Preparing for a disorderly transition
The reflation trade was the key feature of fixed income markets throughout February. We’re maintaining a defensive tilt to prepare for what is likely to be a painful move to higher bond yields.
The reflation trade continued during February amid the positive economic data, continued supportive monetary and fiscal policy settings, and strong evidence of vaccine effectiveness and distribution. Expectations for higher inflation was the key driver for higher bond yields.
If bond yields are moving higher as a result of moving to a more sustainable growth profile, then this is broadly a positive story. That said, the move to higher bond yields will likely be painful, delivering negative returns in duration-based assets as we have seen in February.
The risk is that any transition becomes more disorderly and markets cease to function effectively for a period. We have seen examples of this in the past and adjustments such as these rarely occur in a straight line. Central banks have committed to low rates for an extended period, and at some point the market will begin to test this narrative. Even if the rise in yields is orderly, the question is when do risk assets like equities react? How much of a rise in yields can they sustain, and at what pace? Previous yield moves can give us some information. Back in 2018 when US 10-year bond yields rose above 3%, risk asset volatility increased. Current circumstances are somewhat different, although it could be argued that with higher global debt levels, risk assets could be more sensitive.
From the perspective of investors who are looking to access income, the challenges continue. Cash rates are essentially zero, and if we now see a rise in bond yields then duration-based fixed income investments are vulnerable and can deliver negative returns. Credit-based assets are most likely to remain the key driver for positive returns. We have been targeting the credit risk and using interest rate hedging strategies to reduce the duration risk to dampen the impact of a rise in yields.
In terms of current positioning in the Australian market, we have reduced our Australian investment-grade credit holdings by 3% (into cash). As credit spreads have compressed into the expensive zone, we have reduced our allocation. Our hybrid exposures remain unchanged and provide a good source of income to the portfolio. Australian residential mortgage-backed securities continue to provide a cash plus yield and are high quality.
In offshore markets we retained our tactical tilt to global high yield at 3% of the portfolio, which continues to provide one of the highest available yields compared with cash. The global high yield market is US domestically focused and continues to benefit from the fiscal support from the US government. It is shorter in tenor than many investment-grade markets and hence steepening of credit curves is less of an issue.
We have reduced our US investment-grade holdings by 1% given the long duration of this market. We are concerned that the rise in yields may lead to a softening in investor demand which would likely see a widening in credit spreads. We have retained our US securitised credit exposures which continue to be defensive in nature and are highly rated and typically senior in the capital structure and diversifies by sub-asset classes.
Asian credit exposures continue to provide reasonable yields over cash and assist with portfolio diversification. We continue to hold exposures to the Schroder ISF Global Credit Income Short Duration Fund which is predominantly European in its exposures and provides diversification to the US holdings. Importantly it is shorter in duration and hence expected to be less variable should we get a spike in volatility. Our emerging market debt exposure continues to be cash plus focused with a risk managed approach, and designed to access value in bonds denominated in US dollar and local currency bonds in emerging markets with less beta than a benchmark aware portfolio.
We have been reducing our interest rate exposures. Duration at the end of February was 0.8 years compared with close to 2.2 years in November last year. Concerns about the extent of the rise in yields led us to remove some of that risk. Our exposures remain predominantly split between Australia and the US. We do retain a small level of duration as we still believe in some situations it will benefit the portfolio.
In terms of currency, we had previously reduced our USD position and last month we reduced our JPY exposures by 1%. Concerns about a continuation in the stronger AUD are leading us to tactically reduce the position.
Overall we have increased liquidity and are actively managing out exposures with a diversified portfolio while maintaining a defensive tilt. As risk assets continue to rally, we expect to begin reducing allocations.
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