What is Active Management and why is it important for bond investing?
First up, let’s look at Passive Index Investing.
The general premise of Passive Managed Funds (also known as Index Investing) is that bond markets are efficient and price all known risks into the value. Investment managers using this approach ‘track’ the performance of the market rather than trying to beat it.
Much recent attention has been focused on passive investing, and several KiwiSaver scheme providers take this approach. However the main problem with market-weighted bond indexes is that they are weighted by how much debt a bond issuer has outstanding. This can mean your money ends up going to those issuers who are most indebted, which doesn’t make a whole lot of sense intuitively.
Bond markets are much less liquid and efficient than equity (or stock) markets due to market segmentation. Global bonds are much harder to buy or sell than they were before the Global Financial Crisis, as new regulations prevent banks holding large corporate bond trading books.
Therefore, they are prone to mispricing of various risks - which a portfolio manager can take advantage of.
Only in New Zealand
The NZ bond market is not efficient either. Before the crisis in 2006, Australasian banks relied heavily on global short-term funding markets, notably in the US. As liquidity evaporated during the crisis, the Reserve Bank of NZ (RBNZ) realised that Australian banks did not have enough long-term funding and in addition were relying on short dated investors who all pulled back from the market in 2008 due to a lack of confidence. All of this led to the RBNZ to create the Core Funding Ratio that the local banks had to meet.
The CFR incentivised banks to:
- extend their debt maturities
- rely more heavily on local deposits from Mums and Dads - as the Reserve Bank saw their deposits as being more “sticky” and less likely to pull their money in times of financial stress.
What does this all mean for portfolio managers of local fixed income you might ask?
Well for us, local bank term deposits (TDs) are now more attractive as banks like to source deposits from local investors and are willing to pay a premium to get the money in the door.
These great TD opportunities do not show up in any sort of bond index; so if you were to simply buy a bond index fund you would not get any exposure.
A secondary effect - because of this distortion in the market (where TD rates are very high relative to where short dated bonds should be priced) - is that short-dated NZ bonds become very cheap compared to those offshore.
As a manager of global fixed income portfolios, it therefore generally makes much more sense to buy short-dated NZ bonds and look to buy longer maturity offshore bonds.
Quirks of the New Zealand Bond Market
There are other quirks that occur in the NZ bond market. For example, rates for high quality BBB or non-rated bond issues that are targeted at the NZ retail market (i.e. Mums and Dads) can often be mispriced compared with their global equivalents. There are times when retail investors look more at the yield of a bond than what the spread (difference between what the bond yields and a NZ Government bond) is.
Global bond managers like us can easily spot pricing anomalies and buy the bond more aggressively (knowing that it is cheap) or pass on it entirely, knowing that we can buy a similar bond offshore, hedge it back to NZ dollars and get a better return for our clients.
Then there are also local biases that play a role in pricing a bond. New Zealand investors know NZ companies and issuers very well. Because of this, we tend to price these bonds at a higher price than if the issuer were to issue a bond in a market where the investors did not know the issuer so well.
Issuers often value diversification of their investor bases and are therefore happy to pay a premium to issue in other markets away from NZD. This means we can often buy NZ Issuers “cheap” in foreign bond markets and hedge them back to NZD at a higher yield than where they would issue locally.
For these reasons and several others, we do not believe in passive fixed income investing and much prefer to take an active approach. There appear to be opportunities that we can take advantage of in bond markets, and we don’t see that changing anytime soon.
That approach to bond investing, where we actively exploit inefficiencies in markets, is our passion at Kiwi Wealth.
This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only.