Fixed Income

Quality cashflows set to shine as the hunt for yield intensifies

The same low-yield environment that has driven investors to seek out higher risk income opportunities could make fixed income more valuable than ever, as quality income streams trump more volatile alternatives.

10/11/2019

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

Why fixed income could be more valuable than ever

At first glance, the low yield world makes fixed income unappealing. Low bond yields will mean low returns on bonds over time (through lower income generation), and they potentially also limit the extent to which bonds can deliver higher returns over short timeframes (through capital appreciation, driven by even lower yields). This suggests a reduced ability to meet investors’ key requirements of fixed income as an asset class: to deliver low-risk return and to help diversify equity risk.

In contrast, we believe fixed income could be even more valuable in a low-yield world.

Firstly, the certainty of high-quality fixed income cashflows makes them especially valuable in a low growth environment relative to riskier income-generating strategies which rely on higher future growth. Not only are the riskier income streams subject to much greater variability, but high growth expectations will likely need downwards revision to reflect the low-yield, low-growth world.

Secondly, more difficult risk management may result in more demand for safety. In particular, as fixed income might be less able to diversify equity risk due to both reduced ‘power’ of duration and some blurring of fixed income and equity portfolios as the search for yield intensifies, this suggests a higher, more stable, demand for fixed income at the expense of equities.

We also believe that the way fixed income portfolios are managed will be critical. Given the likely ongoing compression of yield curves and credit spreads in a low-yield environment, active management will be even more valuable with future beta returns lower, alpha potentially harder to capture and volatility management more difficult. Diversification and risk management will remain as important as ever.

Our portfolio settings

Our current portfolio settings capture some of the above thinking.

For some time now, we’ve been overweight duration and cautious on lower-quality credit, believing downside economic risks would drive yields lower, and make riskier assets vulnerable to earnings (and hence default) disappointment. With yields now having fallen considerably, central banks having eased to a degree, some thawing of US-China trade tensions having occurred, and signs global data may be stabilising, we now see risks to growth as being more symmetric. This has seen us pare our long duration position considerably – from about 1 year more than benchmark during August, to close to neutral at the time of writing. Although near neutral now in our overall duration positioning, we have in place several country level positions: longs in Australia and the US – where our views are that further easing will be delivered – against shorts in the UK and Europe, where monetary policy looks largely exhausted, particularly in the latter.

Effectively, having captured some of the beta move to lower bond yields via an overweight duration position, and with a lower prospect for strong beta returns to continue alongside the low level of yields, we’re now positioned to capture some of the relative opportunities between countries.   

The ‘more symmetric’ view on the growth environment suggests that holding high quality credit to earn income will be rewarded. We still favour Australian investment grade credit – including both corporate bonds and AAA-rated RMBS – for this purpose.  We continue to monitor both US recession and inflation risk to gauge the likelihood of the ‘tails’ to the economic distribution, and while both appear unlikely on a 1-year view, more medium-term risks persist. As such, we continue to avoid global high-yield credit, which is most vulnerable to growth/earnings/default disappointment given its current tight spread, and like owning longer-term inflation linked bonds in both the US and Australia as inflation expectations are depressed.

In the low-yield world, it will be a challenge to sensibly balance income generation with efficient risk management, and we are looking for ways to effectively diversify both income and risk sources. We’ve recently made an allocation to US mortgages, as this helps diversify interest rate and corporate credit risk, and we are exploring several other opportunities. We are also working hard to maximise the alpha we can generate within allocations.

Overall, the portfolio retains its high-quality focus, moderately constructive approach to duration and caution on riskier assets, though we are additionally seeking to capture several relative opportunities and seek new sources of return and diversification. We believe we are well-positioned for the world we envisage and expect actively-managed fixed income to continue to be a valuable portfolio holding in this environment.

 

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