Fixed Income

Tail risk remains as markets discount the negatives


Mihkel Kase

Mihkel Kase

Fund Manager – Fixed Income and Multi-Asset

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The worst of the health crisis appears to be behind us, at least for the time being. News flow is no longer dominated by the pandemic and many countries are looking to begin moving back to some level of normal. Restrictions are slowly being eased, but a close eye is being kept on the situation to identify and deal with any future outbreaks. The situation differs greatly from country to country, but overall it appears that we are in the early stages of a return to more normal conditions.

The extent and duration of the economic shock and its consequences, however, remain unclear. The market continues to focus on positives and appears to disregard the negatives. For example, in early June the US equity market was up almost 45% off its lows, largely off the back of the policy response and flattening of the virus curve. That said, economic data is expected to continue to be dismal and this highlights the fact the global economy is in recession. Among other indicators, US unemployment may be better than first feared, but will still be a significant negative. Furthermore, geopolitical risks continue and the market commentators are starting to look forward to the US presidential elections to try and assess the potential impact of policies on both sides of the political landscape.

A long and uncertain tail

From an investment perspective, this is arguably a more challenging phase of the current crisis and we still see a large amount of uncertainty and a wide range of potential outcomes. Going into lockdown is relatively easy; the question is how quickly we will come out and whether consumer behaviour will change as a result of the virus and the future potential threat in the absence of a vaccine. I would argue that we have not necessarily removed the potential tail risk.

In managing an absolute return income fund there is a focus on the downside risk or tail risk that can negatively impact capital. The snap back, driven at least in part by the various government stimulus packages, has occurred at breakneck speed and suggests to us that markets are pricing the positives and ignoring the negatives. Liquidity has been restored, but the solvency concerns remain and will take some time to play out. Hence, we remain defensive but have been repositioning the portfolio.

Our portfolio position

In terms of portfolio positioning, we have been deploying cash into credit assets, given the extent of the spread widening. Over the past two months we have allocated 5% of the available cash we had accumulated in the lead up to the crisis into investment grade credit. This has been mainly into Australian investment grade, which has been slower to tighten. We also reduced part of our short global high yield position.

In addition, we have also looked to change the mix of our credit allocations. We trimmed our exposure to global corporate bonds, given the extent of the liquidity-induced rally. We also trimmed our exposure to Australian higher yielding credit to take some profit on the recent partial retracement of spreads. After month-end, we then allocated 2% into the Schroder ISF Asian Credit Opportunities Fund. The rationale is to improve diversification and access additional yield via the higher term structure in these markets.

We have retained our emerging market debt absolute return exposures, which continue to provide risk managed exposure to emerging markets. This exposure performed relativity well in the crisis, given the focus on downside risk which helped manage portfolio volatility. We also retain our US securitised credit exposures, which provide diversification from corporate credit. The holdings were biased to higher quality segments going into the crisis and despite some pressures coming through this market, the allocation has fared reasonably well. However, we will continue to monitor the flow-through effect of the fiscal stimulus in the US on the US consumer. 

Our exposure to AAA-rated residential mortgage backed securities continues to serve its purpose as a source of high-quality yield. Even with potential stress in the housing market, these have held up well and continue to amortise in this low rate environment.

On the currency side, our key positions are long USD and Yen versus the AUD. We have seen continued strength in the AUD versus the USD as we have continued to reduce our allocation to 2% from a high of 5.5% earlier in the year. The Yen position is stable at close to 2%. We believe the AUD can go lower on risk asset weakness which supports its role as a downside risk hedge. That said, stabilisation in the environment could see the AUD move higher.

Our duration position remains moderate at 1.7 years. With central banks implementing various forms of yield curve control we continue to see duration as less useful as either a source of yield or for risk management. That said, some duration is important and will benefit us should we get another downdraft in risk or in the less likely event that the market starts to price in negative rates in Australia or the US.

Cash remains elevated at 21% ensuring we maintain liquidity and can easily deploy more cash into opportunities as they arise.

Looking forward, we will continue to balance both return and risk. Risk assets have enjoyed a solid month from which the portfolio has benefited, but we are also acutely aware of the potential downside risk. Challenges remain in the broader economy and we expect volatility to return as we move through the next phase of this crisis. We therefore retain a defensive bias and a focus on managing downside risk.

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