The strategy To get better value from my bond fund

I know my adviser included some bonds in my portfolio, but I don't pay a lot of attention to them. Isn't one bond fund much the same as another? Most investors tend to focus on the share component of their portfolio because that's where the big returns (and losses) can be made. Whether deliberately or otherwise, bonds have tended to be a passive investment in most portfolios - something we have because we need to be diversified, but not something we put much effort into.

However, Ross Gustafson, the executive bond manager at Tyndall Investment Management, says this type of thinking is outdated and inappropriate in the changing bond market. He told trustees at the recent Association of Superannuation Funds of Australia annual conference that they needed to look for more active managers for their bond exposure. He says the same is true for retail investors.

Why is that?
Traditionally, bond funds have been invested mostly in government bonds. Because one government bond is much the same as another, and the managers tend to measure themselves against the bond indices, it was difficult for bond funds to add value.
Gustafson says the bond market has changed dramatically in recent years.

For starters, he says, the proportion of the market that is made up of company-issued bonds has exploded.

Six or seven years ago it represented about 6 per cent of the Australian bond market. It's now up to a third, and Gustafson reckons it will be more than half in a couple of years. In February, the main bond index, the UBS composite bond index, is being expanded to include BBB grade bonds, which will increase the weighting of corporate debt by about 7 per cent.

You don't have to be an investment guru to work out that corporate debt is less secure than government debt - even if it is issued by household name companies with high credit ratings. So bonds overall have become a more risky investment.

Gustafson says few investors have cottoned on to the fact that, as corporate issuers have increased their weight in the bond market, it has also started to look much more like the sharemarket. We all know the local market is heavily concentrated in a few industry sectors. With News Corp out of the ASX 200 share index, and Telstra set to be fully privatised, Gustafson says financial, property, and telecommunications companies will make up about 45 per cent of the index. But those same industry sectors already make up about 80 per cent of the corporate debt in the UBS index.

Does that matter?
Gustafson says the conventional theory is that you invest in bonds to smooth out some of the risks in your portfolio. Traditionally, bonds have tended to perform differently to shares; for instance, they've often done better when share prices are weak. But, as AMP investors saw when that company ran into problems, when a company is not doing well both its shares and debt securities are affected. So the diversification benefits of holding bonds are eroding as the big listed companies make up more of the debt market.

So what should I do?
There's not a lot you can do about the underlying structure of the bond market. But Gustafson says investors should be aware of the changes and look at how their fund managers are responding. If you haven't worried too much about bonds until now, it may be time to talk to your adviser about whether your fund manager is managing the changes or simply going along for the ride.

Active fund managers can work to dilute some of the effects of this corporate concentration by diversifying away from the main index, but a passively managed bond fund cannot.

Gustafson says that, while Tyndall favours Australian bonds in the short term (as Australian interest rates are under less pressure to rise than those in many overseas markets), investors can also get better diversification over the long term by including overseas bonds in the mix. You can do this either by investing in both local and international bond funds or funds that include a mix of the two.