Fixed Income

Complacent investors exposed by retreating tide

Mihkel Kase

Mihkel Kase

Fund Manager – Fixed Income and Multi-Asset

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In last month’s commentary, I raised the point that the market appeared somewhat complacent as the coronavirus began to spread. Not having any expertise in virology, this was predicated primarily on the view that the market appeared fully priced and hence somewhat fragile to a shock that could derail its momentum.

That shock just happened to be in the form of the coronavirus. The ramifications of this exogenous shock to the supply and demand sides of the global economy remain uncertain for a variety of reasons.

First, there is considerable uncertainty about the extent to which the virus will spread and mutate, as well as its anticipated death rate. This is essentially unknowable at this stage – and while some were initially comparing it to SARS, the short answer is that even the experts are unsure.

This in turn feeds into uncertainty as to the longer-term economic impact. If other countries take the China approach of forcing quarantine and closing the means of production, the economic effect will be significant. In any case, the extent of the disruption and the final effect from here is still an unknown.

The third element, important from a portfolio perspective, is how the markets react. We have seen authorities attempt to calm markets by pumping in liquidity as well as announcing various government packages to stimulate economies. Despite this, recent market gyrations highlight the uncertainty and variability in potential outcomes.  

Our portfolio position

In our recent webinar, 'Finding income in changing markets' we stressed the importance of remaining defensive, patient and liquid. Being defensive ensures lower portfolio volatility and lower capital variability, particularly given current valuations. Being patient avoids simply blindly “buying the dip”, which is not always a winning strategy. Importantly, being liquid also allows us to more easily reposition portfolios to take advantage of opportunities as they arise.

So where are we and in what direction are we heading? First, cash remains elevated at 26%. While cash rates are low, cash provides us with both capital stability and the option to easily buy assets.  

Second, our credit exposures are all investment grade and – while not immune to potential mark-to-market volatility, represent higher quality issuers and hence those with low default risk. We continue to hold exposures to AAA rates RMBS which provide low risk yield. We also retain our preference for Australian investment grade, given the shorter tenor of this market. Hybrids remain at close to 10%. Over the month we further reduced allocations to global corporate bonds into cash as a risk reduction trade. We also continue to hold a small short to global high yield as a downside risk protection trade.

Additional diversification is achieved via our Emerging Market Debt Absolute Return Fund exposure, which provides access to local currency and hard currency bonds. In addition, the exposures to US securitised credit provides closer exposure to the US consumer, a sector which we believe will be better supported in the coming months as opposed to direct corporates.

Duration at month end was at 1.75 years with key positions being in Australia and the US. This has been an important offset to variability. We have also continued to hold our long USD position against the AUD, which also assists portfolio diversification and downside risk management. 

In the longer run this may be the start of a market repricing where the risk premium is re-established and allows us to set up for the next run in markets. In the meantime, we remain defensive, patient and liquid. As risk assets reprice, we will be alert to new opportunities that present themselves across our global opportunity set.

We will also look to actively position the portfolio in a more constructive manner once the risk premium has been repriced to a level where we believe investors are being compensated not only for the risk of loss, but also the potential volatility to come.

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