An alternative take on fixed income

Over the past 30 years, traditional fixed income investors have benefited from the tailwind of falling rates and a long-term bull market for bonds. However, with interest rates at historically low levels, investors are quite rightfully questioning the future role of traditional fixed income in a balanced portfolio. With ten-year Australian government bonds only yielding a paltry 1.55%, traditional fixed income is not really delivering much actual income and there is a huge reliance on capital gains coming from further falls in rates to generate any meaningful return. Even more concerning is the asymmetric risk stemming from a potential normalisation in rates, when fixed rate bonds fall in capital value as yields rise.

So, if traditional fixed income is not the answer going forward, what are the alternatives?

Many investors are realising the diversification benefits of the evolving asset class of Australian and New Zealand Private Debt, which has traditionally been the domain of the institutional arms of the big four banks in Australia.

Private Debt involves lending to companies on a cashflow basis with security, currently providing higher income compared to traditional fixed income (6% current yields and higher). Private Debt is floating rate, which means that the asset yields move in line with interest rates. Importantly, these investments do not suffer any capital loss as a result of any change in interest rates.

For these reasons and more, Private Debt is uncorrelated to traditional asset classes like equities and fixed rate bonds, which makes it an ideal alternative defensive investment with genuine diversification benefits.

To help illustrate this fact, we recently completed a study covering the past 20 calendar years using a Private Debt Benchmark based on BBSW plus a gross credit spread of 450 bps, less 50 bps of modelled credit losses (consistent with big four bank loan books). Starting with 100% exposure to equities (ASX 200 Accumulation Index) and then various combinations of traditional fixed income (Bloomberg AusBond Composite 0+ Yr Index) and Private Debt in a 60:40 balanced portfolio, the 20-year compound returns and volatilities are shown below.

How it fits – portfolio inclusion of Australian and New Zealand Private Debt

Compound returns and volatilities over a 20-year period (1999 to 2018)

To further assist in illustrating this point, we have portrayed the potential growth of an initial $10,000 investment over the same 20-year period. This analysis demonstrated that an allocation to Private Debt can help to achieve better return outcomes and can smooth out the investment path for investors in a balanced portfolio.

Portfolio Composition Analysis – growth of $10,000 over a 20-year time horizon

“A balanced portfolio illustrates superior returns and lower volatility (capital stability) when an exposure to Australian and New Zealand Private Debt is included, which translates to a higher portfolio sharpe ratio.”

These results are impressive given that 20 years ago, the ten-year government bond was above 5% and the RBA cash rate was 4.75% and these starting points are intuitively more favourable towards traditional fixed income allocations given current levels of 1.55% and 1.50% respectively.

One of the key attributes of Private Debt is the illiquidity premium – as Private Debt (just like Private Equity) doesn’t have a liquid secondary market, an illiquidity premium can compensate investors for locking up their money for a period of time. However, liquidity risk needs to be carefully assessed individually by each investor. Investors typically suited to this type of investment have a long-term investment horizon and a buy and hold approach to this part of their portfolio.

If you wanted to criticise the study, you could point to the fact that the modelled level of losses is perhaps too low. If we consider the big four banks to be the market beta for Private Debt, then this is where manager selection and the ability to add alpha is of crucial importance. Top tier Private Debt managers have consistently delivered returns in this range over this time period for large sophisticated institutional accounts.

Much like the way in which Private Equity is now considered a core allocation alongside listed equity, Private Debt is increasingly becoming a more commonly used allocation to complement existing traditional fixed income portfolios.

This information has been prepared by Revolution Asset Management Pty Ltd ACN 623 140 607 AFSL 507353 (‘Revolution’). Performance numbers provided are as at the date of this article, and subject to change. Although every effort has been made to verify the accuracy of the information contained in this document, Revolution, its directors, officers, representatives, employees, associates and agents disclaim all liability (except for any liability which by law cannot be excluded), for any error, inaccuracy in, or omission from the information contained in this document or any loss or damage suffered by any person directly or indirectly through relying on this information. The information in this document is not financial product advice and has been prepared without taking into account the objectives, financial situation or needs of any particular person. All investments involve risk. Past performance is not a reliable indicator of future performance.