A key observation from this year’s review cycle has been the low levels of income distributions from Zenith’s International Fixed Interest (IFI) - Bonds universe. Despite the increased attractiveness of bonds and the reflation of real global bond yields, cash distributions haven’t kept up, as investors are patiently waiting for fund managers to “show them the money!”.
Fixed income’s role in balanced portfolios
A core allocation to fixed income plays a critical role in diversifying balanced portfolios, including generating positive real returns, lowering volatility and providing a regular source of income. However, the delivery of cash distributions to the end investor is often an ‘after thought’, as fund managers focus on total returns and outperforming benchmarks. While that approach makes sense from a portfolio management perspective, it can create challenges for income-focused investors.
This distribution drought – what’s happening?
To illustrate the lack of recent distributions, the following chart plots the median yield-to-maturity (YTM) at the start of a financial year and the actual income distributions for the 12-month period for Zenith’s IFI – Bonds universe over the past five financial years.
Source: Zenith Investment Partners, Managers
Cash distributions have averaged less than 1% over the past three years, despite portfolio yields increasing materially, following the 2022 bond market sell-off. While YTM is an imperfect measure of future distributions and includes forecast capital appreciation, it’s widely used by fund managers as a guide to future returns.
For those retirees that rely on investment income to support their lifestyle, fund pension payments this shortfall presents a real challenge. Advisers are being forced to find alternative sources of liquidity, including selling defensive and growth assets to meet cashflow requirements and pension payments.
Why are cash distributions falling?
So, what is driving the reduction in cash distributions? Are portfolio managers overseeing portfolios with a requisite focus on generating income for the end investor? The answer to these questions lies in complex areas of tax legislation, fund accounting and also market-related factors such as movements in the Australian dollar (relative to the US dollar and other major currency pairs), bond market volatility and the role of active portfolio management.
1. Current movements & the taxation trap
Currency movements or the depreciating Australian dollar have been the largest driver of the recent declines in distributions, which is partly due to the taxation regime governing funds in Australia. Gains on fixed income securities and currency instruments are generally taxable on a realisation basis (excluding those managers that make a Taxation of Financial Arrangements (TOFA) – fair value election).
Here's how it plays out:
- Currency hedging is done using short-term FX forwards (typically three months), while bonds are held for years.
- When the AUD falls against the USD (or other currencies), realised FX losses immediately offset income in that financial year.
The corresponding bond value increase (in AUD terms) isn’t realised until the bond matures—often years later.
Based on our research, the timing mismatch between the average tenor of FX forwards and the holding period of bonds, coupled with the depreciating Australian dollar have been the main contributor to the recent decline in fund distributions. The timing mismatch can benefit investors, when the Australian dollar is strengthening relative to the US dollar and other major currencies. As the chart illustrates, global bond funds delivered income distributions that materially exceeded starting yields over the 2020 and 2021 financial years.
2. More trading, more realisation events
In addition to currency, the recent period of elevated bond market activity has resulted in more active trading and positioning changes across managers, creating more realisation events and the potential for trading losses to offset income.
For example:
- A manager may hold an overweight position in US Treasury bonds and elect to hedge the position with a short position in US 10-year Treasury futures, based on a view of an upcoming non-farm payrolls data release.
- If the bet doesn’t come off, a loss on the futures position will be realised, resulting in a revenue loss, reducing the level of distributable income.
The impact of trading and turnover on bond portfolios and ultimately distributable income, varies across managers, closely linking to each manager’s investment philosophies and processes. More traditional bond managers, investing in physical bonds and focusing on longer-term trends in inflation and monetary policy, tend to exhibit more stable distribution profiles. In comparison, active managers that frequently adjust portfolios and use derivatives, including futures, interest rate swaps and credit derivatives can introduce more income volatility.
How can managers improve the stability of income distributions?
The most practical solution for managers to mitigate the impact of currency on distributable income is to make a TOFA election, which allows for the matching of FX gains or losses to the financial year period when the underlying bond is sold or matures.
TOFA elections, if administered correctly, are complex to implement requiring significant investment in back-office processes and systems. Further, the election requires ongoing hedge effectiveness testing, defining hedge ratios and processes for rebalancing and monitoring. The process becomes more complex again if active currency positions are utilised, with each position required to be identified as either a hedge or a profit seeking trade. As such, global bond managers have been reticent to make the election, with only a few managers displaying the operational expertise to administer such an election.
From a portfolio management perspective, improving income stability would require managers to:
- Make fewer active trading decisions.
- Reduce turnover in portfolios.
- Shift investment philosophies to prioritise distribution stability over pure outperformance.
While possible, these changes are difficult to implement in practice, as they may conflict with a manager’s broader strategy and performance objectives.
Finding the right fixed income strategy
Selecting the most appropriate fixed income strategy is a multi-faceted decision, spanning forecast returns and volatility, correlation to equity markets and the more client-centric decisions such as frequency of distributions, redemption liquidity and the stability of income. If stable distributions are a priority, consider these tips:
- Prioritise domestic fixed income:
- Domestic fixed interest strategies, with limited non-AUD portfolio holdings and the investment process is more of a ‘buy and hold’ approach with less directional views.
- However, many domestic fixed interest managers hold offshore securities and hedge non-Australian dollar exposure, which introduces the risk of currency volatility.
- Check for a TOFA election:
- Confirm if a TOFA election has been made.
- Understand the timing method that is being applied, noting that a ‘fair value’ election will not mitigate the risk of income distribution volatility.
- Consider master/feeder fund structures:
- In these structures, currency hedging transactions are managed offshore in tax light jurisdictions.
- Profit and losses on currency transactions are only recognised in the underlying fund net asset value (NAV), rather than impacting Australian taxable income.
- Under a Be aware of the responsible entity’s approach to distributing income, noting that this is a discretionary decision, typically governed by a distribution policy. Some managers set explicit distribution targets, while others only distribute coupon income and retain trading gains.
Managing expectations in fixed income
The decline in cash distributions from global bond funds isn’t necessarily a reflection of poor management—it’s largely a by product of tax laws, currency movements, and market volatility. While managers can take steps to smooth income, advisers should be mindful of how different strategies align with their clients’ income needs.
For those seeking a steadier income stream, understanding fund structures, currency hedging approaches, and taxation nuances is critical. And as always, diversification remains the best tool to navigate the Bermuda Triangle of income distributions.
