Download FINDING RELATIVE VALUE OPPORTUNITIES IN FIXED INCOME

Perpetual Diversified Real Return Fund
FINDING RELATIVE VALUE
OPPORTUNITIES IN FIXED INCOME
Real return strategies offer investors the convenience of
an expanded set of investment opportunities within a
single fund. In addition, these funds have tremendous
scope to adjust the asset allocation, based on the
manager’s view of the likely returns and risks of any
asset class. However, this ‘go anywhere’ investment
flexibility is not the only differentiating characteristic of
real return investing. Leading real return funds can also
utilise investment strategies such “relative value” to
exploit risk and return imbalances between asset classes.
This enables investors to better diversify risk and
enhance their return.
The team behind the Perpetual Diversified Real Return
Fund (the ‘Fund’) follow the same strong valuation
discipline underpinning all investment strategies at
Perpetual. Managed by Perpetual’s Multi Asset team, the
Fund seeks to own investments with reliable cash-flows
at attractive prices irrespective of asset class labels,
provided they align to the Fund’s investment objective of
delivering inflation plus 5% p.a. over rolling 5 year
periods (before fees and tax) with the least amount of
risk.
This means that the Fund can invest outside of the more
traditional asset classes like domestic and global shares,
fixed interest, cash and property to include a broader
range of investment opportunities – some of which don’t
fit neatly within the classification of a single asset class.
Equally, if the risks outweigh the potential benefits, any
asset class can be removed from the portfolio.
THE ISSUE OF FIXED INCOME IN
TRADITIONAL DIVERSIFIED PORTFOLIOS
The following fixed income examples illustrate the key
differentiating features of a real return fund being able to
remove individual asset classes from their asset
allocation and also turn potential portfolio risks into
opportunities, in order to diversify and improve risk
adjusted returns for investors.
In June 2016, over one quarter of the world’s government
bonds were trading at a negative yield. There are three
possible explanations why an investor would choose to
hold a bond with a negative nominal yield.
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The Perpetual Diversified
Real Return Fund seeks to own
investments with:

