How to maximise returns from your fixed income allocation

Credit markets often get lumped into monetary policy or bond market conversations. The broad-brush treatment is then applied.

However, relative value can be found within the asset class, often for reasons that have very little to do with the rest of the fixed income market.

"Very often the reason some things become cheap will be technical, relating to factors that are occurring at a base market level," says Andrew Papageorgiou, head of bank capital and corporate capital at Realm Investment House.

As just one example, Japanese pension funds that owned unhedged Aussie bonds sold those bonds when the Aussie Dollar outperformed against the Yen. 

"In one way, corporate credit securities are a bond play, a credit play and also a currency play," Papageorgiou says.

As Andrew discusses in this wire, Realm Investment House takes advantage of this kind of market minutiae. 

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Edited transcript

How are bond markets responding to inflation and rate hikes?

Initially, when bond markets started to sell off in reflection of these increased inflation risks, or the narrative around inflation starting to move to the front page, the correlation between credit markets and bonds started to rise. Which is to say that yields were rising and credit spreads were rising as well. Now, when that occurs it can be a reflection of a couple of things. For example, some might take the view that the selling off of credit markets speaks to rising policy error and the potential for recession down the line. It might speak to the idea that market volatility is just rising generally and it's a risk off environment, credit is selling off as well.

But in reality, where credit markets found themselves, and certainly larger credit market indices found themselves late last year, was with their yields at record lows. 

In real terms, so in inflation-adjusted terms, high-yield bond markets, investment-grade bond markets, were actually registering very heavy, negative real returns, which is to say that the yield provided by the credit was actually negative when you adjusted it for inflation rates. 

And what that did is it caused a level of repositioning by the market. So you could imagine, if you owned a benchmark corporate bond portfolio that is exposed to interest rates and credit markets, and you were now facing the risk of interest rate markets selling off materially, you could imagine that would be a bitter pill to swallow there for investors. So they started to reposition, they started to sell off their positioning, sell off their market exposure.

The consequence of that was that credit spread started to widen. And the correlation got quite high. 

It's not fair to suggest that the correlation between bonds and credit is always high. There have been instances where bond market yields rise materially and credit follows it. 

There was the taper tantrum that gets referenced quite often, that occurred in 2013. And there was that short period at the end of '21 and '22 of course. But now we've started to see uncoupling of that again. 

And in this more recent sell-off within bond yields that's occurred post-Russia, after initially responding to the Russia and Ukraine concerns, we've seen credit markets stabilise slightly. But the market is still very soft, with high levels of uncertainty. 

I think most investors would suggest that we are dealing with a pretty fat-tailed environment, which means predictive certainty right now is extremely low.

However, we have seen an uncoupling, for the moment, between spreads and rates. 

Moving forward, the big consideration for credit market investors will be whether these rate rises drive an increased risk of recession, drive adverse economic outcomes, that then impact on credit quality. 

And the measures the market will be looking for are what is going on with credit spreads within the triple-B part of the investment-grade market, which is the bottom of investment grade. 

Why's that important? Because if you get downgraded from triple-B or investment grade, you go to sub-investment grade. You become what's known as a "fallen angel". That part of the market is generally pretty sensitive to movements or changes in economic activity. And then, of course, the sub-investment grade part of the market generally reflects those risks around a deteriorating economy pretty well.

The following transcript has been edited for length and clarity

: Even though these markets have sold off, they've sold off from near record lows, and find themselves in the case of the US investment-grade index, triple B index for 10 years, for example, is still probably tight versus long term measures. And in terms of sub-investment grade credit, you're still sitting 350 to 400 basis points beyond the risk-free rate, which for context is below the long term default history of sub-investment-grade credit. So clearly even though the selloff in rates is creating a level of volatility around the market, I think it's also fair to suggest that credit spreads, while they're reflecting that general volatility, they're not going so far as to point to a real deterioration in the economic environment.

Which debt securities will deliver the best returns?

A lot of the relative value work that we do looks at the relativities between markets. It's one of the key pillars of our process and approach. Very often the reason why certain things become cheap will be technical, relating to factors that are just occurring at a base market level. 

