When Michael Blayney, head of investment strategy at first state super, looks at his computer screen at the situation with fixed income he has “this feeling of how low can the yields go?”
“They keep getting lower,” he says. “It makes life challenging.”
It’s a situation all funds are facing. Yields have slumped to record lows due to an unprecedented confluence of factors including quantitative easing and significant downward pressure on inflation.
With yields at such lows, investors face the prospect of sharp capital losses, particularly if inflation picks up. The scenario means that the role of fixed income, particularly its defensiveness, is being seriously questioned.
The days of ‘set and forget’ and index hugging are certainly dead. But despite the risks, many are remaining faithful to the ability of traditional fixed to protect portfolios in times of crisis. What they’re doing is becoming more creative and turning to defensive substitutes, particularly in credit.
“We’re not giving up on traditional fixed income,” Blayney says. “However, in recognising the lower yields, we have been reducing exposure and trying to find other places.”
Some funds have ‘given up’ on bonds
“At some point the market is going to be looking back; it’s going to be fighting the last war [disinflation],” Russell Investments’ Graham Harman says. “If inflation comes back, the whole thing can unravel.”
In response, some funds have given up on bonds. Hostplus sold out of bonds in 2010 when they were yielding 3 per cent.
Subsequent falls in yields “hurt”, says chief investment officer, Sam Sicilia, but the shift to equity markets paid off. “It’s not going to be defensive any longer,” he says of fixed income.
“Every time interest rates rise your returns go south.”
Sicilia says bonds can go lower and to negative. “But how negative can things go before they lose their effectiveness? We’re probably close to it.”
But Adam Bowe, fixed income portfolio manager at PIMCO’s Sydney office, says it’s not time to throw in the towel with fixed income. He says there are other structural factors also at play that could cap a rise in yields.
He believes we have entered a ‘new neutral’ period where yields oscillate around lower-than- average levels.
Two structural factors will keep global growth, and therefore rates and yields low: ageing demographics and an overhang of aggregate debt. “Central banks won’t be able to lift interest rates to levels they averaged prior to the crisis,” he says.
Bowe says he’s also not that worried about inflation; inflation rates in the likes of Australia and the US are not that far below the target rates of 2 to 3 per cent.
“If central banks successfully get inflation back to targets it’s not a huge deal for bonds,” he says.
In terms of a rapid breakout of inflation, “for the next couple of years we see the risk of that scenario as being relatively modest,” Bowe says.
“The reason for yields being low are structural,” he adds. “For those structural reasons, such as demographics and debt level, to turn around will take a long time. For the next few years it’s very hard to see those low level[s] of average interest rates shifting remarkably higher.”
Sue Wang, principal at Mercer Investments, agrees that broadly, fixed income, bonds and all debt instruments are still the best instruments to provide you with diversification in the event of poor performance from growth assets and equities.
But given the risks, investors are evolving and looking at new fixed income options and strategies.
Benchmarks themselves increasingly inefficient
Wang says the traditional benchmark aware strategies are “clearly concerning” and coming under pressure. “The benchmarks themselves are inefficient, and increasingly inefficient,” she says, adding that they’re increasingly incorporating absolute return fixed-income strategies, but also looking to replace fixed income with infrastructure debt in their defensive buckets.
For downside protection, Hostplus itself has shifted to unlisted assets that now make up 40 per cent of its portfolio. That includes airports, ports and power stations.
“They are the assets society needs for it to be civilised,” Sicilia says. “How bad would the world have to get before they switch off the water supply? You’d expect to be paid something irrespective of what happens because society simply needs those assets.”
But will Hostplus go back into bonds?
“We can’t go back to bonds,” he says. “We don’t need bonds when bonds aren’t the place to be.” Sicilia says Hostplus can invest a large chunk of its portfolio in unlisted assets because it has a relatively young demographic, and therefore big inflows and low outflows.
But what would he do in the fixed income space if he were CIO of another fund? He says he would explore credit; buy credit paper of companies he believed would survive long term.
“If you own BHP shares, why wouldn’t you own BHP notes?”
