The next few months are going to be painful for Australians. Here's how you can invest your way out of it

The interest rate cycle is finally starting to change, with the US Federal Reserve tipped to see its first cut in September. As its peers start to cut, Australia is expected to hold for at least the remainder of 2024 and push the trigger next year.

Real Asset Management’s Head of Fixed Income, Michael Frearson, believes that the next three to six months will be the toughest the Australian economy has experienced in some time as we finally see the full impact of those rate hikes come through.

There’s little left in the way of consumer household savings, wages growth is finally slowing and unlike the past where China’s imports of our resources provided a buffer, China is clearly experiencing its own slowdown.

But while the outlook may look somewhat subdued, it’s all good timing to bolster your Australian fixed income portfolio and Frearson shared how he is managing for the outlook.

The peak of the rates cycle and what comes next

It’s been clear for some time now that we’ve hit a global peak in interest rates and the next step is likely to be down. New Zealand has already started, while the US is expected to see its first cut as soon as September.

Closer to home, there have been mixed views on whether the Reserve Bank has another hike in it. Frearson thinks not.

“We currently expect them to cut in February, but that is always dependent on the data,” he says.

He expects credit risks to remain elevated across the period of transition from tightening to easing, and notes, “the longer rates stay higher, the greater the likelihood of further problems in the real economy.”

“Fixed rate bonds should benefit as rates fall; however, the longer end of the curve has already started to price that in,” says Frearson, noting that this means we shouldn’t expect a huge uplift in these assets.

When it comes to floating rate assets, he expects yield to come down slightly and “we expect credit spreads to remain relatively stable in the mid-2% range.”

Soft landing ahead

Despite the elevated risk, Frearson doesn’t fear a repeat of 2022’s sharp selloff in bonds and equities.

“The risk of a moderate recession is increasing, and no one is expecting a significant drop off in economic activity,” he says, anticipating a soft landing ahead.

He points out the sharp selloff during 2022 was linked to a sudden change in the path of interest rates, when markets had largely priced in consistent expectations for stable rates.

“During that period, a lot of people discovered they didn’t have defensive portfolios because they weren’t looking at the duration risk on fixed income,” Frearson said.

Those portfolios, like Real Asset Management's Australian Diversified Fixed Interest and Credit SMA, that still offered a positive return in this period typically had overweight positions to floating rate credit and were underweight duration. This reflects RAM’s barbell approach to portfolio construction which blends floating rate credit with high quality fixed rate bonds and actively managing subsector exposure across the portfolio.

Managing fixed income for a changing rates cycle

Yields are at their most attractive point in 15 years, and with the view that an easing cycle is approaching, Frearson has been adding duration to his Australian portfolio. His portfolio is currently sitting at around 1.1 years duration. To put it in perspective, there was very little duration in the portfolio over a year ago.

“We’ve been progressively adding to our duration positioning due to both the more attractive value on offer – Australian government bond yields are above 4% - and our view that rates are likely to fall, and we will benefit from some attractive fixed rate exposure,” says Frearson.

Adjusting the duration is a key tool Frearson uses to enhance returns in different periods.

“In the near term, we continue to favour floating rate credit in our portfolios via subordinated debt and capital securities because we continue to see the potential for rates volatility later this year,” Frearson says.

“The relative value remains attractive in subordinated securities issued by very high credit quality banks and yield to maturity is still very attractive in the 6.5-7.5% range.”

He expects the increased duration in the portfolio to provide a tailwind as interest rate easing commences.

Frearson focuses on the investment grade end of the listed market so has been able to avoid deteriorating segments, such as the smaller end of the building industry, where there have been defaults in construction.

He is expecting stability in credit spreads and points out that spreads have rallied strongly in senior debt, subordinated debt and capital securities.

“Capital securities on a relative basis continue to be attractively valued compared to those more senior structures,” says Frearson.

Diversification as an ongoing support in times of volatility

Diversification is also critical regardless of the market cycle.

“You need diversification across sectors because one of the biggest risks is drawdowns from credit losses,” says Frearson.

The RAM Australian Diversified Fixed Interest and Credit SMA, which has won four IMAP Awards for Australian Fixed Interest managed accounts, has exposure to over 800 different individual securities – not just to offer a variety of drivers and returns, but also to protect the portfolio from company-specific credit risks and portfolio drawdowns.

That said, Frearson views large banks and diversified financials as attractive additions to a portfolio. Capital notes from Westpac, Commonwealth Bank and NAB are amongst the top five holdings in the portfolio.

Concerns that plague equity investors around valuations and future profitability of big Australian banks are not something that keeps Frearson awake at night.

“We invest higher in the capital structure in securities which provides certainty as to the income stream, when the call date and maturity date of the investment is. It’s not influenced by movements and valuations of banks equity and there isn’t the same risk to distributions,” he says.

He also points out that Real Asset Management’s credit score system continues to rank the bank credit as very high quality and they have strong balance sheets.

The biggest risks in fixed income and how to manage them

Beyond this outlook, Frearson reminds investors that the biggest risks involved in fixed income investments are default risk and illiquidity. Being in illiquid and non-transparent investments can be a risky strategy as we move to the tail-end of the rates cycle.

“It’s my advice to keep things simple and focus on quality income streams in transparent investment grade portfolios. If you don’t understand what you are buying or what is in the fund, you probably shouldn’t be buying it,” he says.

Find out more about Real Asset Management and the RAM Australian Diversified Fixed Interest & Credit SMA here.