Storms will come: Get your defences ready

In our previous Collections piece, our quartet of fixed income managers discussed 10 risks that could wreck markets.

To recap their views: While US$18 trillion of stimulus spending has stemmed the economic and asset price bleeding, investors are grossly underestimating the risks as we head to the other side.

Any potential delay to a vaccine; deepening of diplomatic tensions between Australia and China; anxiety in bond markets over the mammoth debt overhang from fiscal and monetary policies are among events that could easily invoke yet another flight to safety.

So, to help you prepare your defences and understand why bonds are still important despite where rates are, this wire will look at how our panel of managers are navigating the challenge of generating income while managing downside risk. Responses come from:

• Kate Samranvedhya from Jamieson Coote Bonds
• Jay Sivapalan of Janus Henderson
• Garreth Innes of Aberdeen Standard Investments
• Adam Bowe from PIMCO

A source of liquidity

Kate Samranvedhya, Jamieson Coote Bonds

Generally, investors should always consider allocating a portion of their portfolio to high-grade government bonds for the diversification benefits. When a crisis hits, investors can tap into government bonds for liquidity, at marked-to-market prices that are transparent and easy for reference.

The month of March 2020 proved that liquidity in the corporate sector disappears in times of crisis. Sell spreads in some corporate fixed interest index funds increased to as high as 1.79%, which reflects transaction costs of selling illiquid securities during stress. That exposes additional risks on exiting, however, we also saw the risk of a reduction in market value from wider credit spreads. Corporate debt did not behave like the defensive asset class it promises to be, but high-grade government bonds did.

Don’t dismiss low sovereign yields

Another factor to call out is the level of yields does not dictate the total return for bonds.

A case in point is Germany, another AAA-rated country, which started the year with 10-year yields at negative 0.20% and has returned 2.2% in its local currency year to date.

The Australian country profile sits in the rare AAA stratosphere, with a free-floating currency that can adjust when the economy needs to, a highly credible reserve bank, and with bond and currency markets that are large and deeply liquid − enough to keep major global investors invested. Currently, Australian 10-year yields at just under 1% is still the highest among the G10 and other AAA countries, except Italy for a good reason. What’s not to like?

A source of income

Jay Sivapalan, Janus Henderson

For investors seeking greater liquidity and capital preservation, assets such as investment-grade bonds issued by Australian corporates, infrastructure owners and Real Estate Investment Trusts (REITs) offer more than double the available income above government bonds, with strong covenants and very low default risk.

Today, with government bond yields where they are, the ‘portfolio insurance’ role these bonds can provide is somewhat eroded. One may ask what role government bonds can play in a portfolio in this environment and our answer is that government bonds remain highly liquid security, which can be traded through periods of market turbulence, enabling instances where quality securities have been oversold by the market to be capitalised upon more quickly.

Our sector allocation views

It is recognised that these exposures may incur higher levels of volatility in the near-term, but we feel will likely result in stronger performance over the next year and beyond:

• Semi-government bonds: Whilst the possibility of the states’ credit ratings being downgraded is a risk, it’s unlikely to have a material sustained adverse impact on spreads. We added exposure to semi-government bonds earlier in April and look for further opportunities in this area.
• Investment-grade credit: Global investment-grade credit, having rallied significantly, has seen a lower level of asset purchases in our Funds with a greater emphasis on industry and security selection. Over the medium-term, we look for corporate debt to deliver strong excess returns for investors.
• Higher yielding credit: With global high yield and loan credit spreads reaching over 1000 basis points and having rallied strongly since its peak, we see some near-term volatility as default risk becomes more evident. As such, we have focused on higher-yielding exposure to higher grade assets than pure high yield.

A source of insurance

Garreth Innes, Aberdeen Standard Investments 

Australia’s advanced standing in relation to coming out the other side of covid-19 augurs for a steeper curve compared with elsewhere in the world. That said, it is already in the price, and we believe that Australian government bonds have ample room to outperform (specifically, curve-flattening) in the event of a further downside shock to economic growth, particularly if the backdrop involves a resumption of US/China/Australian geopolitical fussing.

Our sector allocation views

• Australian 10-year: We have become increasingly wary of outright duration at current valuations. However, we like 10-year Australian government bonds, especially as a spread against similar maturity US Treasury bonds. The pickup of around 0.25% is meaningful in a world of negligible cash rates.
• Inflation-protection: We have also put some inflation protection into our core Australian fixed income portfolios as the global monetary base has expanded swiftly in recent months. The push to de-globalisation may also stoke inflation pressures as capacity moves from cheaper countries to more developed countries with higher costs of production.
• Investment-grade credit: We are overweight investment-grade credit as central banks join the party and commence direct purchases of the asset class. Credit spreads remain wide versus recent history while other risk assets have adjusted more meaningfully. As corporations become more defensive, corporates will take measures to address debt-heavy capital structures, including raising equity, lowering dividends and cancelling buyback programs. This should lead to more conservative debt metrics and potential upgrades to credit ratings on a 12-24 month horizon.

A source of opportunity

Adam Bowe, PIMCO

We are still finding very attractive opportunities in the current market to construct portfolios that continue to provide both attractive income relative to cash, and diversification against the riskier parts of broader multi-asset portfolios.

Our sector allocation views

Our base case is for a deep but short-lived recession and a U-shaped recovery but we cannot dismiss the risks of false starts as economies reopen. The risk of permanent capital impairment is real and with this in mind we continue to maintain a safety-first approach while patiently re-deploying capital into attractive high-quality segments of spread markets.

• One of those attractive high-quality sectors is global financials which we view as an attractive source of income generation in the current market. Their balance sheet strength and capital levels have improved materially relative to the last financial crisis and central banks have been very quick to provide liquidity and stability to the financial system.
• And for the diversification benefits of core bonds we think long-dated state government bonds in Australia are attractive. With a modest give up in terms of liquidity and credit quality they provide an attractive yield pick up to Commonwealth government bonds while still providing the defensive core bond characteristics. Additionally, the RBA has included them in their asset purchase program and committed to maintaining a smooth functioning bond market which limits the degree to which spreads can widen going forward.

In conclusion

For every reason to be bullish, there is a reason to be bearish. While markets are on a roll, there is no doubt stormy weather is up ahead. Wise investors would be prudent to ensure their bunkers are decked out with some quality defences.

Don't forget to read the previous chapter - 10 risks that could wreck markets - in this Collections series here. Click follow below to be notified when I publish content in future.