Digging deep in the fixed income toolbox
Digging deep in the fixed income toolbox
As we noted last month, markets have remained remarkably resilient in the face of uncertainty – in large part because of the massive policy support for both the real economy and for financial markets themselves. Yet, as investors, we nonetheless need to ensure our portfolios are prepared for a range of possible outcomes.
Markets are currently fixated on the US election, however our focus is beyond the election itself. While the outcome will be important for several years as a macro driver across a range of issues – fiscal policy and geopolitics for starters – the scenario that most concerns us over the next year is a more meaningful period of corporate insolvency, which would cascade through both the real economy and markets. We are monitoring corporate profitability and balance sheets very closely for this. The scenario that is most talked about is bond yields spiking higher driven by inflation concerns. We think this is extremely unlikely, but buying some insurance against it makes sense.
The role of fixed income in a high-risk environment
Fixed income provides some very valuable portfolio construction tools for generating income and managing risk, though undoubtedly the challenges of the new lower yield environment will require managers to harness them a little differently.
Focusing on high quality income generation is the starting point. Corporate bonds remain attractive for this purpose. While absolute levels of yields are low, and spreads on corporates have now ‘normalised’ after the extreme widening of March, corporate spreads to government bonds are nonetheless at about historic averages. This make them relatively attractive compared to government bonds, whose term premium is suppressed, and potentially compared to equities, for which the cashflows are much less certain.
As the return to credit is driven by solvency rather than growth, a slow and uneven recovery will be OK for corporate bonds, so long as balance sheets are in good shape. We continue to believe Australian credit is a sound place to invest, as overwhelmingly Australian corporate issuers are resilient to the headwinds of COVID-19, and the quality of the market remains high.
Our portfolio position
We are focusing on positioning for quality income generation across a broad opportunity set, keeping portfolios well diversified, and being flexible to both capture opportunities and manage risk. We see further potential to adapt to changing market conditions by accessing more low risk alpha opportunities, with returns to broad market betas probably reasonably limited, and by adopting a more targeted approach to risk management. As spreads have compressed, we have downgraded our view on corporate bonds compared to a few months ago, and now expect the bulk of near-term returns to be driven by income (or carry) rather than further capital gains. Accordingly, we’ve trimmed our exposures a little, mainly away from riskier exposures. Mostly, however, we’ve rotated into other parts of the opportunity set that offer better value – that is, a better income for the risk of earning it. For example, within the broad global opportunity set, Asian credit is attractive versus developed country high yield, and US securitised debt is more appealing than US corporate debt.
In Australia, we’ve trimmed our higher yielding and Residential Mortgage Backed Securities (RMBS) allocations, and within investment grade we’ve rotated from banks to non-financials. While banks have led the spread re-pricing in recent months, we think the extent of the loss provisions likely to be required is still underpriced.
Our second key focus is on seeking effective diversification. The low yield world threatens fixed income diversification in several ways. First, there is reduced potential for bonds to offset equity losses by gaining materially (that is, for yields to fall significantly lower). Second, correlations between fixed income assets are likely to increase as yield curves converge. However, there are several things we can do to mitigate these threats:
- We are being more targeted in our approach to duration management. In a low-volatility interest rate environment where central banks have yield curves under administration, this means being even more selective about where to own duration and preparing sensibly for higher interest rate volatility. We continue to prefer Australian duration in intermediate tenors, and recently added duration on the expectation that the RBA will need to ease further. We are also preparing for higher US interest rate volatility through yield curve steepening positions.
- We have sought further diversification within our credit allocations. This includes lending to households (via RMBS) rather than simply corporates, emerging markets rather than simply developed economies, and more recently, private rather than simply public debt.
- We’ve also made increasing use of lowly-correlated relative value positions to add value in a low-risk fashion, at a time when returns to market betas are likely to be constrained. Recent examples include spread trades between Australian and German rates, and between European and US credit.
In this uncertain environment, we are confident both that fixed income continues to play a very important role in portfolios both as an income generator and risk manager, and that the fixed income portfolio we are managing is well positioned to deal with a range of outcomes. We continue to run modestly more interest rate risk than the benchmark, and remain constructive on credit assets relative to government bonds. Our overriding focus remains on positioning for quality income generation across a broad opportunity set, keeping the portfolio well diversified and being flexible to both capture opportunities and manage risk.
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