Reliable cash flows

at attractive prices

irrespective of asset class labels

that align to the Fund’s investment
objective of CPI+ 5% p.a.*

with the least amount of risk
* over rolling 5 year periods, before fees and tax
THE PERCENTAGE OF NEGATIVE YIELDING DEBT
IN THE BLOOMBERG BARCLAYS GLOBAL
AGGREGATE INDEX, BY MARKET VALUE
30%
25%
20%
15%
10%
5%
0%
2012
2013
2014
2015
2016
2017
Source: Perpetual Investments, Bloomberg.
Data as at 13 May 2017.
First, if the investor intends on holding the bond to
maturity, they may conclude that losing a guaranteed
small amount of money is a better alternative to
potentially losing more money in another asset class,
such as equities, over the same time period. In a similar
manner, perhaps they believe the negative nominal yield
received will be higher than inflation over that period, in
other words deflation.
Second, the strategy could be profitable if they don’t
intend on holding the bond until maturity. The investor
may expect the value of the bonds will continue to rise as
yields decline to even more negative nominal rates and
therefore they could make a capital gain by selling this
investment to someone else at a higher price; otherwise
known as the “greater fool” theory.
Third, since government bonds trading at negative yields
were such a large part of the index there was “career risk”
and “benchmark risk” if these bonds were excluded from
the portfolio. Put simply, investors or fund managers
investing this way are focussing on relative returns
versus a benchmark, rather than producing positive
returns over the rate of inflation. This is a crucial
differentiator between real return funds and traditional
diversified funds. Where the objective of the client is to
build and protect wealth, traditional diversified funds
(and those who are managing them) that focus on simply
delivering relative returns may not be entirely aligned
with the main goals of the people investing in them.
RISK MANAGEMENT OF FIXED INCOME
IN THE PERPETUAL REAL RETURN FUND
Despite being labelled defensive investments,
government bonds lose money when yields increase.
There is nothing defensive about losing money. It doesn’t
matter what the label on the tin says, bonds, particularly
those trading at historical low yields, can and do lose
money in rising interest rate environments. For example,
a 10 year government bond would be expected to lose
approximately 8.5% (price change) when interest rates
increase by 1%. Given the poor likely returns if interest
rates were to remain low, and the risk of losing money if
interest rates were to increase, Perpetual made a
common sense decision to remove all negative yielding
government bonds in favour of Australian Government
bonds which continued to offer a yield higher than the
current rate of inflation.
Over the first 9 months of 2016, Australian bond yields
continued to fall (meaning prices rose) and reached a
historical low of 1.8%, which was below both the Reserve
Bank of Australia’s inflation target band and the
expected rate of inflation. The opinion of the Perpetual
Multi Asset team was that the risk of Australian bond
yields rising had increased due to an improving cyclical
outlook for Australian economic growth as the drag from
mining investment reduced, improving employment
data, strong investment in housing and infrastructure,
and the recovery of energy prices leading inflation
higher globally. Therefore the returns on offer were not
compensating for the risks and it was a clear cut
decision; we removed the Fund’s exposure to Australian
government bonds.
This view proved to be correct as interest rates across the
world increased by approximately 1% on improving
inflation data (which had started to improve since July
2016), and then accelerated inflation expectations linked
to increased infrastructure spending and tax cuts (fiscal
easing) by the newly elected Trump administration.
In March this year we added back Australian bonds into
the Fund to take advantage of more attractive higher
yields and a shift in our economic outlook for Australia.
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AUSTRALIAN GOVERNMENT 10 YEAR YIELD
%
EXITED
ADDED
3.25
3.00
2.75
2.50
2.25
2.00
1.75
Jan-16
Apr-16
Jul-16
Oct-16
Jan-17
Apr-17
Source: Perpetual Investments, Bloomberg.
Data as at 13 May 2017.
“In June 2016, over one quarter of the
world’s government bonds were trading at a
negative yield… Given the poor likely returns
if interest rates were to remain low, and the
risk of losing money if interest rates were to
increase, Perpetual made a common sense
decision to remove all negative yielding
government bonds in favour of Australian
Government bonds which continued to offer
a yield higher than the current rate of
inflation.”
The movement back into Australian bonds coincided
with a relative value opportunity in global bonds. The
European Central Bank (ECB) is persisting with the
quantitative easing (QE) programs first introduced in
2015 despite a broader based recovery in economic
growth and core inflation moving higher. For now, ECB
intervention and political risks relating to key European
elections this year has kept interest rates from rising as
much as other parts of the world, notably the US. The
yields on German 10 year government bonds (German
Bunds) have steadily fallen from 2008 to 2016, and are
currently offering a mere 0.35% yield. With European
political risk currently receding, economic growth in the
region appears more robust, the possibility of the ECB
gradually tapering its QE program is increasing. In
contrast, US 10 year Treasuries are currently trading at
yields of 2.4%; this is 2% higher (‘spread’) from those
offered in Germany. Looking at the relationship between
German and US 10 year government bonds, this spread
has seldom been wider.
10 YEAR GOVERNMENT BOND YIELD
%
6
US
Germany
5
4
3
2
1
0
-1
2007
2009
2011
2013
2015
2017
Source: Perpetual Investments, Bloomberg
US - GERMAN 10 YEAR SPREAD
%
28 YEAR HIGH
2.5
2.0
1.5
1.0
MEDIAN
0.5
0.0
-0.5
-1.0
-1.5
1989
1994
1999
2004
2009
2014
Source: Perpetual Investments, Bloomberg
“At the time of writing, in order to allow
investors to potentially profit from shifts in
the global economic outlook, we have a
relative value position in government bonds
which makes money if German Bund yields
rise more than US Treasuries. Importantly,
this is not a directional view on interest rates
– returns are unaffected if bond yields
globally go up or down by the same amount –
it is the relative move between US and
German bonds which is important.”
We believe the spread between these two governments
bonds is likely to narrow over the balance of the year,
given the strength of European economic growth and the
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declining political risk in Europe. In order to allow
investors to potentially profit from this view, we have a
relative value position in government bonds which
makes money if German Bund yields rise more than US
Treasuries. Importantly, this is not a directional view on
interest rates – returns are unaffected if bond yields
globally go up or down by the same amount – it is the
relative move between US and German bonds which is
important. In addition, risk management of the position
is enhanced by both positive carry and, with the spread
coming off a 28 year high, what we believe is a
reasonable valuation buffer.
APPLICATION TO PORTFOLIO
CONSTRUCTION
Referring to our proprietary four quadrant approach to
portfolio construction, “relative value” positions such as
this fit in the third quadrant – Diversifying
Opportunities. Investments in this quadrant are those
that we consider for inclusion in the Fund because they
have the potential to provide uncorrelated returns and
are not linked to the general movement of the overall
stock market.
Often these diversifying investment opportunities are
those typically overlooked by traditional balanced funds,
simply because they may not always fall neatly into a
single asset class. This includes relative value trades,
such as the US – German yield spread, as well as
currency holdings or skill-based sources of return such
as market neutral equities. Including positions with
these characteristics can have the effect of improving
risk adjusted returns.
WHAT DOES THIS MEAN FOR YOU?
The above highlights how we have managed both the
risk and opportunities within the fixed income asset class
over time. Initially we removed the government bonds
which were the least attractive because of negative yields
and following that, exited the asset class entirely when
our measures of value, cycle and momentum were
unfavourable. The final step is exploiting the potential
normalisation of the relationship between two different
Government Bond markets as the intervention of central
banks begin to recede.
So whilst this example is just one of many investments
that the Perpetual Diversified Real Return Fund may hold
at any one point in time, it demonstrates how breadth of
investment ideas and portfolio construction can help to
protect and grow the capital of investors on a daily basis.
We monitor these opportunities and decisions
continually, as a key component of our risk management
process to ensure your portfolio is working towards your
objectives.
To find out more about the Perpetual Diversified Real Return Fund, visit
www.perpetualrealreturn.com.au, contact our Adviser Services team on
1800 062 725 or speak to your Perpetual Business Development Manager today.
This brochure has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It is general information only
and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a
financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage
as a result of any reliance on this information. The product disclosure statement (PDS) for the Perpetual Diversified Real Return Fund, issued by PIML,
should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling 1800 022 033 or visiting our website
www.perpetual.com.au. No company in the Perpetual Group (Perpetual Group means Perpetual Limited ABN 86 000 431 827 and its subsidiaries)
guarantees the performance of any fund or the return of an investor’s capital. Past performance is not indicative of future performance.
MORE INFORMATION
Adviser Services 1800 062 725
Investor Services 1800 022 033
Email
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