With long-term horizons for fixed income predicted to remain low, Vimal Gor, head of income and fixed interest at BT Investment Management, and Richard Quin, managing director and head portfolio manager for Bentham Asset Management, present two views on the landscape. Click here to read Gor’s assessment.
Fixed income markets are approaching a tipping point that should prompt investors to re-evaluate their portfolios and how they are positioned in an environment of historically low government bonds yields and increased volatility in equity markets.
My belief is that global credit investments will have an increasingly important role to play in portfolios, over the coming years.
Global floating rate credit offers attractive yields, diversification, as well as protection against inflation. Importantly, credit can be senior and secured, providing more capital protection than exposure to equity.
Long bonds more risky at historically low yields
There are also reasons to be concerned. Government bond yields are trading near all-time lows (pushing prices higher than PAR or $100), underpinned by the low inflation outlook both domestically and around the globe; and more importantly a fall in the term risk premium.
The current environment of record low interest rates means that historical returns achieved from cash/fixed income are unlikely to be replicated in the medium term. In fact, bonds no longer provide enough income to outpace targeted inflation and as such investors should consider alternative options.
Looking at current fundamentals, US government bond yields assume that the US economy is too fragile for the US Federal Reserve to increase rates any further for an extended period. However, market pricing (and the Federal Reserve’s own expectations) is at odds with US economic indicators such as jobs data and housing numbers which are particularly strong.
We believe that this disconnect makes government bond pricing volatile, and with little yield compensation. Although government bonds typically provide protection in risk-off markets, we are sceptical as to whether they will offer the same level of protection in the future.
The risk of capital loss for long dated fixed rate bonds is pronounced. By way of example, take the Barclays Global Govt Bond index – which has a yield of 2.5 per cent (in $A) and duration of 7.9. A one per cent rise in interest rates will see the capital value of this index fall by close to 8 per cent.
Equity markets have their own issues, and come with the increased capital volatility associated with the asset class. The recent decision by BHP Billiton to cut its dividend was a wake-up call for equity investors – a reminder that income from shares is discretionary, not a legal obligation like a bond coupon.
While many Australians rely on the local banks for yield, banks are susceptible to risks associated with a falling housing market, which most Australian investors are already exposed to. Holding Australian bank hybrids which are AT1 capital in addition to bank shares only exacerbates these risks.
The role of global credit
A logical alternative to complement fixed income portfolios going forward is global credit, offering diversification and attractive levels of income with an intermediate level of volatility. Take, for example, US senior loans that are currently yielding more than 8 per cent (in AUD), and have the added benefit of low duration (being floating rate), seniority in the capital structure and security over assets.
Another attraction for global credit is liquidity. Global credit is a large and deep market and significantly larger than global share markets. It has many different investor types, including asset managers, banks, insurance companies, pension funds and sovereign wealth funds. This diversity of investors means credit investments are traded between buyers and sellers even during challenging times. Moreover, global credit also tends to be more resistant to shocks: when credit markets fell in the global financial crisis (GFC), they took just one and a half years to recover, compared to four and a half years for equities.
In terms of diversification – senior loans and high yield complement a portfolio of equities and traditional fixed income. Adding global credit to a portfolio of Australian shares and government bonds can not only improve absolute returns, but improve returns per unit of risk.
Importantly, there’s a tendency to think that investors need to choose between the high volatility/high risk of shares, and the low risk/low return of government bonds. However, global credit provides clients with additional options outside the traditional ‘barbell’ approach, and should be considered as part of any strategic asset allocation.
Gor and Quin will be presenting at the Fixed Income, Cash and Currency Forum in Melbourne on July 26 – 27. To register for the event click here.