The defensiveness of traditional fixed income may have waned, but floating-rate global credit can strengthen a portfolio by adding income, protection from rising rates, diversification and resilience, writes managing director of Bentham Asset Management, Richard Quin.
The typical Australian investment portfolio is largely split between cash/government bonds and equities, with a strong domestic focus. Safety and familiarity are the appeals here.
Focusing on these two extreme ends of the investment spectrum has worked beautifully well over recent decades. Both equities and cash/government bonds provided returns comfortably above inflation, with the added benefit of low correlations between these asset classes dampening volatility across portfolios.
But history is unlikely to repeat itself in the near term. Today’s climate of low-but-rising interest rates does not mirror the past. The structural bull market for fixed income over the past 30 years – supported by falling inflation and interest rates – cannot be repeated. Fixed income now faces significant headwinds as extraordinary post-GFC policies of ultra-low (or even negative) monetary policy and quantitative easing are unwound by governments and central banks globally, with the intent of moving to a higher, more ‘normal’ interest rate environment.
Normalising interest rates is an obvious risk to fixed income, as a higher discount rate is negative for bond prices. But this risk is currently amplified as the sensitivity to interest rates has risen in many bond sectors.
In this scenario, traditional fixed income (e.g. fixed coupon government and corporate bonds) likely loses its key ‘defensive’ characteristics, providing little-to-no real yield and risking repeated negative returns (as experienced over the past 24 months), potentially adding volatility to portfolios.
We see an opportunity for investors to put their fixed income allocation to work a little differently to the past; placing a greater reliance on credit spreads rather than interest rate risk to generate returns. Greater diversification around credit allocation may help create a more ‘resilient’ portfolio for the typical Australian investor; defending against low income, rising rates, and a domestic Australian downturn.
With this in mind, we encourage investors to assess the performance drivers embedded in their fixed income portfolios using our five-point checklist:
Checklist Item #1: Yield
We believe a fixed income allocation should generate real income but the Australian fixed income sector is simply not delivering at the moment.
Current yields on traditional fixed income sectors are barely providing a real rate of return for investors, sitting squarely within the RBA inflation target band of 2–3 per cent. As at 30 Sep 2018, the Bloomberg Ausbond Composite Index yielded just 2.57 per cent, while the 10-year Australian Government Bond yielded 2.67 per cent. The yield on many traditional fixed income funds is similarly hovering around 2–3 per cent. Cash provides little alternative, offering limited premium over inflation.
To earn real income, we are looking to global credit sectors. There is value in capturing credit risk premium and managing that credit risk through diversification and a focus on quality (senior/secured) credit assets, largely with floating rate coupons, from developed nation issuers.
Checklist Item #2: Duration
Interest rate duration (the sensitivity of an asset’s price to changes in interest rates) is a hidden risk in supposedly ‘risk-free’ government bonds and ‘low-risk’ investment grade corporate bonds. For example, interest rate duration of Global Government Bonds has increased from 4.8 years in January 1994 to 7.9 years now . Interest rate duration has been creeping higher in these sectors as borrowers have sought to lock in low interest rates for long terms by issuing very long-dated bonds. Credits as varied as Microsoft (AAA/Aaa) and Argentina (B+/B3) have issued 40-year and 100-year bonds respectively.
This fundamentally changes the risks embedded in traditional fixed-rate bonds, as performance has become much more sensitive to interest rate changes. To reduce portfolio interest rate risk while maintaining yield, we are focusing on floating rate credit sectors such as corporate loans and asset-backed credit. Floating rate coupons mitigate the risk of rising yields, as the variable coupons on these bonds/loans rise as rates rise. We have also taken outright negative interest rate duration positions in some portfolios.
Checklist Item #3: Geographic Exposure
Global diversification may offer significant benefits for Australian investors, many of whom have sizeable domestic investment allocations, concentrated in Australian equities (especially financials) and housing. Domestic fixed income markets have a similarly overweight position in Australian financials, compounding investors’ reliance on the performance of the Australian economy and housing market.
Taking a global perspective naturally offers greater diversity of issuer, sector and economic outlook. Global credit markets generally also offer deeper liquidity, broader investor bases, and (importantly for credit investors) a range of security structures.
We remain most comfortable with the robust macroeconomic data and economic outlook for the US, Europe and UK, and have focused our portfolios in these regions, with small exposure to Australia/NZ.
Checklist Item #4: Diversity
Diversification is a key tool for managing credit risk. Credit losses tend to be unexpected and occur in industry clusters, making diversification by issuer, industry and geography important for creating a robust credit portfolio. Interestingly, diversity is more important in credit portfolios than in equity portfolios (but less recognised) due to the asymmetric returns of credit portfolios.
We see particular risk in the ‘DIY’ approach of gaining credit and fixed income exposure through a small handful of hybrids or bonds. We have invested our Global Income Fund across 650+ unique issuers globally to support robust portfolio performance with a view to fully exploiting the risk-reduction available from diversification in credit markets.
Checklist Item #5: Seniority
Debt structure definitely matters when creating a resilient portfolio. A company’s highest-ranking lender is paid first (both for ongoing payments, such as coupons/dividends, and for return of capital in a windup) and equity is paid last, making investor seniority a key determinant of capital resilience.
While a “default” is often made to sound catastrophic for debt investors, a US senior, secured loan typically recovers an average of 66 cents in the dollar. By comparison, the lower-ranking high-yield bondholder (senior, but unsecured) typically recovers just 39 cents in the dollar. Sitting below the loan and bond are hybrids, and ranking lowest among a company’s capital providers is equity – typically recovering zero in a default scenario.
Given the importance of preservation of investor capital, we have allocated more than 70 per cent of our flagship multisector credit portfolio to senior and/or secured investments.
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