With the Australian fixed interest market pricing in several more interest rate cuts, some fund managers have increased their government bond allocations given the downside risk to international markets, while others have switched into higher-yielding bonds to enhance income.

Advance Investment Solutions fixed income portfolio manager Ron Mehmet says many domestic fund managers have reduced their underweight allocations to government bonds given the safety they represent.

"There's more downside risk given the debt problems in Italy and Greece, so domestic fund managers are going back into bonds and switching out of cash just in case of another rate cut," Mehmet says.

"There has also been some switching out of floating-rate bonds to fixed-rate bonds as rates could be cut again and so, over time, returns could be lower than if you were in fixed-rate investments."

While government bonds are considered expensive, with yields having traded below the cash rate for some time, strong demand from offshore investments will keep yields low in the near term. "Every time bonds sell off, overseas funds are buying our bonds, which is capping yields," Mehmet says.

Some fund managers, however, have switched to semi-government and corporate bonds out of government bonds to maintain returns on their portfolios.

Colonial First State Global Asset Management co-head of global fixed interest and credit Warren Bird says government bond yields are too low and "do not reward investors for taking term risk and thus our portfolios have been positioned shorter than our benchmark duration".
 
"Locking in longer-term bonds now would mean that investors would see the value of their portfolios reduced when yields eventually rise back to more normal levels above the cash rate. The focus for us is to make sure we are positioned to protect our investors' capital when that happens," Bird says. 

He says in order to enhance income, Colonial First State funds that are permitted have moved out of Australian government bonds into higher-yielding state government and corporate bonds.

"State government bonds are paying around 50 to 75 basis points more than Australian government bonds, while on corporate bonds we can earn anywhere from 75 to 300 basis points or so above within the investment grade space and more than that in high yield," he says.

"Of course, we strongly believe that investors moving into corporate bonds need to diversify properly in order to manage default losses, and in our funds we own as broad and diverse a portfolio as possible given the parameters of our different funds."