IN FOCUS6-8 min read

Commentary: A defensive harbour

Fixed income markets are in a consolidation phase with central banks nearing their last rate hikes. Despite uncertainties, we believe fixed income offers a defensive harbour against potential volatility, and our approach favours higher quality corporate debt and government spread sectors.

05/09/2023
Defensive Harbour SFIF Sep

Authors

Stuart Dear
Head of Fixed Income

This is a year of consolidation for fixed income. Markets are coming to terms with where money policy tightening ends and what lies beyond. On the former, we are reasonably confident that a large number of central banks are close to their final rate hike in the cycle, but on the latter, considerable uncertainty remains.

Following aggressive repricing throughout 2022, government bond yields have since traded a wide range, contemplating both how high central banks need to take cash rates, and how quickly they will then need to be cut. Returns have been moderate – the Bloomberg AusBond Composite Index has delivered 2.79% YTD to 31 August, slightly ahead of cash as represented by the Bloomberg AusBond Bank Bill Index at 2.45% over the same period. Credit assets have outperformed government bonds via higher income and spread compression (with the Bloomberg AusBond Credit Index returning 4.13% YTD).

This has not yet been a year of cyclical outperformance of fixed income over other assets. While headline inflation rates are moderating, services inflation, underpinned by robust labour markets and firming wages, is proving sticky. Growth, meanwhile, has held up better than expected in most countries – ongoing fiscal support and the general benefit of inflation to corporate profitability have partly offset the effects of higher rates. There are certainly pockets of leverage under stress – e.g. in commercial real estate – but there has been no great credit unravelling yet.

When thinking about fixed income, both patience on the cycle and a strategic medium term mindset are required.

Restrictive for longer

Our view on the cycle is that it remains favourable for fixed income. Cash rates are now at restrictive levels in most economies, and there is evidence they are beginning to bite. Households are under interest rate and cost of living pressure, and forward indicators suggest labour markets will soften. While inflation remains elevated, it is softening, and central banks are aware of the risk of overtightening. This supports our view that there will be only one more rate hike by both the RBA and the Fed. With central banks and market participants suggesting we are close to terminal rates (i.e. peak cash rates), the focus might turn from rates that need to be ‘higher for longer’ to ‘restrictive for longer’.

There is always uncertainty around cycle turning points, but the considerable differences between this cycle and others – higher inflation, changing savings patterns (older cohorts are de-saving), fiscal activism, and lingering supply-side disruption – mean that in our minds, the range of possibilities from here is wide. Markets have narrowed in on the ‘soft landing’ scenario, in which inflation moderates nicely but high rates don’t cause a recession. Complacency around this view is a risk.

Shelter for investors

In a cyclical sense, we therefore think fixed income has plenty to offer. Yields are high, the evidence suggests the cycle is softening, and markets are priced for a benign outcome. Relative to other assets, high quality fixed income can offer both decent yield and the ability to perform should the economic cycle turn down more meaningfully.

More strategically, we expect fixed income to offer a defensive harbour as cycles potentially become more volatile. On average over the next decade we expect inflation to run higher than over the last several decades, resulting in persistently higher yields. This should provide good ongoing income from fixed income. At the same time, higher macroeconomic volatility, and therefore uncertainty, should see market risk premia (term, credit, equity) rise, but underlying repayment probabilities on high quality debt should only shift marginally. The predictable cashflow profile which underpins debt investment should therefore remain, and provide shelter for investors from volatility.

Positioning

We are positioned for the end of the tightening cycle but acknowledge the considerable uncertainty beyond. This involves a modestly long interest rate position, constructive positions in higher quality corporate debt and government spread sectors, and limited exposure to riskier debt.

Within these broad settings there is considerable dispersion between countries and sectors that are providing opportunities. In particular:

  • We prefer interest rate duration in Australia and Europe, where the cycle is slowing more quickly, and we are running small long duration positions in each. In August, we reduced US duration and added to Europe
  • In the US, we expect the yield curve to steepen from heavily inverted levels. We believe this will most likely occur via the Fed cutting rates at some point next year, though a rise in longer-term yields could occur. We are both overweight short dated Treasury yields (yielding about 5%) and underweight long dated yields (yielding about 4.2%), and added to this position in August. We also continue to like inflation exposure in the US, as markets seem optimistic about a return of inflation back to low levels
  • Our strongest conviction is in Australian investment grade corporates. Spreads are wide relative to the high quality / low risk of the underlying issuers. The recently concluded Australian reporting season provided a reasonably robust picture of Australian corporate health. We also like Australian Tier 2 bank sub-debt, in which issuance to meet regulatory capital requirements is keeping spreads wide, relative to the low underlying risk
  • Globally our credit exposures are limited, and we continue to run a small short position in US high yield. We have considerable flexibility to add exposure as the opportunity arises
  • Beyond corporates, we also favour the sub-sovereign (state government and supranational) issuers over government bonds. Aiding performance of these sectors is the likely ongoing compression of swap spreads

As we approach the anticipated end of the cycle, we believe asset allocators should rebalance back in favour of fixed income. High-quality fixed income now offers attractive potential income levels and a defensive harbour against uncertainty.

Learn more about the Schroder Fixed Income Fund.

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Authors

Stuart Dear
Head of Fixed Income

Topics

Fixed Income
Bonds
Australia
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