Risks mount as prices diverge from fundamentals
Fundamentals and pricing continue to diverge, as abundant liquidity keeps asset prices buoyant. Credit yields are at all-time lows while duration is at all-time highs – yet the market keeps growing. Nonetheless, deteriorating corporate earnings and rising economic stresses can’t be ignored forever. We continue to take advantage of quality income opportunities while guarding against downside risk and staying defensive, diversified, active, and liquid.
The current market dynamics continue to be dominated by the liquidity story. The fiscal response from governments around the globe has ensured that cheap and readily available credit continues to wash through markets. The income shock to the consumer from the pandemic has been alleviated, in part at least, by government stimulus packages. As a result of this seemingly abundant liquidity, the market continues to look through the current poor fundamentals and push risk assets higher. The question is how long can this last.
Credit markets grow as fundamentals deteriorate
This divergence between fundamentals and pricing can be seen in many markets. One example is the current dynamic in the US investment grade credit market. The yield on the index has recently hit an all-time low while duration is at an all-time high (due to an influx of bonds with longer average maturities), and the average quality of the index continues to fall as leverage rises. This is occurring at a time where there has been a rapid growth in market size while underlying stress is rising and the fundamentals, especially around corporate earnings, continue to deteriorate.
Very low cash rates and various price distortions in many government and some corporate bond markets appear to be hindering price discovery and suppressing volatility, which is arguably lulling the market into a false sense of comfort. That is not to say that all assets are problematic. There will be winners and losers over time, and this is where both the opportunities and risks of the current market environment present themselves. What it does reinforce to us is the mantra we carried into the crisis – that is to remain defensive, diversified, active, and liquid.
Our portfolio position
This is reflected in different ways through our portfolio positioning. Our defensive posturing can be seen in our credit exposures, which are predominantly to investment-grade rated bonds. With lower likelihood of default and less volatility than lower quality and higher risk markets, these are an important source of high-quality income.
Our active approach is seen both in bottom up stock selection and top down asset allocation. The bottom up stock selection process across our global exposures is key, particularly given the current environment. Our analysts research and identify the credit assets that are appropriate on a risk–reward basis, looking to avoid defaults and negative capital impacts by picking the winners and avoiding the losers. Meanwhile, our top down, active approach to asset allocation controls not only the total risk in the portfolio but where we take that risk. Our active approach has seen us add to overall credit since March and broaden the composition or our holdings. This has allowed us to participate in the credit rally.
Our portfolio remains well diversified across credit, rates and currency markets. In the credit space, we have a core of Australian investment grade credit. We also hold exposures to AAA-rated residential mortgage backed securities as a source of high-quality yield, as well as Australian hybrids that provide a subordination risk premium by being down the capital structure.
We hold some US investment grade credit but have recently reduced this exposure given the market dynamics mentioned above. Our US securitised credit exposures provide diversification from corporate credit via holdings biased to higher quality securitised segments, helping protect capital. Our holdings in the Schroder ISF Asian Credit Opportunities Fund aim to improve diversification but also allow access to additional yield via the higher term structure in these markets. Our emerging market debt absolute return holdings provide risk-managed exposure to emerging markets in both local and hard currency bonds. We have also increased our allocation to the Schroder ISF Global Credit Income Short Duration Fund, which adds to our European credit exposures.
We also achieve further diversification through duration, retaining a long duration position of close to 1.9 years. This is predominantly split between Australia and the US. Duration can still play a role in portfolios, although its effectiveness is challenged in an environment of low rates and yield curve control. We hold duration for some carry but also to provide some downside risk protection against more extreme scenarios in a risk off phrase.
This is also supplemented by currency management – another portfolio level insurance policy. We believe currency can continue to provide downside risk management benefits to the portfolio. We believe that holding duration combined with currency remains an effective method of maintaining downside risk protection.
Liquidity is reflected in our portfolio in several ways. First, physical cash remains elevated at close to 20%. Second, higher quality assets tend to be more liquid. Third, the bonds in the portfolio have a natural maturity profile.
Overall, we remain alert to both risks and opportunities as we seek to deliver income and manage downside volatility.
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