SMSFundamentals | Jul 18 2012
SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
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By Greg Peel
When the laws allowing the establishment of self-managed super funds were put in place late last century, Australians were being drawn to the stock market in greater numbers than ever before as retail investors sought to participate in various public sector privatisations. The Australian government also began to run a budget surplus, negating the need for much in the way of government bond issuance.
The world then stumbled through the bubble and bust of the US tech sector and 9/11, after which “money” became very cheap. Australia suffered only a mild recession in 2002-03, but it was enough to expose the exorbitant fee structures and trailing commissions of the traditional funds management sector. Super investors were angry, and a fire was lit under the SMSF growth cauldron at the same time China suddenly began to dominate global economic growth and commodity demand. China pushed up commodity prices and cheap money, assisted by financial sector deregulation, pushed up bank prices. Therein you have a very large chunk of the ASX 200. Super investment was all about owning shares and not much consideration of other asset classes.
The GFC blew that idea out of the water. And Europe has ensured equity investment has been a pariah ever since. It's not that smurfs (SMSFs) are no longer investing in the share market – equity investment in portfolios still ranks as the highest proportion – but they have in recent years built up large stakes in cash (particularly in term deposits) as well as stakes in fixed income (including inflation-linked bonds or ILBs).
Pre-GFC, yield was not very important to Australian investors. The equity market was all about capital appreciation, and even investment property investors were ambivalent about what rental yield they were receiving when rising house prices were all that mattered. Post-GFC, yield has become the fundamental driver of investment decisions. For smurfs, the stark realisation that capital may never be “safe” has focused attention on income necessities into the future. Stock portfolios are now biased towards yield generation, and large allocations to cash and bonds ensure low risk income along with capital preservation.
Interest rates on term deposits, and in some cases even on access accounts, remain very attractive in relative terms. They're not as attractive in absolute terms as they were a year ago, before the RBA cut its cash rate by 125bp, but as a low- to no-risk investment (in the GFC the government guaranteed deposits up to $100,000) they represent a worthy addition to any portfolio. The question is for smurfs: Will cash provide enough yield, after tax and inflation, to see me through?
Many smurfs have, or are considering, fixed income as a portfolio allocation. Australian government bonds, for example, are essentially (sovereign) “risk free”. However, if you are only deciding now to invest in government bonds…well…you may have missed the boat. At around 2.8%, the Australian ten-year bond yield is at an historical low. Yet for the past twenty years, Australian government bonds have been a consistently strong investment.
Twenty years ago, inflation in Australia was running at 9% (and higher prior). It was in the wake of the 1987 stock market crash, the early nineties Japanese crash and the global recession in the early nineties, which was sorely felt in Australia, that central banks decided they could not control economies without first controlling inflation. In the ensuing period, Australian inflation has steadily fallen and today the RBA targets a 2-3% band. As inflation falls, bond yields fall, which means bond prices rise. Australian bond prices have risen steadily from twenty years ago to today.
It is unlikely inflation will fall a lot further from here, and at 2.8% it is debatable how far the yield on “safe haven” government bonds might fall from here. Upside risk is more likely into the future, meaning downside risk for bond prices.
After a period of lax and, ultimately to some extent destructive, global financial sector deregulation, the world has now begun to move towards market re-regulation. Access to money has tightened, meaning a higher cost, and this is weighing on bank earnings. Banks and their fully franked dividends were once considered a “defensive” investment but the last decade has proven that to be anything but the case. Banks are now further up the risk scale and the halcyon days of cheap money are gone, bringing banks back into the pack of capital return potential.
Mining CEO's believe strong Chinese economic growth will continue for another decade yet at least, but some analysts are now declaring the commodity “super cycle” to be over. Between those two opinions one might argue the cycle is not over but we have now passed the point of peak acceleration, settling back into more steady demand growth for commodities. Combine this with the supply cycle finally now catching up with the earlier demand cycle, and it's hard to see any more spectacular upside for commodity prices outside of smaller, interim “mini-cycles”.
