Taking credit
where it's due ...

For most investors, fixed interest assets - traditionally defined as bond and other debt securities issued by governments and semi-government agencies - have long been a core component of a long-term, diversified portfolio structure.

Historically, a steady supply of government-guaranteed debt - new bonds issued to finance public sector spending - has kept pace with the demand for fixed interest investments from Australia's growing superannuation and professional investment community. For investment managers, in turn, opportunities to add value have involved structuring portfolios relative to an index made up of largely homogeneous government and semi-government securities, using techniques such as duration and yield curve management.

Changing market dynamics

But now, there are some fundamental changes underway in the structure of Australia's fixed interest market, with profound implications for all investors seeking to maximise the opportunities and avoid the pitfalls of investing in this sector.

These changes include:

• the privatisation of many former public utilities, which has removed the protection of government guarantee from new debt instruments issued by a number of major organisations (eg Telstra); and

• an increasing attraction for private companies to finance their operations through the issue of corporate bonds into the professional capital markets, rather than the traditional avenues of bank loans or offshore debt raisings.

Current market composition

The combined effect of these changing market dynamics has been a quite sudden and dramatic increase in the proportion of Australia's fixed interest market occupied by corporate as opposed to government bond issues.

Transformation of Australian Bond Market

(corporate bonds as a % of WDRA composite bond index)

As can be seen from the graph, over the past year, the percentage of the Warburg Dillon Read Composite Bond Index represented by corporate issues has increased from approximately 7% to over 16%. On our current projections, it is expected that the equivalent figure in twelve months time will be over 25%. This fundamental change in the composition of Australia's debt market poses some significant issues for Trustees with regard to the approach taken in managing fixed interest assets within their portfolios. Specifically, it means that credit analysis takes on a new importance, over and above the fixed interest management skills that have traditionally been required to add value in this sector.

The role of credit analysis

Unlike Government securities, corporate bonds are not government-guaranteed. However, they are priced to factor in this additional risk and as a result, the bonds trade at a margin above Commonwealth and semi-government securities of similar maturities. Properly managed, therefore, they present an opportunity for investors to obtain additional value, particularly in the current low inflation and low interest rate environment.

In order to fully analyse a corporate security, specialist skills are required to understand the credit position of the issuing company, and to position the portfolio in anticipation of major contingencies such as rating agency downgrades or defaults. Reliance on assessments by ratings agencies alone is not a sufficient substitute for this work, as any action taken in response to those assessments will of necessity be after the market pricing has already adjusted to the changed risk or opportunity.