been a period the markets were being range-bound. What I mean by that is that there have been episodes where the markets have sort of fallen down a bit, and at the same time we have experienced some rallies to levels that are a little bit encouraging. But ultimately, I think what we are entering now is more of a range-bound environment. There are quite a few issues that are still emerging form the financial crisis that occurred in 2008 and has build into 2009, and so as we deal with these situations unfortunately range bound markets are most likely to feature going forward.

Valtwies: It’s pretty hard to keep up with the economic data coming out of the US. It’s good one day, and bad the next. What impact would another round of quantitative easing have on bonds?

Lewthwaite: I think in general the data, particularly in the middle part of the year, has started to soften and a lot of the stimulus that was applied to the US economy in particular, but also some of the other economies in the western world, is waning, so ultimately, economies do look like they need further support. So your reference to further quantitative easing I think is a realistic possibility as we head to the latter part of 2010. The idea behind that, I guess, is to create greater money supply and keep bond yields in particular caped, or low. And so what we’ve seen over the past few weeks in particular is bond yields have fallen or stayed quite low in some places and we expect that to continue. I think, ultimately, higher interest rates in a western world that does have significant debt levels, would it be at the government or department level, unfortunately, seems very unlikely in the sense that higher interest costs is not going to be good for economic growth and it is not going to get unemployment levels down from some of the very high levels we have see in places like the US.

Valtwies: So Brett, how about your portfolio? In the uncertain environment, is it a case of cutting the duration and going defensive, or is it more looking further out? 

Lewthwaite: I think there is an element of watching the duration side of things because bond yields are quite low, particularly on a historical context. Whilst we don’t think that bond yields are going to experience a significant selloff anytime soon, the asymmetry of the risks is not as attractive as they have been. So you do want some level of duration, but not too much. I think, in relation to other parts of the bonds markets, credit markets in particular look very attractive, credit spreads are sill very wide, particularly given where we’ve come from over the last few years, and stable assets essentially of very good companies that are paying their debts back in full and doing so with very good coupons seems like a very sensible place to invest. Ultimately, at the moment we have situations where you can achieve portfolio outcome of CPI or inflation plus 3-4%, which is a very good outcome and you can probably do that taking a lot less risk than you have over the last few years, so I think that’s the good news in the current outlook.

Valtwies: Does the prospect of rising interest rates in Australia make bonds less attractive, and what does this mean for investors?

Lewthwaite: Look, I think Australia is a slight anomaly in the world economy. Australia is one of the places that have seen a number of rate rises; I think it does have one of the more hawkish central banks, but that’s appropriate given that Australia has feared much better than the other western nations through the recession that we have seen over the last few years. Australia hasn’t had a recession, still has good levels of employment, house prices are still at higher levels, so I think that it is in the RBA’s interest to lean on the possibility of imbalances emerging. So it is possible that we do see some more rate rises, but I think they will be modest because of the backdrop that is quite challenging for most of the developed economies out there, and therefore, in terms of will a rate rise impact bonds, I mean there is a potential for that, but I think its modest and therefore not of a great  concern to people in bond funds.

Valtwies: Ok, how important is it then for investors to maintain an allocation to fixed income securities?

Lewthwaite: Well, I think fixed income securities can come in many forms. So I think what we have seen over the last 20 years in superannuation savings, it is a fairly new concept in Australia, it is about 20 years old, and most of that time has been a particularly good time for putting money into things like equities. And generally, except for the odd episode of significant downfall, equities have been a pretty good investment. But things have changed considerably as a result of the financial crisis, which essentially was a banking crisis. And so the concept of being a little bit more defensive is very realistic as we look forward. The allocation over the last few years to defensive or fixed income type of securities has fallen quite a lot compared to where it was in the late 1980s, and a greater allocation to fixed-income style securities is appropriate. Now that does not necessarily mean you go out and buy 10-year bonds. It might be that it is shorter dated instruments, a lot of credit-based securities, those sorts of things. And they are going to give you something like 7 to 8% return, which with the level of risk which is embedded in some of these securities being quite small, I think it is a pretty good outcome, 7 or 8%, the environment we currently find ourselves.

Valtwies: Thanks for joining me today, Brett.

Lewthwaite: Thank you very much for having me.