It's hard to see big miners and banks – the bread and butter of the ASX 200 – offering spectacular capital upside in the medium term. Across the market, listed companies continue to undergo a process of deleveraging, as do consumers, and this is weighing on growth potential. Equity valuations may at this point look “cheap”, but they can continue to be cheap for a while.
Aside from the GFC prompting a shift back to yield-based investment preferences, a natural shift to yield is providing a further undercurrent. As the population ages, and more Australian smurfs become retirees, the shift from growth to income investment demand becomes more pronounced. In short, yield is becoming more expensive and will continue to do so under demand-supply dynamics.
So if large cap stocks are not offering fabulous wealth, and the great bond rally is over, and commodity prices have settled back, and property prices have waned, where else might a smurf look to invest?
The reality is, notes Bentham Asset Management, that most Australian SMSFs are currently “bar-belling” the risk reward balance in their portfolios, holding a lump of high risk/high reward on one side balanced by low risk/low reward on the other. The result is that investors are completely ignoring the middle ground of medium risk/medium reward, and are doing so at their cost.
“As more Australian approach retirement”, writes Bentham managing director Richard Quinn, “income is becoming an increasingly prominent consideration for most investors. Given the case we have outlined [which I have laid out above] for the critical drivers of of returns for Australian investment portfolios over the medium term, we believe that short-duration credit is poised to come into its own as a safer and more predictable source of income – and one with less risk than equity thereby protecting capital. It is a pity it tends to be lost in the middle”.
Short duration credit includes instruments such as corporate investment grade and non-investment grade (high yield) bonds, hybrid securities, residential mortgage backed securities and syndicated loans. The inexperienced investor might look at this list and immediately see “risk” looming large. However, such shorter term instruments mostly fit into the risk scale above government bonds but below most recent corporate bond issues. Australian banks, for example, have recently been on a fund raising spree through bond issues, but these represent subordinated debt, otherwise known as “unsecured”. The goal of a short duration fund manager such as Bentham is to exploit the availability of lower risk debt while still securing attractive yields. Senior secured debt, for example, is the most senior debt obligation in a corporate capital structure, implying holders of senior secured debt are “first in line” – for distributions, principal returns and payouts in the event of wind-up.
The benefits of secured debt, and a comparison to the ultimate “risk” capital, being equity, is well outlined in the following table:
If we return to the earlier risk/reward (barbell) chart above, we can see that our suite of shorter duration credit instruments sits in the intermediate risk range above fixed interest and below equities but in line with Australian inflation-linked bonds. Perhaps most notable on this chart is the placing of Australian property trusts (REITs) by comparison which rate as higher risk and lower reward than either high-yield bonds or syndicated loans.
Credit instruments are not, of course, guarantees of wealth and income impervious to risk, but they offer a “lost” middle ground of attractive risk/reward balance. The biggest problem a retail investor faces, nevertheless, is how to access such a market. Global credit issuance is reserved mostly for major institutional investors and minimum face values are beyond the realms of the typical retail investor.
Which is why a fund manager is welcome at this level, with smurfs and other investors able to allocate part of their portfolios to this asset class. Bentham Asset Management operates three funds of this nature, which are all globally invested (despite their titles), all accessible at retail level minimum investments, and all marked to market and tradeable (invest/redeem) daily. The latter element equates the funds to listed funds to a great extent, but Bentham funds are not ASX-listed.
The three funds in question are the Bentham Global Wholesale Income Fund, the Bentham Wholesale Syndicated Loan Fund and the Bentham Wholesale High Yield Fund. There is a deal of overlap in each in terms of specific asset classes, but a leaning to particular instruments. Aside from the types of instruments suggested above, Bentham's will also invest in cash on the one hand and high-yield listed equities on the other, as well as deploying derivative hedges, as the market dictates. The three funds are currently returning 9.0%, 10.0% and 9.8% respectively.
As the following graph suggests, Bentham's funds were not immune to the credit crunch and GFC, but despite the credit nature of their portfolios still managed to outperform equities, and have certainly outperformed in the ensuing period.
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