Fixed Income

Agile footwork essential to avoid the pitfalls of low growth

As the fireworks fade and the clock ticks over into a new decade, investors can be forgiven for toasting the year that was. Against all expectations, 2019 turned out to be a strong year for most asset classes, thanks in large part to central bank actions tempering market volatility and smoothing economic cycles. However, that doesn’t mean the outlook for 2020 is benign – quite the contrary.

While there are some positives going into the new year – including improved macroeconomic conditions, central bank easing, and a more stable manufacturing and trade environment – assets remain more highly valued than a year ago. Yet, as we have frequently argued, both cyclical and structural trends are likely to see us remain in a low-growth world. The question is whether investors are ready to adjust, or whether growth asset classes will continue to exercise their allure, as low rates encourage further risk-taking.

The benefits of an absolute return strategy

We believe absolute return fixed income offers a very compelling solution to the portfolio problem described above. A low-yield environment is likely to see fixed income become more important, not less so, as income certainty becomes more highly valued. Yet that doesn’t mean fixed income can simply be used in the same way as before.

At low yields, the ability of fixed income to hedge risk is reduced, suggesting a need for wider portfolio de-risking. Within fixed income portfolios, we are likely to see an ongoing compression of yield curves and credit spreads, so that investors can no longer simply rely on beta for returns. Volatility will also become more difficult to manage, underlining the value of active management to uncover alpha and reduce risk.

An active, well-managed absolute return fixed income portfolio should be designed to meet the income objectives of investors while appropriately managing risk. The Schroder Absolute Return Income Fund takes an approach which aims to both enhance return and manage risk by dynamically allocating to a range of diversified exposures through time.

Understanding of, and access to, different fixed income offerings has to date been a challenge for investors. In November we launched an exchange-quoted version of the fund, the Schroder Absolute Return Income Fund (Managed Fund) (Chi-X Code: PAYS). Alongside our offering we welcome the development of a range of new investment products seeking to solve the income problem, but would caution that, as always, understanding how the investment works, its risk profile and role in your broader portfolio is crucial.

The year ahead

Looking to 2020, there is some good news. The risk of global recession appears to have receded, with recent central bank easing and geopolitical developments helping to support a more positive macroeconomic environment (including an apparent Brexit resolution and initial US-China trade deal). Yet we don’t see the slowdown of the last two years ending anytime soon. Growth may lift to about trend and inflation edge higher, but we nonetheless expect further policy easing in Australia. While valuations of risky assets have yet to be severely stretched, room for further price growth has certainly become more limited, so investors would do well to exercise caution.

Our portfolio position

With the portfolio having benefited from strong returns from both rates and credit in 2019, we’ve adjusted both levers in recent months. In rates, we’ve pared our long duration position, from a peak of 2.5 years in August to 0.9 years now.  We did this after yields had fallen considerably, central banks had eased to a degree, and there were signs of both sentiment and hard activity data stabilising at lower levels. We’ve also shifted the composition of our interest rate exposure to now hold more US duration than Australian.

Within our credit allocations, we still favour Australian investment grade credit – including both corporate bonds and AAA-rated RMBS – to access high quality income.  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 securitised debt and continue to hold emerging market debt, as these help diversify traditional 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.

Our currency lever was less successful in generating return in 2019, however we view our short AUD exposure as being an effective diversifier for the portfolio, particularly for managing downside risk. This is especially relevant as we have been reducing duration and hence will continue to look to currency to support the defensive role duration plays.

Overall the portfolio retains its higher-quality focus, though we are additionally seeking new sources of return and diversification. We believe we are well-positioned for a more challenging return environment and expect absolute return fixed income to continue to be a valuable portfolio holding in 2020.

View our Fixed Income range here

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