A safer place for income in a world of lower returns

High-grade bonds earn the majority of their return from compounding income (i.e. income on coupons and maturing bonds being reinvested), over time. This means in different interest rate environments (rising, falling or flat), the asset is self rebalancing over time. 

High-grade bonds provide balance to portfolios, and comfort to investors knowing that in times of market stress, their capital is protected and liquidity is not compromised. Australia’s sovereign debt retains a coveted AAA-rating and its relatively high yield remains attractive to offshore investors (with over 60-70% of the market liquidity sourced from outside of Australia). The relatively high yield, combined with a AAA rating, attracts offshore investors - translating to being highly liquid in all market conditions.

Combined with other defensive exposures across the risk spectrum, high-grade bonds can help achieve risk-adjusted outcomes for investor portfolios.

Figure 1: How high-grade bonds can fit within a portfolio.

Source: JCB team analysis. Provided for illustrative purposes only.

In the defensive part of a diversified portfolio, high-grade bonds can act as a ‘core’ alongside more speculative exposures that can be used as ‘satellites’. They may suit investors who are seeking exposure to a defensive investment strategy and want a regular income stream if transitioning to retirement or are already retired. They may also suit SMSF trustees who are looking for much needed portfolio diversification away from shares and cash and an asset to help protect capital.

Portfolio benefits of including high-grade bonds

• The most defensive allocation, backed by governments.
• A strong portfolio diversifier (negative correlation) against other risk assets.
• An effective protector against deflation.
• A stable source of income and liquidity.

3 ways to add value

JCB is a specialist active manager of domestic and global high-grade bonds. We invest in the highest grade bonds available. These investments are explicitly backed by the governments of Australia and the world and, as active managers, we focus on selecting the right combinations to deliver strong portfolio defence.

We add value through:

1. Aiming to produce outcomes that are genuinely defensive and to add alpha by delivering less volatility versus the index, lower beta, smaller drawdowns/faster turnarounds – all through a highly liquid investment solution. These outcomes compound over time for investors. Our flagship domestic fund, the CC JCB Active Bond Fund has delivered a net excess return of +0.18% p.a. since inception (3 August 2016) to 31 March 2019 with a portfolio beta of less than 0.80.
2. Our investment philosophy, which is centred on duration management, targeted security bond selection (across and within sub-sectors) and incrementally adding value (versus taking outsized positions).
3. Our process, which adds value by combining our global teams’ long-term secular views of financial markets with a nearer-term perspective. We employ a systematic way to assess in real-time global financial and economic health which exploits over 500 proprietary indicators.

Core tenets for long-term success

JCB’s Investment Team is well seasoned and has managed bond portfolios through a multitude of cycles and events including interest rate hikes and falls, policymaker interventions, natural disasters, political crises and market crashes. This experience gives us the foresight to guide our future decisions, coupled with adherence to some core tenets:

• Risk management – We constantly assess the risk/reward profiles of our holdings and carefully size our positions to ensure we are properly compensated for the risks that we are taking. This is critical in this late-cycle environment featuring potential bouts of volatility and rising uncertainty.
• Technical analysis framework and disciplines – A differentiator of our investment process is applying technical analysis frameworks to participate on the upside and protect on the downside. Fund manager and author Jack Schweger (author of
  "Market Wizards: Interviews with Top Traders”) noted that, “even if you are going with or against the trend, you can apply risk management because technical analysis establishes an area where you want to either buy or sell.”
• Promoting continuously optimal investment team decision-making dynamics - The team spends significant time communicating and debating investment ideas. Ideas and scenarios are tested to ensure our decisions are robust and well-considered.

Seasonal trends suggest its time to overweight duration 

Risk asset performance for 2019 has been robust despite mixed economic data (particularly from Asian manufacturing and European political woes, growing risks and system imbalances and total global debt ballooning to over US$244 trillion in Q3/2018, according to the Institute of International Finance).

We recommend being careful and strengthening duration from mid-May onwards. Since 2008, we have noted the skew within May spread changes for 10 year German Bunds and 10 year Italian BTP bonds. When things go bad in May for BTPs, they can go very bad, very quickly – yield hunters for 2019 thus far may look to reverse positions during this month and realise profit. 

This clearly can have credit-wide implications, so we plan to be cautious on longer-dated spreads, whilst underweighting or shorting Italy in our global portfolios. In short, we are strengthening our views on duration coming into mid-May 2019.

Closely monitor US credit delinquencies

Asset quality matters – even more so in this late-cycle environment, and when markets becoming challenging, lower quality assets are severely punished. 

This is evidenced by widening credit spreads, poorer pricing and a lack of liquidity which was in full view during the GFC (2007-09), the dot.com bubble (2001) and Greek/Chinese concerns (2011).

