There is not much good news for investors at the moment but they can take comfort from one thing - the fixed-interest market has remained a safe haven during the extreme volatility of the past year.

Cash and fixed interest have been the only asset classes to produce positive returns this year. Now that interest rates are coming down, fixed interest is likely to produce better returns than cash. That's the good news.

The bad news is that asset consultants during the past few years have reduced the allocation to fixed interest in most balanced superannuation and non-superannuation portfolios. Fixed interest is demonstrating its worth as a defensive asset but few investors have benefited.

A further problem investors face is it is not always clear what goes into a fixed-interest portfolio these days.

With the reduction in government bond issuance during the past decade, fund managers have expanded their universe of securities. As a result, the performance of fixed-interest funds can be more volatile and more varied than in the past.

The UBS composite bond index - the benchmark for fixed-interest investors - was up 4.2 per cent during the year to June 30 and has continued to rise. The index was up 6.9 per cent during the year to the end of August.

Safety dumped

Fixed interest used to make up about 20 per cent of a balanced portfolio but super-fund trustees over the past decade have shifted more of that money into alternative assets that supposedly had similar defensive traits but with higher yields. Such assets include infrastructure funds and hedge funds.

Many funds in those sectors have been hit hard by recent market volatility and have not demonstrated the defensive characteristics expected of them.

Investment research company Rainmaker says the allocation to Australian fixed interest at June 30 in big super funds was just 8.6 per cent. The allocation to international fixed interest was 5.6 per cent.

The problem with fixed interest was that while it was safe, the returns were low. As interest rates moved through their steady decline from the early 1990s to the early years of this decade the yields on conventional fixed-interest securities tracked rates down. Investors were dissatisfied with returns of 4 per cent or 5 per cent a year from their bond funds.

The trouble with the alternatives - as investors are discovering - is they may be exposed to equity-market volatility and may have high levels of borrowing.

Leanne Bradley, a product and investment specialist at Aberdeen Asset Management, says fixed interest may come back into favour. "We have been having lots of conversations with asset consultants about opportunities in fixed interest," she says.

Bradley says Aberdeen's view is there is more money to be made out of fixed interest. Returns are expected to come from two sources - a continuing rally in the bond market and the narrowing of spreads in the corporate credit market.

Debt structures

Fixed-interest funds are made up of government and semi-government bonds, corporate-debt securities, and sometimes asset-backed securities (such as mortgage pools) and hybrids.

Fixed-income funds used to invest exclusively in government and semi-government bonds but have diversified their holdings with the reduction in federal government debt during the past decade and the reduction in the volume of government bonds in the market. The different types of assets in these portfolios can have different performance characteristics.

The bond market has rallied in response to the peak in the interest-rate cycle. As cash rates come down the higher rates available on bonds become more valuable and the bond market tends to rally.

If the Reserve Bank continues to cut interest rates, the bond market should continue to rally. Bradley warns that future rate cuts are already priced into the bond market and so, while the trend of the bond market will continue to be positive, the best of the rally may be over.

Corporate credit is a different story. When companies issue debt securities in the capital market, the rates they pay can be expressed as a margin over government bonds or bank bills. That margin, called the spread, is a measure of the risk of investing in corporate debt.

One effect of the global credit crunch is that corporate spreads have widened during the past year. When things start to return to normal those spreads will narrow and fixed-interest investors will make substantial capital gains.

Losses

Earlier this year the consensus among fixed-interest fund managers was the global credit crunch had run its course and spreads would not widen any further. Managers started adding corporate credit and asset-backed securities to their portfolios.

But things have worsened during the year and many of these holdings have produced losses. At the same time they are providing funds with high yields.

The Aberdeen Australian Bond Fund has produced a return of 4.3 per cent for the year to the end of August, compared with the 6.9 per cent increase in the UBS composite bond index. The fund is providing a yield of 8.5 per cent, compared with the benchmark yield of 6.8 per cent.

The Aberdeen fund has 75 per cent of its assets in corporate-debt securities, asset-backed securities and hybrids. Those securities are providing high yields but are also a drag on the total return. Fund managers such as Aberdeen are betting that spreads will start to narrow again, at which point they will maintain their high yields but also start making capital gains.

Another example is the AMP Capital Enhanced Yield Fund. The fund reported a capital loss of 5.03 per cent for the year to the end of August and an income return of 11.5 per cent. The fund invests in corporate-debt securities and hybrids.

As long as the fund manager does not crystallise the losses and investors are able to hold their units, the benefit of the high yields will flow through to investors and the losses will be reversed.

This view that spreads must come in, thereby turning the losses to gains, presumes the spreads have gone too far.

Back to basics

Greg Michel, the fixed-interest portfolio manager at ING Investment Management, says the widening of spreads has far outweighed the credit risk.

Credit spreads are the margin borrowers pay above standard benchmarks such as the bank-bill rate, the cash rate or the government-bond rate. Up to the middle of last year, banks and highly rated companies could raise funds in the credit market by issuing securities with spreads of as little as one-10th of 1 per cent. Since late last year spreads have blown out to 1.5 percentage points or 2 percentage points over benchmarks - a factor of 15 or 20 times.

Simon Doyle, the head of fixed income at Schroder Investment Management, says: "Investors have shunned bond funds, preferring the perceived safety of cash. It has been hard to argue with the logic of this, given the collapse in risk assets and the general destruction of investor wealth in recent months.

"The problem is that by avoiding bond funds investors leave themselves exposed to a change in the interest-rate outlook - as interest rates come down cash returns will decline."