It is vital fixed interest remains true to label and plays its diversification role, according to Aberdeen chief executive officer Bill Bovingdon.
Bovingdon says it is important fixed interest offsets exposure to Australian equities, in particular, given they are among the largest single assets in most investors' portfolios.
He joins a range of experts in sharing this belief, many of whom are urging investors to be painstaking in researching risk and ensuring their portfolio is truly diversified.
Research house Morningstar's executive summary in its January income sector wrap-up cautions that fixed interest is no longer the vanilla asset class it once was.
"There has been a quiet revolution in this asset class over the last five to six years. The nature of fixed interest securities has changed: it's no longer just about government and corporate bonds. Income fund managers now invest in hybrids, mortgage and asset-backed securities, collateralised debt obligations (CDOs) and credit default swaps," it said.
"The global credit universe is also now significantly larger than the global equities universe, and there's been a steep increase in the number of fund managers both in Australia and offshore attempting to take advantage of these opportunities."
Bovingdon says that in the past 15 years of uninterrrupted growth in Australia, people have been more inclined to slip in other assets under the defensive asset banner in their chase for yield, such as mortgage trusts, hybrids, high yield, emerging markets, CDOs, infrastructure and hedge funds.
"All of those things at a price are good assets, but no-one will benefit in a falling interest rate environment. That is the key," he says, before adding that once a growth slowdown of any significance occurs, investors need assets that are benchmarked against the longer Australian interest rate curve.
"So you need something with Australian duration in it. Even global bonds don't do work for you in a non-synchronised slowdown as we have had in the past couple of years. The rally in international bonds has already happened."
According to Bovingdon, the era of do-it-yourself fixed income has come to an end and the benefit of a properly constructed portfolio will come to the fore over the next 12 to 18 months.
"It will be a once-in-a-decade period where bonds have their day in the sun and become the best performing asset in a portfolio. Investors can construct a very high-quality portfolio in bonds that will give a running yield of over 10 per cent. If you get falling interest rates over the rest of the year, you can see another 3 or 4 per cent in capital gain. A 13 or 14 per cent return will be hard to beat by a lot of other asset classes."
Bovingdon is witnessing superannuation funds not only looking to allocate more money into bonds, but also specifically focusing on areas battered by the sub-prime crisis.
"There are lots of opportunities in high-grade mortgage-backed securities, high-grade financials and swap markets all in the high-quality end of the market. You don't have to do anything too adventurous to get good returns in fixed interest at the moment as long as you properly construct a portfolio," he says.
Morningstar head of research Anthony Serhan also believes being true to label is critical. For those investors who have taken up income investments with the belief that all securities represent some degree of capital stability, they have been dealt a harsh lesson over the past 12 months.
Investors surfing the risk spectrum in search of higher returns need to be aware of all the risks they are taking and, more importantly, that they are making an appropriate allocation for their portfolio.
"From a fund perspective, it is how funds are being managed, what is the level of diversification and what level of gearing is placed in there," Serhan says.
"This whole idea of gearing into fixed interest securities on a fundamental basis is really quite odd. You borrow money to invest because your risk appetite can't be satisfied by equities. If your risk appetite is such that you need to gear to get adequate returns out of fixed interest security, my initial reaction is invest more in equities.
"People were after more return for no risk. As has been quite apparent, you can get some big market events where risk becomes all too apparent."
Serhan's solution is to challenge the underlying investment thesis that is being put forward and ensure it is achieving diversification.
"When you look out across the market, particularly direct investors who got caught up in some of these debenture products that went under, some of the people put all their money into this one investment. We talk about diversification, but we don't talk about it enough," he says.
Sub-prime had also affected this part of portfolios where fixed interest had become confused with alternative investment, further complicating the risk landscape for investors.
To get a clear picture of the underlying risk, investors must consider all the fees before they can determine returns.
Performance fees are also creeping in with fixed interest products, Serhan says. While they are more prevalent in the equity asset class and alternative vehicles, they are emerging on the income side. They may not necessarily be seen as a negative as long as investors ensure the performance fee is coming into play after an appropriate benchmark.
Tyndall head of fixed income Roger Bridges says there have been various products sold as fixed interest - ranging across a whole raft of different risks from credit to duration to liquidity - which should be priced for the risks.
"In the old days, it used to be government bonds. It was very simple and basically investors got returns based on the underlying cash rate plus the premium for the duration of the bond," Bridges says.
"Today, there are many more premiums you can earn through liquidity or credit. People have been hunting those premiums when yields were low to boost returns and that meant investors were being exposed to risk, which they may not have been aware of or didn't understand.
