Fixed Income

The changing Australian debt landscape

In a low-yield, low-growth world, fixed income is set to become even more important as a source of reliable cashflow and as a portfolio stabiliser. Stuart Dear shares why active management is likely to prove essential as beta falls and alpha becomes harder to capture.

03/12/2019

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

There are two dramatic changes underway that are altering the Australian fixed income landscape. The first is the move to a near-zero policy and bond yield environment. The second is the significant shift towards non-bank funding channels for private sector borrowing. This paper assesses the impact of these on the ability of Australian fixed income to meet the future requirements of investors.

At a glance

Our key conclusions are that:

– Fixed income is likely to be even more relevant for delivering low-risk income in a low yield world, due to the certainty of cashflows.

– The ability to diversify risk, both within fixed income portfolios and between fixed income and other asset classes, is challenged. This may actually result in more stable permanent demand for fixed income.

– Australian private debt is a welcome enlargement to the local opportunity set. However, while we believe Australian debt is underutilised to a degree, we continue to expect investors to search for opportunity and diversification offshore.

– Fixed income solutions targeting particular investor requirements will be increasingly demanded.

– Active management will be even more valuable with future beta returns lower, alpha potentially harder to capture and volatility management more difficult.

1. Why do investors want fixed income?

To determine how this changing landscape is likely to impact investor decision-making, we first need to understand why investors typically hold fixed income investments. The key strategic reasons to hold fixed income are:

– As a source of low-risk income.

– For diversification, particularly against equity risk.

The future return and risk distributions of different assets (and combinations of assets) are always uncertain. As a result fixed income plays a useful strategic role – both as a reliable income generator (given the known cashflows from high-quality debt) and as a source of differentiated returns that are predictable over the long term and typically lowly correlated through periods of equity stress.

There are also tactical reasons to hold fixed income, mostly related to concern about riskier asset performance. In a cyclical downturn or other periods of stress where riskier assets come under pressure, the short-term payoff profile for safer bonds likely shifts to the right of the return distribution bell curve; if not, at least liquidity and capital stability are preserved in times of uncertainty.

Finally, the certainty of cashflows make high quality fixed income integral to specific investment solutions, including situations where an investor has a certain time horizon in mind, requires a specific income profile, or (especially) wants to immunise their portfolio against time and cashflow liability risks.

2. The challenges of near-zero yields

Near-zero yields threaten the income and diversification properties of fixed income in several ways. Here are some of the most significant.

2.1 Lower income

Clearly, income is lower. The yield on a bond relates coupons to price. While current coupons may still be high relative to yields, over time the cashflows from coupons should converge lower towards yields, as new debt is issued with lower coupons. Since income drives total return from fixed income over time and is the only return component on a hold-to-maturity basis in the absence of default, this means lower future returns from bonds.

2.2 Changes in the return distribution

With income and total returns lower over time as a result of lower yields, the distribution of returns is affected in several key ways:

– The return distribution shifts to the left, with negative central tendency outcomes if yields are sub-zero.

– Even if the expected return is positive over time, with yields above zero, there will be more periods of losses over short time-frames, as there is a lower income buffer to absorb changes in capital value.

– The breadth of the distribution may actually narrow. The experience of Japan is that yield volatility is actually lower as yields fall, despite high debt levels and inherent sensitivity to shocks. Although the capital value change increases at lower yields due to convexity, lower volatility of yields overcompensates for this increase, such that total return volatility is lower.

– Although it’s tempting to think that the only way yields can move is up, and hence that there is an asymmetry in short-term returns with yields at low levels, the early evidence suggests there is no discernible change in skew as yields move lower.

Figure 1: The return distribution shifts with yields

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Source: Schroders, indicative only

Figure 2 provides some historical evidence that volatility falls as yields fall, while the distribution of returns stays reasonably symmetric.

Figure 2: Lower volatility and unchanged skew at lower yield

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Source: Schroders, Bloomberg

The observation that skew is little affected by yield levels is supported by two recent events:

  • Options pricing in the US was skewed for many years after the global financial crisis (GFC) to reflect expectations of higher rates, as puts were perennially more expensive than calls. However, it eventually shifted to accept a more symmetric outlook as rates stayed ‘lower for longer’ (see Figure 3).
  • More recently, expectations for the European Central Bank cash rate have rebalanced in a similar way, with rates stalled at sub-zero levels.

Figure 3: Skew in rates: after initial shocks, expectations adjust to lower yields

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Source: Bloomberg, Schroders

2.3 Persistence of low yields

These observations on the shape of the distribution in terms of breadth and skew both presume, to a degree, the persistence of low yields. This presumption is underpinned by: 

  • Downward structural trends in inflation and potential growth, due to well-known demographic and technology factors.
  • Large debt loads, which make rate rises too painful – but which also reinforce low growth, as high indebtedness limits credit creation, in the classic liquidity trap. This has been the case in Japan, even though progressively more debt is owed by the government, and effectively funded by the central bank, so in theory crowding out has been minimised.
  • The policy frameworks of central banks, which target narrowly defined consumer inflation, and the bluntness of the tools at their disposal. Despite limited success, central banks are in the process of ‘doubling down’ on policy accommodation and appear unlikely to meaningfully change regimes – at least before another crisis. 
  • An array of non-economic buyers. Central banks and regulated financial institutions (both insurance companies and banks) are effectively forced to hold home currency sovereigns, while sovereign wealth and reserve managers typically buy bonds of other countries, somewhat insensitive to price. The true ‘free float’ of bonds excluding these buyers is significantly lower than notional outstanding bonds on issue.

