Fixed income opportunities in the COVID-19 recovery

The rally in risk assets continued into November, as markets focused on the positive vaccine news against the backdrop of government-driven fiscal stimulus packages. Markets are continuing to look through the short-term impact of the increases in COVID-19 cases, instead focusing on the continued government support of markets and consumers, which at this stage looks unlikely to materially reduce any time soon.

Domestically, third quarter GDP came in at 3.3%, representing a large turnaround from the second quarter, at −7%. While we are out of the technical recession of two consecutive quarters of negative growth, the recovery is expected to be uncertain and uneven. For example, the unemployment rate of 7% is expected to move higher to 8%, indicating continued labour market weakness.

Low rates an ongoing dilemma for fixed income investors

What is clear is that cash rates in Australia are unlikely to rise in the near term. The RBA cut rates further to 0.10% in their Novemebr meeting, as largely expected, and continued to indicate they are not in favour of negative rates. So, the challenge of low cash rates for investors is likely to continue for some time. While the low rates are good for borrowers, they are bad for savers. With cash rates below inflation, real yields are negative, and holding cash is eroding purchasing power. This is in stark contrast to 2007, when cash rates were closer to 7% and the yield above inflation was almost 3%.

This dynamic has left investors in something of a dilemma around the best use of fixed income assets in portfolios. With cash rates low and sovereign bond yields low and, in some cases, negative, delivering income remains a challenge. Cash and sovereign bonds play a role in portfolios, especially in terms of providing liquidity and capital stability. Sovereign bonds also provide diversification against equity risk. However, in the current environment, investors are increasingly seeking out alternatives.

Against this backdrop, the role of credit investments has grown in importance. With a diverse and large opportunity set, and meaningful depth and breadth, credit is an increasingly important asset class to consider. Some investors have already partially addressed the income challenge by using hybrid securities (typically bank-issued convertible bonds). While a familiar asset class to many, they form only part of a possible solution. To truly exploit the available opportunities, investors must look more broadly.

Our portfolio position

Our approach to the current challenges in a low yield world is to continue to deploy cash to a variety of credit-based assets, spanning different asset types and geographies as we seek out opportunities that currently offer a more compelling a reward for the additional risk.

In the Australian market we retain our investment grade credit holdings and have shifted into sectors, such as transport and property, that have been more impacted by COVID-19 shutdowns and offer better recovery exposure. Our hybrid exposures continue to provide a subordination risk premium and a good source of income to the portfolio. Australian residential mortgage backed securities (RMBS) continue to provide a cash-like exposure, although we are allowing these exposures to pay down principal and are actively deploying the proceeds into more attractive global assets.

In offshore markets our allocation is for high-yield assets (at 3% of the portfolio), providing a yield boost, compared to investment grade corporates. The global high-yield market is benefitting from fiscal support from the US government, but also remains supported by investors shifting further along the risk spectrum as central banks focus most of their liquidity support to buying investment grade corporate bonds.

We have retained our US investment grade holdings but are looking to trim the exposure as the duration or interest rate risk of the market continues to increase. We have been increasing our US securitised credit exposures while reducing exposure to lower yielding Australian securitised assets. These exposures continue to be defensive in nature and are highly rated and typically senior in the capital structure while delivering higher income.

Our other global holdings include Asian credit, emerging market debt and short duration European credit exposures, all of which provide access to additional yield and diversification compared to the US and Australian markets.

In terms of foreign currency position, the USD position remains small as we have longer term concerns around a potential weaker dollar, as the US has extreme fiscal and trade deficits. Our foreign currency preference remains the JPY as we believe the yen is best placed to provide diversification and is expected to perform well during periods of equity market weakness without the longer term negative fundamentals that can potentially cause USD weakness.

In terms of interest rate exposures, we retain a long duration position of close to 2.2 years, predominantly split between Australia and the US. In the US, we are positioned in the shorter maturities which are anchored to the cash rate, while avoiding longer dated maturities; this tends to benefit the portfolio when interest rates increase. In Australia, the positioning is less concentrated and across the yield curve. We do believe duration still has a role to play in portfolios, although we believe the effectiveness of duration is more limited going forward. We continue to assess our overall interest rate exposure, particularly where the interest rate risk is on the yield curve and how best to achieve some downside risk protection for periods of market stress.

Overall, we remain very active, with a liquid and highly diversified portfolio. We have maintained a defensive bias that we continue to believe is appropriate to deliver an income stream from the defensive portion of a client’s portfolio.

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