This year has been challenging for fixed income investors across all sectors, but the extraordinary developments in emerging market currencies and yields spelled significant pain for Lonsec’s fixed income fund managers. Volatility had long been anticipated by investors but it finally reared its head in 2018 with February’s selloff, followed by a similar bout of volatility and drawdowns in October. That, along with rising yields in the US led to many moving out of credit markets in favour of more defensive assets.

As the chart below shows, emerging market debt experienced a significant reversal in fortunes, going from the top performing peer group in 2016 and 2017 to the worst performing in 2018 (to the end of September). This was driven by a variety of events, including a strengthening US dollar, rising geopolitical risks—especially in Turkey—and investors moving back into the perceived safety of global bonds.

Australian fixed income manager returns were weaker than last year with only seven out of 13 managers outperforming the benchmark over the year ending September 2018. Over the three-year period returns were much weaker, with only one manager outperforming out of nine, although mostly with lower levels of volatility than the benchmark.

Average peer group returns by calendar year

Source: Lonsec

Average returns in the alternative income groups have been lower than last year, reflecting the challenging credit conditions across the board. Overall, eight managers outperformed the Lonsec sector benchmark while five underperformed. The strongest performing manager returned 3.3% while the worst returned -0.1%, demonstrating further compression in results from the previous year. Over three years, performance is stronger with ten out of eleven managers having outperformed the benchmark.

Within the unconstrained bond universe, results have been underwhelming, with 10 of 23 managers outperforming the Bloomberg AusBond Bank Bill Index. The unconstrained sector is highly diverse, and returns can vary greatly given that mandates are very flexible and implicitly seek to outperform cash at a minimum. However, compared to last year the dispersion of results was narrower with the best performing fund returning 2.9% and the worst returning -3.8%. Over the past few years, unconstrained bond managers as a peer group have delivered modest returns and have generally underperformed Australian fixed income funds year to year.

Growth in fixed income products covered by Lonsec

Source: Lonsec

Unconstrained bond products remain one of the drivers of product growth, along with post-retirement income-focused solutions. For investors willing to take on additional credit risk, there has been growth across both high yield and investment grade products, while at the other end of the spectrum Exchange Traded Funds (ETFs) and passive products have also experienced steady growth. There has also been notable growth in the number of funds offering responsible investment strategies. Investors should remain mindful of the role fixed income plays in an overall portfolio and how riskier assets may be impacted during adverse market events.

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