Commentary: Improving value in fixed income
We have been deploying cash and increasing the interest rate and credit risk of the portfolio via high quality credit, as inflation peaks and growth weakens.
2022 delivered the worst returns for fixed income markets in decades. However, the reset in both the level of interest rates and the credit spreads for corporate issuers means the outlook for fixed interest markets has improved considerably for 2023. This is due to key shifts in the direction of the two major drivers for fixed income – growth and inflation. Firstly, with inflation looking to have peaked as COVID-induced supply chain pressures ease and energy prices fall, central banks have slowed down the pace of policy tightening. They will likely move into a policy pause phase over the first half of 2023. While it is too early to call for rate cuts, a pause makes sense as central bankers consider the impact of the hikes to date. Secondly, growth is likely to slow, perhaps significantly. Our US recession indicator continues to flash red, with 65% of components indicating a recession within the next 12 months (a reliable indicator of the past three US recessions), mostly as a result of the combined, but delayed, impact of the significant policy tightening to date.
For portfolio positioning within the Schroder Absolute Return Income Fund, this outlook means we will look for further opportunities to increase the fund’s exposure to both interest rate risk and credit risk via high-quality credit. We cut most of the interest rate risk and ran duration at close to zero over most of 2022. Now, with Australian 10-year yields approaching 4%, we’ve started rebuilding the fund’s duration exposure in the fourth quarter of 2022, as the balance of risks shifted from higher inflation to slowing growth. As at January 2023, the duration exposure was at one year, with exposure split mostly in the US rates (as it is the most advanced in terms of the growth cycle) and Australian rates (as we expect high stress in the housing sector).
Cash deployment has started
During 2022, we reduced and hedged a significant portion of the fund’s credit exposure as credit spreads widened and underperformed sovereign issuers. The fund’s cash holdings moved to 50% as we shifted strategy to insulate the portfolio from rising interest rates and widening credit spreads. During the fourth quarter we started to deploy the cash and reduced credit derivative hedges. In particular, we have increased exposure to high-quality, investment grade issuers in Australia and Europe where credit spreads are in the 85th to 90th percentile (i.e. they have only been cheaper for 10% to 15% of their history). At these levels, we believe investors are being compensated for the risk of default in a recession scenario. At this stage, we are avoiding non-investment grade credit (issuers rated BB and below) as spreads here are trading closer to the 50th percentile and are likely not pricing in recessionary risks, therefore they carry too much risk for the credit premia on offer.
High-quality opportunities abound
As we continue to deploy our cash reserves, we see attractive opportunities to access high-quality assets with attractive yields. We have also started to rotate our exposures across different regions as we search for pockets of value. For example, Australian credit has lagged the rally seen in global credit markets and this allows us to continue adding exposure at attractive yields. Within the Australian market, we deem the banking sector to be high quality and well capitalised with a robust regulatory framework. Currently banks are issuing subordinated paper with a risk premium over cash of over 2.2% p.a. which can provide high quality yield to the portfolio. Similarly, Australian BBB rated corporate issuers’ risk premia remain elevated at an average of 2%, which is also an attractive source of income to the portfolio. We have funded these purchases by reducing cash and by reducing exposure to Asian credit where spreads have compressed significantly since November when China reversed their COVID-zero policy, and are bordering on expensive.
Currency exposure remains moderate with a 2% long USD position. Our view is that bond valuations and the effectiveness of duration as a downside risk management tool have improved. Hence, we have placed less reliance on currency as a risk mitigator.
Overall the rise in bond yields and credit risk premia is likely to set up the portfolio for stronger future returns and is allowing us to deploy cash into high-quality yield and build the income profile of the portfolio.
Learn more about the Schroder Absolute Return Income (Managed Fund - PAYS)
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