Our concerns are magnified by the interest rate hikes experienced during this current credit cycle: US interest rates have risen essentially from deeply negative territory (via QE’s additional stimulus) to +2.50% on the world’s largest debt loads. 

Meanwhile, BBB-rated corporate debt – the lowest rating on the investment rating scale – now represent over half of the Bloomberg US Corporate Bond Index from 33% in 2008. Even though the US Fed has seemingly paused (or even have an easing bias for the remainder of 2019), the credit cycle moves with a significant lag effect relative to monetary policy: these preceding impacts are taking their time to filter through the system, with their full forces being distorted by the 2017/18 US stimulus and tax cuts. 

Figure 2: Credit is the lifeblood of the economy – the risk of slowdown is rising: Credit delinquencies (US) are taking a concerning path.

Source: JCB team analysis using data from Bloomberg

Notes: Shaded area represents recessionary periods as denoted by the NBER. Past performance is not an indicator of future performance.

Figure 2 highlights accelerating US credit delinquency as debt and pressures build. We will be monitoring housing and auto loans for key leading indicators. There are cracks in the dam wall of credit and the Fed knows it.

We favour high quality in our assets and avoid (by virtue of our high-grade mandate and investment philosophy) credit.

Duration is just part of the picture

Compared to recent history, duration is extended (at 6.5 years at 30 April 2019). Some of the media and commentators hold this fact out as representing a risky position given the mathematical relationship between higher yields leading to lower returns. But there is more to this story.

A good way to think of duration is to consider this measure as the weighted average time for an investor to receive all cash flows (that is, coupons and principal). Does this number alone imply that high-grade bonds are now much riskier as commentators suggest? 

More information is needed to get the full picture: many people just focus on this absolute number and conclude that high-grade bonds are risky. What they fail to appreciate is the odds of a yield change (detrimentally: upwards in the short term). 

Considering the fragility of the global economy and the weak inflationary pulse, material upward moves of say 1-2% are unlikely. The quantum of such moves compares to other periods in the financial system where moves like this were possible (e.g. from 2004-2006 in the U.S., cash rates rose +425 bps over two years, or 1994 in Australia with +275 bps over six months – the current economy bears little resemblance to these episodes).

The reality is that high-grade bonds are self-rebalancing and provide long-term benefits to portfolios. A rising yield environment is actually a good news story for patient holders of high-grade bonds as coupons from the index and maturing bonds need to be re-invested, taking advantage of compounding. They are an effective self-rebalancing asset class which exploit the power of compounding across different environments. This feature is specific to government bonds: corporate credit under similar stresses would likely result in defaults. Figure 3 highlights that after soft years (i.e. 1994, 1998, 2008), the subsequent annual returns were robust off the back of compounding from coupon re-investment and maturing bonds investment.

Figure 3: High-grade bonds calendar year performance over time: Australian high-grade bonds are self-rebalancing and long-term beneficial for investors.

Source: JCB team analysis based on data sourced from Bloomberg. Notes: Past performance is not an indicator of future performance.

What to expect from high-grade bonds

We expect high-grade bonds to continue to play a key role in investor portfolios by defending and protecting just when one needs these qualities. For patient holders of this asset class, we also expect stable and ongoing income to be provided off the back of a relatively strong Australian fiscal position.

In terms of total returns, we expect high-grade bonds to continue to deliver constructive real returns over the medium to long-term.

Figure 4: A comparison of broad market indices for Australian Shares and Australian Government Bonds: Australian Government Bonds have performed more defensively in real terms than shares over extended periods.

Source: JCB team analysis based on data sourced from Bloomberg. Notes: The maximum and minimum lines represent the highs and lows of calendar year real returns for Aus Shares (Red) and Aus Govt Bonds (blue). Shaded years refers to negative share market years. Past performance is not an indicator of future performance.

How to prepare for a world of lower returns

In a world of lower forward return expectations (relative to trend), normalised volatility and heightened risk, investing success will come down to effective risk management and asset quality. 

It’s not only about how much your portfolio returns but how it’s generating those returns and how it holds up during market downturns. Attention needs to be paid to portfolio construction, how certain exposures will behave as the markets digest these challenges and having skilled managers to navigate this uncertainty moving forward.

In summary, we believe investors should hold high-grade sovereign bonds to:

• Secure principal and income stability over time (well-suited for income seekers looking for consistency)
• Diversify against risky exposures of shares (a solid diversifier for portfolios overweighted towards growth)
• Protect against cyclical downturns in a highly liquid form (something which few assets can actually deliver).

Want access to a steady stream of income?

As one of Livewire’s premium partners, Jamieson Coote Bonds has committed to educating investors about income investing through this instalment in the Livewire Income Series. To find out more about the income options that JCB provides, please click the 'contact' button below.