Seeking defensive income in a world rich in risk
Seeking defensive income in a world rich in risk
As we round out the third quarter of 2020, to say it has been a somewhat strange year so far is a gross understatement. The exogenous shock resulting from COVID-19, the massive stimulus injections from central banks, and the challenging economic environment make navigating investment markets a challenge. The disconnect between fundamentals and risk assets is stark and, in the absence of continued liquidity and support from central banks, risk assets would arguably be lower.
Currently, risk assets appear to simply shrug off any concerns. There are bouts of volatility, but they don’t appear to last, and markets continue to march forward. The challenges, however, are real. Default rates in corporate bonds are rising, as the high level of leverage and falling revenues hurt many companies. That said, the current default rates appear manageable by the market and hence the credit risk premium has not been sold off.
The economic data and the delay of additional fiscal stimulus in the US, given the two parties cannot agree, is also largely ignored by the market, at least to date. Uncertainty around the US election and the possibility of a contested outcome, not to mention potential social unrest, are once again largely ignored at this stage, as is the apparently deteriorating relationship between the US and China. That said, any one of these issues or something out of left field could cause markets to question current levels and valuations. Can liquidity continue to paper over the cracks?
Meeting the investment challenge
The challenge for investors in this climate of uncertainty is to build a portfolio of assets that generates a defensive income stream. There are two important parts to this challenge.
The first part is to generate income. As many are acutely aware, the low level of cash rates naturally makes allocating capital to this asset class less attractive as an income source, creating a need to find alternatives. Cash is an important part of any portfolio, as it delivers a highly liquid, low volatility and essentially capital stable exposure. However, the current environment raises two questions: how much cash should investors hold, and what opportunities are there to deploy capital into other income-producing assets?
The second part of the challenge is to be defensive. The issue from an investment perspective is that the divergence between market fundamentals and market pricing appears quite stark and makes taking large amounts of risk somewhat dangerous to capital preservation.
Our portfolio position
Our investment approach is based on our value, cycle and liquidity framework, taking an active approach to both bottom-up stock selection and top-down asset allocation. This looks to build a diversified portfolio of assets across credit, rates and currency markets to meet the fund’s objective while maintaining liquidity.
In light of this and the current market dynamics over the last quarter, we have been adjusting our portfolio position to take advantage of some of the areas where we see opportunity. First, we continue to invest some cash holdings. As we mentioned earlier, cash is liquid and capital stable, but the expected returns from cash are miniscule. In recognition of this, we have deployed some cash into income-producing credit assets. Adjustments to credit exposure in the portfolio were both in the total holdings and the mix across different assets and geographies.
We have also reduced our allocation to higher yielding Australian credit on the view that prices had rallied strongly and there may be some price weakness, given the pressure on asset values coming through bank balance sheets. We have also moved our global high yield short position to a more constructive stance. This is largely a tactical tilt designed to increase yield in the portfolio in an environment where liquidity-driven price momentum looks likely to continue over the short-term. We are mindful of valuations and potential volatility, hence the limited size of the position at 2.5% of the total portfolio.
We have also increased our US securitised credit exposures. These exposures continue to be defensive in nature, are highly rated, and are typically senior in the capital structure. As such, they have the advantage of subordination to help protect capital while also delivering income.
We have topped up our Asian credit exposure to access the additional yield and diversification available in this segment. We also added the Schroder ISF Global Income Short Duration Fund to our portfolio, giving us exposure to predominantly European credit. This provides diversification and supplements our US holdings, but importantly is shorter in duration and hence expected to be less variable should we get a spike in volatility.
In terms of rates exposure, we retain a long duration position of close to 1.9 years. This is predominantly split between Australia and the US. In the US we are positioned in the long end of the curve, which has benefited the portfolio during the recent sell-off. In Australia, the positioning is more in the shorter end, which has continued to rally. We do believe duration still has a role to play in portfolios, although we also think the effectiveness of duration is challenged in an environment of low rates and yield curve control. As such, we currently hold duration positions mainly to provide some downside risk protection in a more extreme risk off phase, as well as for some moderate carry.
In currencies, we have reduced our USD position and added to our JPY position. We believe currencies can continue to provide downside risk management benefits to the portfolio. We also think that combining duration and currency positions is an effective method of maintaining downside risk protection, despite sometimes detracting from performance at the portfolio level. In the current environment where credit has continued to perform well, despite the occasional wobble, we still believe it is important to have some ‘insurance’ against a reversal, which the currency positioning can help provide.
Looking forward, we retain our defensive portfolio positioning. The liquidity-driven rally we have seen in risk assets looks to be disconnected from the fundamentals in many companies and businesses. We retain elevated levels of cash for the purposes of portfolio liquidity and we maintain our defensive bias with exposure to predominantly investment-grade credit. We continue to seek diversification through European credit, Asian credit exposures, US securitised exposures, and our emerging market debt absolute return focused portfolio. This supports the allocation in Australia which we continue to see as a low risk market. This higher quality focus, along with our currency and duration positions rounds out our active, defensive and liquid posture.
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