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.
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.
For the full portfolio and market update please click the download button in the page header.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.