Fixed income opportunities start to emerge amid the market meltdown
It’s been a tough few weeks for investment markets, with almost nowhere to hide. Both equity and fixed income assets have fallen sharply, with bond yields backing up aggressively as prices fell. And it isn’t simply the (sometimes quite violent) price action that has investors worried.
Bond markets have been exceptionally illiquid, sometimes bordering on dysfunctional, with even “safe” sovereign bonds hardly trading. Global credit markets have been even harder hit, with spreads widening dramatically as investors scramble to sell securities at perceived risk of default.
Yet amid the market carnage, there are some positive signs.
Central banks have again been stepping in to stabilise markets and encourage liquidity, leading to some tangible improvements. In the US, the Federal Reserve has been taking a range actions, including buying corporates to support investment grade credit, helping companies access funding and easing the default cycle. In Australia, we’ve finally seen the arrival of quantitative easing (QE), with the RBA vigorously buying bonds and supporting government bond liquidity.
Interestingly, the RBA’s QE plan is slightly different to some other central banks. Rather than buying a certain number of bonds, they're targeting their buying to keep three-year yields at 0.25% – which indicates that the cash rate is likely to be on hold at 0.25% for the next three years.
Overall, we expect to see central banks in both Australia and the US buying almost unlimited amounts of bonds, primarily in the five to seven year portion of the yield curve in Australia, keeping yields pinned and ensuring the market starts to function more normally.
As so often happens, the market sell-off looks set to create some attractive opportunities – especially since much of the selling in fixed income appears to be driven by a need to create liquidity, rather than an assessment of underlying asset values (notably, passive fixed income ETFs have been among the most active sellers.)
In credit markets, the sell-off of investment grade and high yield credit has been very aggressive, with markets currently pricing in something approaching a worst-case scenario.
Hybrids in particular look to be mis-priced at the moment, with yields spiking to 9% over cash. And while there is a possibility of some hybrids being converted to equity, we think the likelihood of a wholesale conversion is very low.
There has also been a massive sell-off in inflation-linked bonds, driven by both the collapse in oil prices and an apparent expectation that inflation will go lower as economic activity plummets. As a result, yields from inflation-linked bonds have shot up dramatically, with the price differential between inflation-linked and conventional bonds appearing to be at GFC levels. That’s despite the fact that the US Federal Reserve has been actively buying Treasury Inflation-Protected Securities (TIPS). If the RBA was to do the same thing in Australia (and currently there are no indications that it will), then these assets could become quite attractive.
Our portfolio position
Like other asset managers, we have of course been impacted by the market fluctuations. Nonetheless, we believe we are well positioned to ride out volatility and take advantage of opportunities as they emerge.
Recently, we’ve been taking some profit on our long duration positions — selling down our US treasury and Australian government bond exposures. Overall, we’ve reduced duration from about 1.25 years to 0.5 years longer than benchmark. At the same time, we have reweighted our yield curve exposure towards the mid-part of the curve, following recent rate cuts in Australia and the US.
In our credit exposures, our current position is that we’re confident that we hold high quality securities with low default risk, and have been patiently watching for opportunities to add back to attractive segments of the market. We continue to favour Australian investment grade credit, but just this week have started to allocate back to Australian higher yielding credit, including bank sub-debt and global investment grade bonds.
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