The defensive income challenge
Over the past few weeks we have been engaging with clients on the challenges around delivering defensive income in portfolios. With central banks continuing to cut cash rates, the traditional short-term and liquid safe haven of cash and term deposits have lost much of their lustre. This has been clearly highlighted in Australia where the RBA cash rate is now at 1%, which represents a yield lower than the official inflation rate. Given the low cash rates and the falling term deposit rates we are seeing investors, in their search for yield, moving further out the risk spectrum to assets including leveraged loans and mortgage funds. In some cases there is the temptation to move into areas they may have previously considered overly risky, or new areas they may not fully understand. This is occurring late in the cycle where valuations are stretched and risks are rising.
Ultimately, we are facing a portfolio construction challenge where one of the traditional ‘go to’ assets – Australian cash and term deposits – has been made less effective in its role. The objective has not changed in that we are looking to produce defensive income while taking an appropriate level of risk. What has changed is that expected future returns have compressed, and require us to work smarter and harder to reach our objectives.
How are we approaching the challenge in our Absolute Return Income Strategy?
Firstly, we continue to believe you should consider the broadest fixed income opportunity set. As we move through different market cycles it is important to have choice, and to this end we believe a truly global capability is important. While Australian assets are an important part of our portfolio, we are always considering the opportunities further afield. Offshore credit, emerging markets, and global government bonds are examples of assets we currently have exposure to which provide diversification and sources of yield.
Secondly, we remain focused on valuations. We target assets that have valuation support where investors are receiving adequate compensation for the risks they are taking. In valuations, we look beyond the yield to the expected returns that factor in expected variations in capital value. Through this, we consider not only the potential return, but the potential downside risks.
The third element is being active in all that we do. That is both the top down allocations and bottom up stock and sector selection. No longer can investors hold a narrow ‘set and forget’ portfolio of term deposits and hybrids, where they simply look to clip the coupon. Falling rates have meant reinvestment risk on term deposits is here. As risks rise and risk premia fall, it is important to know what assets you hold and the role they play in a portfolio.
Understanding what assets you hold and the role they play in a portfolio.
With this in mind, the current macro-economic backdrop remains challenging. With global growth slowing and central banks seemingly unable to generate inflation, the continuation of unconventional policy continues to distort markets. Markets appear to have faith in central bankers supporting asset prices rather than considering fundamentals including corporates’ ability to sustain earnings in the face of weakening growth. It is hard to know where the tipping point is that causes volatility to spike again and asset valuations adjust.
Given our current outlook, we have a core portfolio of high quality investment grade credit that is diversified by geography, sector, quality and capital structure. This provides an important source of return but importantly, has a low probability of default and low capital risk. This is supplemented with our exposure to our Absolute Return Emerging Market portfolio that adds diversification and exposure to local and hard currency emerging market sovereigns. Add in 1.85 years of duration, this provides term premium and importantly, protection against changing interest rates for the portfolio. We have a small inflation linked position which serves more as a downside risk exposure which will be a benefit to the portfolio in the case of an inflation scare. Finally, we hold currency exposure to the USD and Japanese Yen to add further downside protection in a risk-off environment. This is combined with an elevated cash level to provide liquidity, capital stability, and the ability to quickly take advantage of opportunities.
Overall, by design, we have a diversified defensive multi-strategy portfolio that actively manages across credit, rates and currency to deliver regular predicable monthly income.
So where to next?
In short, we look to remain defensive in our risk allocations, maintain a long duration position, and remain diversified. The portfolio is delivering on its target and we are not looking to increase risk to chase yield at this stage of the cycle. The world remains in an uncertain place with trade wars, geopolitical challenges, and ongoing central bank activity, to name a few. We remain focused on delivering income, managing capital volatility and being patient and alert to both opportunity and risks, and await asset repricing before looking to reposition portfolio in a more constructive way.
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