Fixed Income

Fixed income opportunities start to emerge amid the market meltdown

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

See all articles

It’s been a tough few weeks for investment markets, with almost nowhere to hide. Both equity and fixed income assets have fallen sharply, with bond yields backing up aggressively as prices fell. And it isn’t simply the (sometimes quite violent) price action that has investors worried.

Bond markets have been exceptionally illiquid, sometimes bordering on dysfunctional, with even “safe” sovereign bonds hardly trading. Global credit markets have been even harder hit, with spreads widening dramatically as investors scramble to sell securities at perceived risk of default.

Yet amid the market carnage, there are some positive signs.

Central banks have again been stepping in to stabilise markets and encourage liquidity, leading to some tangible improvements. In the US, the Federal Reserve has been taking a range actions, including buying corporates to support investment grade credit, helping companies access funding and easing the default cycle. In Australia, we’ve finally seen the arrival of quantitative easing (QE), with the RBA vigorously buying bonds and supporting government bond liquidity.

Interestingly, the RBA’s QE plan is slightly different to some other central banks. Rather than buying a certain number of bonds, they're targeting their buying to keep three-year yields at 0.25% – which indicates that the cash rate is likely to be on hold at 0.25% for the next three years.

Overall, we expect to see central banks in both Australia and the US buying almost unlimited amounts of bonds, primarily in the five to seven year portion of the yield curve in Australia, keeping yields pinned and ensuring the market starts to function more normally.

Opportunities emerge

As so often happens, the market sell-off looks set to create some attractive opportunities – especially since much of the selling in fixed income appears to be driven by a need to create liquidity, rather than an assessment of underlying asset values (notably, passive fixed income ETFs have been among the most active sellers.)

In credit markets, the sell-off of investment grade and high yield credit has been very aggressive, with markets currently pricing in something approaching a worst-case scenario.

Hybrids in particular look to be mis-priced at the moment, with yields spiking to 9% over cash. And while there is a possibility of some hybrids being converted to equity, we think the likelihood of a wholesale conversion is very low.

There has also been a massive sell-off in inflation-linked bonds, driven by both the collapse in oil prices and an apparent expectation that inflation will go lower as economic activity plummets. As a result, yields from inflation-linked bonds have shot up dramatically, with the price differential between inflation-linked and conventional bonds appearing to be at GFC levels. That’s despite the fact that the US Federal Reserve has been actively buying Treasury Inflation-Protected Securities (TIPS). If the RBA was to do the same thing in Australia (and currently there are no indications that it will), then these assets could become quite attractive.

Our portfolio position

Like other asset managers, we have of course been impacted by the market fluctuations. Nonetheless, we believe we are well positioned to ride out volatility and take advantage of opportunities as they emerge.

Recently, we’ve been taking some profit on our long duration positions — selling down our US treasury and Australian government bond exposures. Overall, we’ve reduced duration from about 1.25 years to 0.5 years longer than benchmark. At the same time, we have reweighted our yield curve exposure towards the mid-part of the curve, following recent rate cuts in Australia and the US.

In our credit exposures, our current position is that we’re confident that we hold high quality securities with low default risk, and have been patiently watching for opportunities to add back to attractive segments of the market. We continue to favour Australian investment grade credit, but just this week have started to allocate back to Australian higher yielding credit, including bank sub-debt and global investment grade bonds.

For more on how COVID-19 is impacting markets, click here

Important Information:
This material has been issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders) for information purposes only. It is intended solely for professional investors and financial advisers and is not suitable for distribution to retail clients. The views and opinions contained herein are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds. The information contained is general information only and does not take into account your objectives, financial situation or needs. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this material. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this material or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this material or any other person. This material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. You should note that past performance is not a reliable indicator of future performance. Schroders may record and monitor telephone calls for security, training and compliance purposes.