2.4 Relative rates of return

With persistent low yields, economic buyers need ongoing valid reasons to hold bonds. At face value, buying a bond for a certain loss over time seems irrational. However, there are still justifications for buying such a bond, including:

  • Short-term capital gains, as yields can move more negative.
  • As a deflation hedge, since the nominal loss on the bond may be converted to a real (after-inflation) gain over time.
  • Currency-related reasons, including:
  1. Where a negative yielding bond may offer a hedged pickup into a higher yielding currency – for example, JGBs hedged back to AUD currently offer a higher positive yield than Australian government bonds.
  2. Where investing on an unhedged basis offers the potential for positive returns including currency effects. There is also the special case of currency re-denomination risk within the Eurozone – for example, Bunds would reprice higher into Deutschmarks if the Euro reverted to its constituent currencies.
  3. Where cheaper funding (achieved by borrowing at a more negative short-term rate) allows you to make a profit. This, after all, is what banks do – fund at cheap short-term rates and lend long at higher rates. 

These examples demonstrate that relative rates of return – compared to inflation, return available in other currencies, and funding costs – matter as much as absolutes. At lower yield levels, relative rates of return are likely to become more important in determining fixed income allocations.

2.5 Compression of yields

Lower volatility, persistence and relative value assessments all suggest compression of yields, which can occur in multiple ways – including between countries, along yield curves and between ratings qualities. Although we’re already seeing this phenomenon, it has the potential to run much further, as the ‘reach for yield’ dynamic drives further compression on relative valuation arguments.

Figure 4: Compression in yields and spreads as yields move lower

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Source: Schroders, Bloomberg

2.6 Reduced diversification potential

These observations suggest that fixed income has reduced diversification potential at low yields, as a result of:

  • Reduced ‘power’ of duration. Even when yield moves are symmetric, if volatility is lower at low yields, then upside return from bonds in periods of stress will be lower.
  • Increasing correlations between bonds and equities. If central bank liquidity supports all assets, but has little impact on real economy outcomes, it will perpetuate ‘low for longer’ yields and (ultimately) returns across all assets. Not only do bonds and equities likely move together, but preference within equities will shift towards bond-like sectors.
  • Fixed income portfolios becoming more equity-like. Given reach for yield into lower-quality assets or extension of duration, fixed income portfolios may take on some of the risk–return characteristics of equities. They may also take on other risks in order to generate returns, including leverage into interest rates or other factors, which comes at the cost of lower liquidity.
  • Reduced diversification within fixed income portfolios. As global assets converge towards zero yields and potentially lower volatility, the opportunity set narrows. Because this makes it harder to generate alpha and manage risk, these skills become more valuable.

2.7 Vulnerability to shocks

In a cyclical sense, despite occasional brief periods during which yields spike as overbought conditions are unwound, there doesn’t seem a material risk of yields reverting to significantly higher levels. This is because growth is softening, inflation is muted, central banks are easing, and riskier assets are also reasonably fully valued. 

However, does a low yield, low growth, high debt world make both economies and markets more vulnerable to shock?

Sustainability of high debt levels likely requires an extended period where central banks and governments need to keep nominal yields well below nominal income. As such, aggressive central bank purchases may still be in their early stages.

At face value, high debt, accompanied by central bank accommodation, appears to reduce growth volatility. This can be good for fixed cashflow investments (as long as growth is high enough to meet commitments), and may support some relative valuation arguments, since the required risk premium may fall. However, any investment that relies on an assumed rebound to higher rates of growth is subject to downwards re-rating (for example, equities and riskier credit). 

Beyond cashflows reliant on higher growth, there are three obvious candidates for shocks to fixed income in a low yield world:

  1. Inflation. Inflation is always the enemy of fixed nominal cashflows. Against structural headwinds, aggressive ongoing central bank accommodation supported by fiscal policy may eventually be successful in lifting inflation of goods and services in developed  economies. In contrast, ongoing disinflation or deflation appears an equally likely risk.
  2. Central bank regime change. As mentioned earlier, this appears unlikely without greater coordination with governments, which would involve higher use of fiscal policy to stimulate demand, and revision of central bank mandates. The shock of unwinding  central bank involvement in markets would likely see both yields and volatility higher.
  3.  Illiquidity. In a low-yield world, liquidity is increasingly dependent on government sectors where debt has grown most. As a result, illiquidity in credit is not properly priced and is potentially exacerbated as investors reach for return. A liquidity shock probably requires a trigger event, such as bank or hedge fund collapse. While financial system leverage is probably not near pre-GFC levels yet, this risk is somewhat unquantifiable in advance.

Read the full report for more on shifting funding channels and debt supply, and how these changes impact the ability of fixed income investments to meet investor needs. 

 

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