More of the same, as nervous savers shrug off stimulus
With monetary policy apparently losing its effectiveness and yield-hungry investors rolling out of cash, high-quality defensive income streams are increasingly in demand. Yet it could take astute, active management to find the diamonds amid the dross and capture genuine alpha.
A painful conundrum: lower expectations or accept higher risk?
It feels like more of the same in markets. Downward pressure on interest rates, talk of QE moving to Australia, trade wars, Brexit – on it goes. The inability of central banks to generate inflation in other countries raises questions about the ability of the RBA to do so in Australia using the same monetary policy play book.
Cutting interest rates is generally thought to be stimulatory for the economy, but to date this appears to be failing, as monetary policy globally appears to have lost its effectiveness. This has led some to question the benefits of further RBA cuts, particularly given the negative effects they have on savers. While the RBA are clear they will continue to cut if they see fit, it appears the negative effect on those relying on interest income is not being counterbalanced by mortgage holders, who appear to be paying down debt rather than spending.
With continuing downward pressure on interest rates, the search for income and yield remain front of mind for many investors. Rolling term deposits has become less palatable at ever lower rates and the forward-looking expected returns of many assets continue to diminish. This is forcing some investors further along the risk spectrum into riskier investments to achieve their income targets.
This becomes an asset allocation decision that can often increase portfolio risk. For example, some investors are increasingly looking to roll out of cash into private assets for additional returns. Yet the risk profile is very different. These assets are typically illiquid and this move is occurring when we appear to be late in the cycle. Buying riskier and less liquid assets to supplement income reduces portfolio flexibility and arguably should be allocated out of the growth portion of a portfolio, not out of the liquid defensive component.
There is a growing discussion that the days of earning essentially risk-free income are coming to an end. The arrival of negative bond yields in some countries reinforces this idea. One school of thought is for investors to adjust expectations downwards to accept the lower forward-looking returns. In doing so it may become necessary to draw down on capital to fund the shortfall from lower income.
It is argued that accepting lower risk and hence lower returns may require investors to eat into capital, but this provides more control and certainty. The alternative is to continue going further along the risk spectrum to generate returns, which increases the risk of permanent loss of capital (such as a company going bankrupt) and reduces certainty of capital.
Seeking defensive income streams
We do have some sympathy for adjustment of expectations and the management of capital risk. We frame our investment objective for the Schroder Absolute Return Income Fund around its role as part of the defensive component of investor portfolios. We focus on preserving capital and generating realistic levels of return through active management and diversification.
At this stage of the cycle we are focused on accessing what we would call “defensive income streams”, with a bias to higher quality assets that have low default risk and certainty over cash flows, via their coupon payments and maturity profile. Importantly, liquidity and flexibility remain key considerations.
In addition to defensive income streams, portfolio diversification is essential. Simply buying and holding a few building blocks of an asset class based on yield means forgoing the benefits that active management and diversification can offer. Diversification can come from duration as well as currencies. Additionally, we believe alpha from active management will continue to grow in importance in the current low yield environment. That applies not only to active allocation between asset classes but also to stock selection. This helps a portfolio work harder without simply adding higher risk and potentially less liquid assets.
Our portfolio position
Our portfolio positioning has retained its liquid, diversified and defensive characteristics. We prefer high-quality investment grade credit exposures which provide reliable returns but, importantly, have a low probability of default and low capital risk. We have a greater exposure to Australia than the US, as Australia has a shorter maturity profile, which means it is less susceptible to negative price moves if credit spreads widen in the event of a risk-off phase in markets. With the quality bias in our portfolios we are net short the global high yield market and hold no leveraged loan exposures.
This positioning is supplemented with our exposure to the Schroder ISF Emerging Market Debt (EMD) Absolute Return portfolio. This adds diversification and delivers active exposure to local and hard currency emerging market sovereigns. The return target and approach to risk are consistent with the portfolio objectives and at this point we prefer the absolute return approach over a more EMD beta driven portfolio.
We maintain duration at 1.5 years, down from a peak of around 2.5 years earlier in 2019. Our key exposures are in Australia and the US, where yields remain positive and appear currently range-bound, although we are alert to this breaking out. We retain our small inflation-linked position which serves more as a downside risk exposure and which will be of benefit to the portfolio in the case of an inflation scare.
We also continue to hold currency exposure to the USD and Japanese Yen to add further downside protection in a risk-off environment. Overall, we are diversified and defensive, continuing to actively manage risk and capital volatility.
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