What has happened has been the repricing of risk, and the portfolio of investors has suffered."
By adding in the leveraging of risk element to boost returns even more, investors are entering the hedge fund space, with some products labelled or sold as fixed interest, he says.
That's why the nature of fixed interest, in some cases, has changed to become a wider investment class by adding new risk through leverage or adding credit to a portfolio.
"I don't think people are asking the right questions. It is the same old story: people going for higher yield without questioning what the risks are. It is a perennial problem and people never seem to learn," Bridges says.
The solution, he argues, depends on what the investor is looking for. There are many reasons to hold bonds either for liability, that is, matching cash flows, or as part of a diversified portfolio to balance the risk/return equation because, primarily, of their long-term negative correlation to equity markets.
A fundamental truth when lending money is the higher the rate, the higher the risk, according to Centric Wealth Advisers head of research (non-listed) James Foot. However, this did not necessarily apply during the past few years when credit spreads contracted to paper-thin levels, resulting in some cases where investors were not receiving adequate return for risk.
During this period of low credit spreads, some manufacturers attempted to improve yields by using leverage. This also had the effect of increasing the fees available to the product promoter. The proliferation of financially-engineered products carried increased complexity and reduced transparency.
"More than ever it was critical that investors looked beyond the marketing literature, or the label, to ensure that they really understood how returns were being generated," Foot says.
"And it was only by comprehending the mechanics of the investment offering that the actual risk became apparent - one of the lessons to emerge.
"The enduring rule for so called mainstream and non-mainstream products is that risk and potential return should be related. We would advocate only moving along the risk spectrum if a sufficient margin is being offered as compensation. If this can't be found then government bonds are a very sound default."
For investors with a long-term horizon, yields in the past few years were "stolen" by traders and hedge fund managers and those with a different time frame horizon, Putnam retail business director Peter Walsh claims.
"Because yields had been bid up so much, they became very expensive to buy so to chase yield people took on increasing amounts of risk.
That is what was going on in the market. In many instances that risk was very concentrated in terms of where it was coming from. The problem was compounded by the fact that some managers then leveraged that risk," Walsh says.
He says the issue wasn't so much about true to label but, perhaps, the perception some funds were more diversified than they were.
As a result, more investors will evaluate risk by seeking diversified opportunities with their fixed income investments. They will aim to understand better what they are and how the high yields are being delivered.
"Fixed income, despite its conservative moniker, is no different to any other. If you concentrate your risk on a particular subset there will be times when it doesn't perform," Walsh says.
When asked about opportunities, he mentions his favourite saying by investment writer Robert G Allen: "Many an optimist has become rich by buying out a pessimist."
Walsh also reveals Putnam's investment team believes the market offers its most exciting opportunities in 20 years.
He sees tempting opportunities in commercial mortgage-backed 10-year securities.
"There are forced sellers, but investors can buy these 10-year securities with attractive yields and, in our assessment, very low risk. Even in the worst 10-year history on those securities between 1986 and 1996, the underlying asset lost 40 per cent of its value, but the incidence of default was only 5 or 6 per cent," he says.
Putnam appears to have struck the right notes with its Worldwide Income Fund, launched under its own banner in 2006. Morningstar described it as top of its class in its January wrap-up.
"The strategy is a best ideas portfolio driven by the multiple strategies Putnam researches across the fixed interest landscape," it says.
"Worldwide Income brings together uncorrelated sources of alpha in the shape of a large number of typically small active bets to create a diversified portfolio.
"Another point of differentiation is Putnam's focus on mitigating downside risk, which has become more important given the credit crunch in the second half of 2007. Risk is examined from multiple angles, and effective use of derivatives has managed to hedge much of the downside - Putnam is one of the few strategies of its kind to escape the middle of 2007 virtually unscathed."
This year, Putnam has gone on the approved lists of Count, AMP Financial Planning, Magnitude and IOOF, and is expecting to be on more as the year progresses.
PIMCO's Diversified Fixed Interest also attracted the praise of Morningstar, which highlighted its core strengths as the underlying level of research and insight.
"The firm was early to spot the potential problems from the US sub-prime mortgage sector, which led to the credit crunch in mid-2007, and has also benefited from the Federal Reserve's interest rate cut in September 2007. PIMCO's positioning in high-quality US corporate debt should pan out well during the credit volatility affecting the market at the time of writing," it said.
As to the next generation of income funds, Serhan says there is a need to get a better understanding of their risk profile space to make sure they are appropriate for clients.
"While returns look really bad at this point, at some time markets will turn and these things will produce double-digit returns," he says.
