Experts Suggest Fixed Income Asset Allocation

This article was originally published on Fixed Income News on 8 July 2022 and is republished here with their permission.

We hear plenty of experts talking about sectors they favour in the current environment, but how does this translate to your portfolio?

In this article, we talk to Jon Lechte, CEO and Matt Macreadie, Director of Credit Strategy for Income Asset Management for their views on how to allocate in this uncertain environment.

[Jon] We are seeing investors drift back into the bond market. For a while, the news feeds were full of “rates are rising beyond your wildest dreams” carnage, but nothing goes one way forever. Clients holding Floating Rate Notes (FRNs) have been content, their income increasing as cash rates (and expectations of cash rates) have been rising. However, those of us (yes, me) who also bought fixed rate bonds, have been hurt, losing 10-20% of their capital as a guide.

Remember FRNs offer some protection against inflation but are by no means a perfect hedge, i.e., if the RBA doesn’t raise rates as fast as the market expects, then FRN returns will lag inflation. However, if the RBA raises rates in-line with the market and/or higher even, then FRN returns will improve.

[Jon] Just recently those who bet that the market has built-in too many rate increases, have been able to secure a fixed rate bond that has outperformed a floating rate equivalent. See Chart 1 below: it shows the yield to maturity on a short-dated government bond and the enormity of the move we have seen − and shows the recent pullback. After trading below 2% only three months ago, this 2029 year government bond traded above 4% in early June before its recent rally to 3.4%. While we have had a recent rally, Australian longer-dated yields are still trading above where they should normalise in respect of the longer-term growth outlook.

Further, a recession in the US is looking more likely as implied by the recent US yield curve inversion. Even if the cash rate and expectations of cash rates continue to rise at the short-end and interest rates have not peaked, Australian longer-dated yields can still pull back as the curve flattens.

Source: Bloomberg

[Jon] If the cash rate and expectations of cash rates continue to rise, a healthy corporate bond (credit) paying a floating rate return is the answer. If the RBA does not raise cash rates as far as the market presently considers likely, a fixed rate bond will likely outperform.

However, whether investors choose floating or fixed, they need to also be aware of the dual issues of higher inflation and weaker growth − even if the cash rate and expectations of cash rates continue to rise at the short-end. This environment would generally see high-yield credit underperform investment-grade credit and curve flattening.
So, for my portfolio right now, I think:

• 60% of your fixed income pool of funds into 3-5 year floating rate investment-grade notes and 20% in 2-5 year fixed rate investment-grade bonds
• 20% for short term investment. I would look at the term deposit market between six months and two years, as there are banks willing to pay way over the swap (bank) curve for deposits right now

Remember the recent market routs, GFC, and COVID-19 were both “saved” by unprecedented government stimulus. There is no stomach for that this time. In fact, the governments and central banks of the world are extracting funds from the markets, going completely in the other direction. Couple that with geopolitical concerns and their effect on supply chains and inflation − I’m not sure what will save the growth markets this time.

[Matt] There is a valid concern that the Australian bond market may have still priced in too much of the RBA cash rate hike – which means that fixed rate notes (and yields) can come down a little further from here. If the RBA does not raise the cash rate as far as the market expects, a fixed rate bond will outperform.

Market expectations for the cash rate are 3.5% by May 2023 − so up 2.15% from the current cash rate of 1.35%, which is still a long way to go. The market also expected cash rate cuts from May 2023.

Turning to credit fundamentals, the threat of higher interest rates, slower economic growth, and rising inflation generally doesn’t bode well for credit quality − especially high-yield credit versus investment-grade credit. Many investors are focused on the cash rate and whether to buy fixed or floating and have failed to understand what could ultimately happen to credit spreads and their performance.

Growth concerns are starting to manifest through falling commodity prices, with iron ore (on a USD basis) down 32% since 5 April highs (on an AUD basis this is roughly 27%). This directional evidence is worrying − alongside what we saw with the US yield curve inversion (10y2y) in April 2022 and early July 2022.

Source: Bloomberg

All else being equal, a weaker growth outlook and weaker terms of trade (from falling commodity prices) means the AUD could fall with increasing imported inflation.

Weaker growth and higher inflation, resulting in stagflation, generally sees high-yield credit significantly underperform investment-grade credit and curve flattening. Investment grade, as opposed to high-yield companies, generally have more buffer to weather tougher times, which helps in relation to refinancing and interest service pressures.

Remember, the most recent sell-off in credit was largely due to duration (holding long-dated fixed rate bonds that suffered as interest rates increased) rather than credit spread-driven. However, as the experience of March 2020 showed, the performance of US high-yield bonds during that month alone was quite pronounced from a credit spread perspective:

• USD BB was down 9.2%, USD B was down 12.5%, and USD CCC – down 20.2%. This is a proxy for AUD high-yield credit spread performance, as there is no local high-yield index.
• Comparatively, AUD investment-grade was relatively protected during March 2020, with AUD AAA – flat, AUD AA down 0.5%, AUD A down 1.7%, and AUD BBB down 2.4%.

There’s no doubt that increasing allocations to more defensive, investment grade credit as well as an appropriate mix of fixed, floating, and short-term investments would be a strategically smart decision. This doesn’t mean you should get rid of all high-yield credit; it simply means that you might target a high yield whilst having a bias towards better quality.

Moving up the credit curve into investment grade securities might mean you give up a little yield/income, but arguably you are getting very efficient returns for risk right now.

Many BBB bonds are offering 6-7% yield to maturity (YTM). However, there’s nothing burnt on the downside through a loss of capital − which almost always ends up being a realised loss in the high-yield space in a stressed scenario.

Either way, nominal yields available via fixed or floating bonds to investors can make a meaningful contribution to combating inflation.

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