Bond yields start to catch the eye
Australian 10-year bonds are now 100bps off their October lows and starting to look attractive at 1.7% – but the corresponding risk to capital values has increased as well.
The main story over the quarter was the rise in bond yields – largely off the back of the improving growth outlook and rising inflation expectations. Whilst not dramatic, we did see Australian 10-year bond yields rise 70bp over the quarter and they are now 100bp from their lows in October last year. We hold low levels of duration, however the upward move in sovereign bond yields did detract from portfolio returns. Also, the strength of the Australian dollar detracted – particularly against the USD and Yen.
Credit markets remained well supported and, despite the move in sovereign bond markets, credit spreads have been relatively well behaved. In a zero-rate world the search for yield continues as abundant liquidity looks to find a home. The carry from coupons and positive return from credit spreads moving tighter added to portfolio returns.
Outlook and positioning
With vaccine rollouts progressing across the globe and the backdrop of stimulatory fiscal and monetary policy settings, the reopening of trade is in full swing as stimulus and liquidity feed into higher asset prices. Whilst there is little likelihood of stimulus being withdrawn anytime soon, arguably much of the good news is being priced into markets. Future expected returns are likely to be more subdued given the current starting point of valuations of many assets.
The next phase of markets is expected to be more challenging. In credit markets, valuations in some segments are moving into expensive territory as the search for yield-based assets continues largely unabated. Many companies have weathered the storm to date and whilst there have been some issues in the hedge fund space, at this stage ample liquidity is keeping the level of corporate defaults lower than would otherwise be the case. We know that in the absence of a meaningful shock, valuations can stay at expensive levels for extended periods as we enter more of a ‘carry’ phase.
In terms of duration, the back up in long end bond yields has improved their attractiveness, particularly in the world of zero cash rates. The Australian 10-year treasury bond has risen 100bp off its lows and with a yield of around 1.7% is beginning to look more interesting. That said, the risk to capital values has arguably increased. There is an increasing tension between central bank policy settings and investors, with the latter concerned excessive stimulus will lead to a significant rise in inflation. Central banks remain firmly committed to low policy rates and their ongoing aggressive support of markets. This resolve will be firmly tested if economic data continues to print firm and concern about inflation continues to build. Any material upside surprise to upcoming inflation data could provide some real headwinds as the market either looks through any spike as a shorter-term cyclical uplift or views it as more of a structural shift in the inflation regime.
In terms of portfolio positioning, given valuations we reduced our Australian investment grade credit holdings by 3% into cash. Our hybrid exposures remain unchanged and provide a good source of income to the portfolio. 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 to cash. We have reduced our US investment grade holdings by 1% given the long duration of this market and sensitivity to widening spreads. We have retained our US securitised credit exposures which continue to be defensive in nature and are typically senior in the capital structure. Asian credit exposures continue to provide reasonable yields over cash and assist with portfolio diversification.
In terms of duration we did reduce outright duration over the quarter to around 0.4 years. As such, we insulated the portfolio from much of the rise in bond yields. Overall, we remain liquid and high quality with a low level of sensitivity to interests rates and moderate currency exposures. Over time we envisage reducing the credit risk in the portfolio and adding to duration-based assets should yields continue to rise. Currency-based allocations are currently more moderate, although the AUD/USD has recently moved to more attractive levels, and should we see a rise in risks we will likely add back to our USD exposures.
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