Fixed-Income Performance Puzzle

Excerpt of column published by Christopher Joye in The Australian Financial Review

After the savage 1991 recession when the jobless rate hit 11 per cent, the Commonwealth’s gross government debt-to-GDP ratio rose to 23 per cent on the back of understandable budget deficits. The government’s persistent inability to size spending to revenues since 2009 has seen the sharpest deterioration in Australia’s creditworthiness in post-war history with the gross government debt-to-GDP ratio jumping from 5 per cent in 2007 to 29 per cent in 2016-2017. Ken Henry, previously secretary of the Treasury, is spot on when he says “governments have not matched the improvement in the strength of bank balance sheets that has occurred since the crisis”.

Beyond animating zombie businesses and destroying the economy’s productive capacity, the problem with zero-to-negative “real” interest rates that leave savers going backwards after tax and inflation is that they force them into dysfunctional decisions. In the search for absolute returns that can furnish adequate retirement incomes in a world where asset prices are being distorted by politicians and policymakers, savers are inevitably going to be assuming excessively high risks of loss.

In theory the most attractive solution to mitigating these hazards is focusing portfolios on “active” strategies that produce bona fide “alpha”: that is, risk-adjusted excess returns that are unrelated to “beta” or the day-to-day movements in mispriced markets as represented by “passive” indices (the ASX/S&P200, for example). This is akin to finding a very cheap house – perhaps offered by a vendor who has to sell quickly because he or she has committed elsewhere—that rewards you with capital gains that have nothing to do with general house price inflation.

One of the most informationally “inefficient” asset classes in Australia that should lend itself to active management is investment-grade fixed income.

This encompasses the $1.4 trillion in high-quality bonds issued by governments, corporates, banks, insurers, foreign companies (like Apple) and asset-backed securities which is almost the same size as the sharemarket. And yet the typical super fund has little exposure to domestic fixed-income compared with enormous Aussie equities holdings, which have massively underperformed bonds on a risk-adjusted basis.

Whereas stocks are traded on an extremely transparent exchange that instantly publishes the prices and volumes of all transactions, bonds are bought and sold in an astonishingly “dark” over-the-counter (OTC) market. This is because the Australian Securities & Investment Commission has not historically required the prices and volumes of fixed-income transactions settled through the ASX-owned Austraclear to be publicly reported like they are in the US.

This produces an unusually inefficient price discovery process wherein bond values are slower to incorporate new information and can remain far removed from intrinsic worth (or stale) for extended periods.

It is also manifest in anomalies like the bond “market-makers” who intermediate buyers and sellers presenting bids and offers that “cross”. That means sophisticated banks are giving investors the opportunity to make risk-free arbitrage profits, which cannot happen on an exchange. It would be like one guy saying he will buy CBA shares off you at $75 and another offering to sell them at $72.50.

Inefficient markets should be manna from heaven for smart active managers that can employ rigorous valuation models to exploit pricing errors to find alpha that is unrelated to the market’s beta factors, including credit risk, interest rate duration risk and illiquidity risk.

Blind Freddy can boost returns through taking on greater risk of loss by buying bonds with higher probabilities of default, longer loan terms and/or inferior liquidity. One needs skill to figure out that a bond spread is cheap by, say, 0.40 percentage points, which can deliver hundreds of percentage points in capital gains if it reverts to fair value.

This brings me to a profound puzzle.

When I examined the performance of 54 active Australian fixed-income funds over the last three and five years relative to their benchmark (the AusBond Composite Bond Index), I found that almost 90 per cent underperformed after fees. This is statistically bizarre because even if you assume that none of these guys have any skill, you would expect some sort of random distribution of returns above and below the index as the lucky ones win and the less fortunate lose.

In the more informationally efficient Australian equities asset class, which is contested by a larger pool of institutional investors, I found that a significantly lower proportion of active managers (only two-thirds) underperformed the ASX/200 index after fees. This amplifies the performance puzzle: you would think that it is easier for active managers to beat their benchmarks in less efficient markets like fixed income.

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There are two possible explanations. The fact that almost all Australian bond funds are systematically underperforming implies they are not active at all and just buying assets on a hold-to-maturity basis, which makes them closet index huggers. After fees they have to underperform.

A related possibility is that the quality of human capital in equities is higher, which makes sense given equities managers charge fees that are multiples of those levied by their fixed-income brethren. Talent will tend to gravitate to those areas offering the best incentives. This is also borne out in the resources employed in each asset class: the typical $5 to $10 billion-plus equities shop has three to seven times more analysts than similarly sized fixed-income funds.

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