Harman also likes high-yield credit, particularly buying global credit and hedging back into Australian dollars. But unlike many others he also advocates cash. “You’re almost better taking cash, no matter how derisory [the returns]. Cash has enhanced opportunistic value. When a big down draft hits in other markets, you have liquidity to enable you to profit from that.”
First State Super’s Blayney says his fund still holds fixed income in their portfolio for diversification benefits. But they have progressively been decreasing exposure, and the vast majority of fixed income is onshore, given Australia’s relatively high yield.
First State Super has also been increasing exposure to credit “a little bit”, particularly investment-grade credit. Blayney says if you view it on a spread basis rather than outright yield, a basket of US investment grade bonds still gets 150 basis points over government yields.
He says even in difficult economic conditions they seem to have very few defaults.
First State Super is also increasing exposure somewhat to private debt, through more direct lending, such as infrastructure debt and project lending. And it is even looking at sub-investment grade debt. The floating rates mean those instruments don’t have the same degree or risk to rising interest rates. Still, “it doesn’t give you the same level of defensiveness as government,” he says, adding that credit type instruments have many of the same risks as equities.
Blayney says he also likes cash, despite low yields, and the fund has a relatively high strategic allocation, because it provides ‘dry powder’ to take tactical opportunities when assets are sold off. Frontier Advisors’ Chris Trevillyan says his clients are also actively considering alternatives.
Trevillyan himself believes that bonds are still likely to provide downside protection, because bond yields can continue to go lower. “But that downside protection is reduced,” he says.
Examining the threat of inflation
He believes yields will likely stay lower for longer and are unlikely to spike up. “It is a risk though, but low probability,” he says. Trevillyan is still examining the threat of inflation because “most of the market doesn’t expect it to happen”.
But another scenario Trevillyan is worried about is a long period of very low, small negative returns. It’s a ‘death by a thousand cuts’ scenario. “As a long-term investor, that’s particularly unattractive with it compounding over a number of years.”
So, along with his clients, he’s exploring defensive alternatives.
Trevillyan says foreign currency should afford downside protection. While valuations are not as attractive after the Australian dollar’s falls in recent years, he expects the Australian dollar to fall during market stresses. He likes the Japanese yen because the Australian dollar is overvalued relative to it, but the problem is that with countries engaged in global currency wars, currencies can shift from fundamentals for a long time. So he advocates pooled exposure to foreign currencies.
Some funds are also looking at using options hedge against equity market falls, particularly to protect their lower risk and pension options where downside risk is more of an issue. At its simplest, they’re using put options on equities.
But that’s not a good long-run strategy, Trevillyan says, because it will be a drag on returns.
Other funds are exploring ‘alternative beta’, and like others, exploring credit, including bank loan credit and emerging markets debt. “They’re not a government bond replacement,” he says. “They are risky, but it is a place to be looking for additional yield.”
Despite all the risk, PIMCO’s Bowe says bonds portfolios can still perform their three roles of real income generation, capital preservation and diversification.
During 2015 and 2016, when many investors moved into high dividend stocks and hybrids for income, a globally diversified bond portfolio or globally invested investment grade credit portfolio generated healthy real income without significant capital volatility. “They can still perform that going forward,” he says.
Australian bonds still have room to go ‘up and down’
Bonds have typically had a modest negative correlation to equities in Australia. They can still perform that diversification role, too, Bowe says.
“Australian bond yields can go lower. The cash rate feels remarkably low, but compared to the rest of the world they’re remarkably high.
Australian bond yields still have room to go up and down.”
In fact, Bowe notes, there has been no change in the relationship between bonds and equities in Australia. “The negative correlation has actually more pronounced during recent market volatility,” he says.
Mercer’s Wang agrees that despite the quest for alternatives, there is still a crucial defensive role. “When the s— hits the fan, you still need liquid, high-quality bonds, typically sovereign bonds of well-rated countries of good duration,” she says. “We’re not saying our clients should completely rid themselves of duration, of sovereign bonds in their portfolio, despite duration having a lot of risk and a lot of sovereign nations looking wonky. Because during periods of fear and flight, quality people still go to US Treasuries and the like.”
This article was updated on 26/7/16 to clarify PIMCO’s position.
