Richard Quin, Bentham (center), Jay Sivapalan, Janus Henderson Investors (right)

The landscape for fixed income investors has changed dramatically with the spread of ultra-low and negative bond yields and the traditional uses of fixed income are challenged.

Richard Quin, CIO of global credit manager Bentham Asset Management, presented on the topic of negative interest rates at an Investment Magazine conference on Fixed Income and Credit.

“What started as a policy experiment has quickly become entrenched across large economic areas” notes Richard. “While short-end rates have been negative for several years in Europe, Switzerland and Japan, it’s a relatively recent phenomenon to see negative yields across the full yield curve out to 30 years,” he said.

Negative-yielding debt now totals more than US$16 trillion globally, or about 30 per cent of the Barclays Global Aggregate Index by market value (in local currency terms).

“Australian investors might consider themselves the lucky ones – we still have positive yields here” he told delegates. “The opposite is obviously the case if you are in Europe, or buying global bonds and hedging back to Euros”. But even in Australia, yields are so low that for investors to generate a real return from fixed income, they are relying on further rate cuts from central banks – beyond the rate cuts already priced into the curve – and for this low rate environment to persist longer-term. “We think there’s a lot of room for Australian and global fixed income to disappoint over the next 1 to 3 years”.

The risks to fixed income have fundamentally changed. We’ve seen volatility in fixed income markets pick up markedly. Just as yields have been falling, duration has been extending in most fixed income indices – amplifying the pain of any correction.

Quin added that the low-to-negative long-term correlation between fixed income and equities has been the foundation for adopting bonds as a diversifier (or insurance) in balanced portfolio. Over shorter periods, he went on to say, correlations can be unstable and can be positive, particularly in Australia. We have recently observed equity markets rallying on an increased expectation of lower rates. It is not out of the question that if we see a reversal of expectations towards higher rates, you will see both bonds and equities sell off.

So how to invest given this backdrop? “In my view, you’re not being rewarded for taking term risk in bonds. Upside is limited (given low bounds of negative rates), and the downside could be large. We’re flat interest rate duration now – we just won’t buy where don’t see fundamental value.” he said. “Where we plan to generate a real yield is from credit, in a yield seeking environment. A period of slow-but-still-positive growth is actually OK for credit. It’s bad for equities, but OK for credit. With a flat (or inverted) yield curve, we are happy to be at the short end. We like floating rate exposures – minimising our interest rate duration exposure, and allowing us to participate in any normalisation of rates in the future.”

“For those looking for defensive positioning, we are using very high-grade asset backed securities (ABS), as an alternative to long-duration investment grade corporate or government debt. AAA and AA tranches of global ABS are very remote from capital impairment. You might expect mark-to-market volatility in a down-market, but you don’t expect permanent capital from credit losses – these are defensive assets. The asset will likely suffer price volatility but not capital loss. Indeed, if you look at the structures in ABS, these securities tend to have an improving credit profile over time, as they naturally deleverage over their lifetime. We see high-grade ABS as some of the best relative value opportunities in credit at the moment”.

Another floating rate sector he  finds interesting in this environment is the US syndicated loan market. Loans is one of the few asset classes to actually adapt to the low/negative interest rates environment, with LIBOR Floors becoming standard in documentation. A “LIBOR floor” establishes a minimum value for LIBOR when setting the loan’s coupon of “LIBOR + Credit Spread”. LIBOR Floors are typically set at zero at the moment, protecting investors against a move into negative interest rates.” explains Quin. “Fundamentally, we like the senior, secured nature of loans as a sector, and believe current credit spreads are more than compensating investors for the anticipated default outlook.”

Asked if negative interest rates are a challenge just for investors, he noted that negative interest rate policy (NIRP) has consequences – some unintended – across the economy, impacting not just investor asset allocation, but also banking and saving systems, households, markets and expectations. “Negative interest rates can crush NIMs (net interest margins) for banks, making systems unstable and banks unprepared to lend.” he  said. “The bigger your balance sheet, the more negative your return could be. There may be a perverse incentive here for banks to lend less for this unusual period. NIRP was never intended to be a long-term solution, and we don’t think central banks are particularly comfortable – or confident – with the policy.”

“We’ve been through the easy part of NIRP implementation: falling yields have provided a strong tailwind for fixed income and many other asset classes. It’s the consequences of long-running NIRP which are untested, and the journey back to positive rates which could be painful for investors.”

Jay Sivapalan, co-head of Australian fixed interest at Janus Henderson Investors pointed out that Australia in a different position and is less challenged than other countries.

“If you look at the asset side of the balance sheet, Australian does have some tools to deal with some of these big slow burning trends. It’s not to say that some of these secular themes won’t play out, but it is not as bad,” he concluded.

 

 

 

 

 

Elizabeth Fry has been a financial journalist for more than 25 years and has written for a number of publications, including CFO, The Financial Times and The Australian Financial Review.
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