Fixed Income

Focusing on absolute returns

Stuart Dear discusses portfolio construction and the importance of balancing defensive features to ensure the portfolio plays both a diversifying role and is defensive in its own right.


Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

Our flagship fixed income portfolio is designed to be a key defensive allocation within broader portfolios. While diversification of equity risk is a key defensive feature, other defensive aspects that we emphasise are income generation, capital stability and liquidity. In managing the portfolio we attempt to balance these defensive features, so that the portfolio plays both the diversifying role and is defensive in its own right.

Focusing on absolute returns and risk is the best way to achieve this balance. Our process is built around a long-term valuation driven approach to estimating returns and risk and therefore strongly supports an absolute focus (as the more expensive an asset is, the lower its expected return, and the higher its risk). This focus on absolute returns and risk – hence absolute portfolio outcomes – puts us in contrast with most of our peers who focus on benchmark-relative metrics, and certainly the benchmark itself (which, being cap-weighted, wants to allocate more to an asset the more expensive it gets). This strong stance against the benchmark as a well-constructed portfolio sees us position our portfolio materially differently to the benchmark.

Valuations of government bonds remain stretched, and this remains the key driver of our main relative-to-benchmark positioning – i.e. our shorter duration positioning and concurrent underweighting of government issuer exposure. We are currently 1.15 years shorter duration than the benchmark, for which the reward (yield) to risk (duration) regarding interest rate risk has moved to its lowest point ever.

Despite our views on valuations, duration / government exposure remains important to ensure the portfolio plays its diversifying role. The last half of 2015 and early 2016 were reminders of the value of holding duration through government bond exposure as these assets strongly outperformed others, in spite of low / negative starting yields. Mindful of this, the approximately 3.5 years of absolute duration the portfolio holds is actually slightly more than the historic average. Where you hold your duration is also important – we are short in Europe (where valuations are worst) and the US (where the case for monetary tightening is strongest) but hold 4.3 years of absolute duration in Australia, where there is still room for yields to fall should the environment worsen.

This recent period of market volatility also serves as a reminder about the different roles cash (being short term return certainty and portfolio rebalancing flexibility) and fixed income (being portfolio diversification in adverse scenarios) play in a broader portfolio. Cash can’t provide the higher short term returns that bonds can to insulate the portfolio from losses elsewhere.  Hence it’s not advisable, in spite of the rough equality of yields on term deposits and government bonds, to give up on defensive fixed income in favour of cash. Nor should a shift to higher alpha fixed income strategies (which are by definition return seeking and likely to underperform cash during adverse market moves) be seen as a substitute for defensive fixed income.

Rather, portfolio construction in defensive fixed income portfolios remains vital. Diversification, capital stability and liquidity are key elements to construction and are important reasons why we hold a more than double benchmark exposure to credit assets (including mortgages, subordinated issues and other non-benchmark exposures) and about 25% in cash. Active management across a forward-looking opportunity set is also essential - credit improved to cheap value in Q1 and we added; we have subsequently removed this additional exposure as spreads compressed and value deteriorated – in order to deliver a more flexible diversified approach to defensive fixed income.

It seems the market noise around central banks continues to obscure some of these bigger picture issues about the role, objectives and management of fixed income portfolios on which we remain focused.

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