The $335 billion AustralianSuper has been trimming its bond portfolio as a proportion of total assets in the expectation that global interest rates have peaked, according to head of fixed income, currency and cash Katie Dean.
The fund currently has some $50 billion in fixed income, around 15 per cent of total assets and down from around 20 per cent last year.
“Last year was probably our peak fixed income allocation within the fund,” Dean said in an interview with Investment Magazine.
“Subsequent to that, the allocation has started to drift down.”
Dean spent four years as an economist with the Federal Treasury in Canberra, and another 12 years as an economist with the ANZ Bank before joining AustralianSuper in August 2014, rising to her current role overseeing the fund’s portfolio of fixed income, currency and cash in August 2021.
Dean says AustralianSuper’s allocation to fixed income can swing from less than five per cent to more than 20 per cent, depending on the interest rate cycle.
“It’s a classic asset allocation decision,” she says.
“When rates look like they have peaked it is normally a good time to start reducing your fixed income holdings.”
Dean says she is expecting central banks around the world to start cutting interest rates this year as inflation eases, a move which will see a further reduction in the fund’s exposure to fixed income as a percentage of assets.
“What we would expect to see over the next six to 12 months is a reduction in the fund’s exposure to fixed income, very much predicated on the view that there’ll be higher returning asset classes,” she says.
While the fund’s percentage allocation to fixed income could decline, this could still see the dollar amount held in fixed income rise because of the fund’s continued growth, fuelled by some $20 billion a year in new net contributions.
“As the allocation to fixed income starts to drift lower, it will mean the actual dollar amount in fixed income won’t grow as quickly as the rest of the fund,” she says.
AustralianSuper now has another $20 billion in cash, or around six per cent of the portfolio, but it does not reveal its total exposure to foreign currencies for competitive reasons.
“That’s market sensitive as we have to participate in the foreign currency market every day,” Dean says.
“I can’t give you too many details, other than to say we have a sizeable foreign currency book.”
Dean oversees a team of 35 to 40 people running fixed income, currency, and cash across the fund.
While most are based in Australia, AustralianSuper set up a team in its London office, allowing the fund to be closer to global markets. The fund’s fixed income portfolio is run against a benchmark of 50 per cent global and 50 per cent Australian bonds. The fund has an exposure to corporate bonds, but Dean keeps a cautious eye on them.
“When rates have peaked, it’s often a good time to start thinking about increasing corporate bond exposure,” she says.
“We have started to increase that exposure, but we are not looking to aggressively move into that sector.”
“At the moment, we are very focused on what we would call defensive yield which is very much based on the idea of a soft landing.”
Corporate distress
But she says if interest rates stay high it could lead to distress for some companies.
“We have to be very conscious to go up in quality and make sure we are getting paid sufficiently for the risk and not buy when spreads are super tight.”
Dean’s job involves constantly watching developments in major economies and the actions of their central banks.
“We manage a book of global and local fixed income securities,” she says.
“We are very focused across all the major regions.”
Part of the challenge is working out how much of global trends will also flow through to Australia and how much developments here might be different.
“We spend a lot of time thinking about what is going on in Australia and whether the rate cycle or the corporate cycle will be different here compared to some other major economies,” she says.
While the Reserve Bank in Australia was slower to raise interest rates compared with many other developed country central banks, particularly the US Federal Reserve Board, Dean says the Australian economy is more sensitive to interest rate hikes because of the higher debt levels of Australian households.
“The US household sector is much better balanced than the Australian sector and has a lot less sensitivity to higher rates,” she says.
“But some of the other drivers are quite similar.
“The US has seen strong immigration which has pushed through to a strong labour supply and allowed wages growth to moderate.”
“We have seen a similar pattern here.”
“Both economies are also experiencing some level of fiscal support.”
“But given that the Australian economy is a bit more sensitive to higher interest rates, the shape and timing of the easing cycle in Australia will probably be a bit different [to that in the US].”
Dean says that the RBA will look through the energy and other subsidies announced in the Federal Budget as it makes its call on the future of interest rates.
“The RBA will be looking at where it thinks inflation is settling,” she says.
“It will look through one-off impacts on inflation through subsidies.”
She sees inflation around the world moderating and conditions in labour markets easing.
“We’ve got inflation around the world moderating and we’ve got labour markets starting to move back into better balance,” she says.
Growth more resilient
But she notes that economic growth has proven to be more resilient than many had expected, a factor which will mean slower expected rate cuts than last year when there were fears of a hard landing in some economies.
She says this means the outlook is for “mid-cycle” interest rate cuts, rather than a significant fall in rates from current levels to those prevailing before Covid.
“There are a number of factors which could mean inflation will be more volatile at a higher level than what we got used to pre-Covid,” she says.
These include the significant investment required for the energy transition, aging populations and shrinking labour force participation rates and geopolitical uncertainty such as events in the Middle East and the Russian invasion of Ukraine.
Countering this are the deflationary forces of new technologies including the use of artificial intelligence.
“It is reasonable to assume that inflation this decade will be higher than inflation was in the previous decade,” Dean says.
“I don’t think we’re going to see 10 per cent rates of inflation again, but we have to be alert to the fact that inflation is not going to go down to levels of between 0.5 and 1.5 per cent in the US.
“It’s probably going to average somewhere closer to (a range of) 1.5 and three per cent.”
This has implications for decision making on the relative exposure to bonds and cash.
“If we are going into a period where inflation is going to be more volatile and potentially higher- and I think there’s strong arguments why that may well be the case- bonds aren’t going to provide the type of protection in a portfolio that they may have traditionally provided.”
“That’s where you start to think about whether cash is a better protector for the portfolio, as opposed to fixed income.”
Dean’s current job draws heavily on her background as an economist.
“There’s a natural synergy between studying as an economist and thinking about the economy and economic cycles and how it reflects in financial markets,” she says.
“The next step is thinking about how you can generate returns for our members through the insights we have on markets and policies.”
“It’s an area that never stops giving. It is very challenging, very stimulating, and very interesting.”
“Every day is a new day.”