For example, the Australian dollar corporate credit market at the beginning of the sell-off on the back of the Russian Ukrainian war really lagged. It didn't sell off anywhere near as quickly as what markets did within Europe, for example, or even north America. But today we find ourselves actually well wide of the long end of the US triple B corporate credit curve, for example. And why? Well, there is a range of issues. But one of them, interestingly enough, is that a lot of Japanese investors own Australian corporate credit bonds outright and unhedged. So they own it in Aussie dollars and they are exposed to the currency.

In one way that corporate credit security is a bond play, it's a credit play, and it's also a currency play. 

So, interestingly enough, we've seen a lot of selling over the last two to three weeks on the back of the Aussie dollar outperforming versus the yen, and Japanese pension funds taking profit. And that's actually reflected into the selling on the street that we've been able to take advantage of. We've bought in at the longer end of the curve here within the Australian corporate credit market. Why? Well, because right now the market's weak, people don't necessarily want the leverage that comes with longer-dated credit securities. There's also this technical element that's coming from Japan. And that's presenting pockets of value over here.

And then when you look at other markets that are presenting reasonable value right now, we go to Europe. They are near the epicentre of everything that's going on. 

It's actually quite interesting to look at the relative performance of Australian securities issued in euro versus Australian securities issued in US dollars, and in Aussie dollars, for example. When you're a European investor and you're selling your portfolio, you're selling everything. You're selling your euro names, you're selling your Aussie names. So on a relative basis, there is some value, especially within the tier one euro market right now, especially when you compare it to what investors are happy to take for ASX hybrids, for example.

In tier two markets through March we saw Euro tier two trading a hundred basis points wide of Aussie tier two. ANZ has an outstanding euro tier two instrument that was trading at close enough to 270 over during March, while the equivalent mark over here was around 180 over. So that's a credit spread differential for a security that sits in the same place within the cap stack or sits in the same place from a security standpoint, 90 basis points wider. Again, tier one, tier two, within euro, interesting. Here, within Australia, the market that's piqued a little bit of interest there for relative value investors is the RMBS and ABS market. 

But, interestingly, the part of the market that is starting to look like reasonable value is at the top of the capital stack, which means higher rated parts of that market. So the triple A, double A and single A part of the RMBS market had compressed to really, really tight levels through 2021. 

There were a number of reasons for this. Again, there's just way too much money. Major banks weren't issuing debt. The liquidity in the system I've already alluded to there.

And essentially, these residential mortgage-backed securities tend to be a bit shorter in maturity. So, you had a lot of demand for this product. Spreads within this market now find themselves somewhere in the context of 70 to 80 basis points wider than where they were last year. 

Now we were heavily underweight, those higher investment grade markets, but we now feel that those higher investment-grade parts of the RMBS market compare very, very favourably to the lower parts of investment grade, and even sub-investment grade for that matter. So again, parts of the RMBS market look like value. Private RMBS still looks good, where you can find opportunities and you can get yourself a seat at the table.

And then there are parts of the market that look a little bit on the dear side. US corporate credit feels like it could sell off a little bit from where it sits right now. We would note that the CDS for sub-investment-grade US corporate credit, for example, is trading 40 to 50 basis points wider than the cash bonds. So what that means is the cost of insurance, to ensure against the default of the sub-investment-grade market, is trading at around 4% while the actual cash securities themselves are trading somewhere closer to around 3.5%. So that's generally the reason why that CDS contract moves quicker, is because it is more liquid. It tends to be bought more reactively, and sometimes can provide a bit of a lead-in on the pressure around the market more generally.

So, generally speaking, happy to avoid the US corporate credit. Happy to stand aside with other parts of the US market. 

From a sector standpoint, energy has obviously performed really, really well because of bottom-up considerations and everything that's going on with the supply side. So that sector tends to look a little bit dear versus where it's been historically. 

But, interestingly, a lot of staple securities and industrials, things like rates, things like utilities, that are at that high investment grade type level, look okay on a relative basis. Generally speaking, there are enough opportunities to keep us busy within the broader credit universe, but it is really a relative sector game at the moment.

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