Fixed Income

Carry on Fixed Interest

Stuart Dear, Deputy Head of Fixed Income, provides an update on the fixed interest environment and the need to be vigilant against complacency.

12/09/2016

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

The Australian fixed income market once again delivered solid returns in August. Supported by the RBA’s latest rate cut, Australian bonds outperformed global bonds with spreads of Australian government debt to US Treasuries narrowing to the lowest this cycle. While global government yields edged a little higher, credit assets were again well-supported by global central bank accommodation and benign economic outcomes.

Carry on remains the theme in fixed income and markets more generally. The Fed’s repeated retreat from earlier hawkish advances, coupled with the ECB and BoJ’s ongoing war against positive yields and the BoE’s bazooka following Brexit, has restored faith that central banks remain at least committed to short-term market stability / liquidity provision, even if there is less conviction their actions will be effective in achieving their stated economic objectives. While the economic outcomes in developed economies over recent years have been benign (modest growth, low inflation), Central Banks have clearly underwhelmed versus the stimulus applied – against which a whole chorus of calls for a wholesale change in policy approach has arisen. For the most part the rallying cry is that fiscal policy could be more effective in stimulating investment, and ultimately generating inflation, than monetary policy has been.  While a shift towards fiscal policy could potentially be a game-changer at some point and trigger a whole unravelling of various market conditions predicated on central bank support, at this point the probability of it occurring is too low and the timing too distant for markets to be sufficiently worried.

While carry / yield seeking behaviour is likely, without an obvious catalyst for change, to continue for some time, we need to be vigilant against complacency. There’s a growing gap between what investors are asking bonds to do for them (keep delivering strong returns with low volatility and minimal forward risk) and the mathematical realities that low yields entail. Even without a big selloff in bonds, the return versus risk trade-off for fixed income is changing, with implications for both, and the way fixed income portfolios, as standalone and broader portfolios in which fixed income is a component, are managed.

While credit valuations are ok relative to stretched government bond valuations, most of the expected outperformance from here – given the material tightening in spreads that has occurred since early in the year – is likely to come via carry rather than capital gain. 

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