The bond market: back from the dead
Stuart Dear, Deputy Head of Fixed Income, discusses how despite low starting yields and poor valuation support, Australian Fixed Income has returned a healthy 3.6% year-to-date, but notes there are still troubling aspects to performance.
To unashamedly paraphrase Mark Twain’s famous quip, reports of the death of the bond market are greatly exaggerated. Despite low starting yields, and in our view, poor valuation support, Australian fixed income has returned a healthy 3.6% year-to-date.
While of course that’s good news for investors in Australian debt, there are several troubling aspects to this performance:
Firstly, it’s because of lacklustre macroeconomic outcomes. Developed economies have only managed to grow at about trend pace over recent years in spite of unprecedented central bank stimulus. Meanwhile, inflation trends are generally weak, in spite of poor productivity performance. This should be concerning for those investors with growth heavy portfolios.
Secondly, in spite of a lacklustre macro performance, equities and credit have rebounded sharply from early year losses, but there has been no material retracement of the downward move in bond yields that occurred. This in part makes sense because it was the dovishness of the Fed and ECB in March that drove the rebound in risk assets. However, ongoing gains in financial assets (and, in Australia, property) alongside modest/underwhelming real economy outcomes is likely to be ultimately destabilising. How will we ever exit the sticky entanglement between markets and central bank policy? It’s not likely to be pretty.
And finally, since the current performance of bonds is likely to be a pull-forward of future returns, it both reduces future expected returns and increases the risk around them. While this is bad news for fixed income investors in isolation, it is also bad news for broader investors for whom bonds are likely to prove to be less effective as defensive diversifiers next time around.
These things said, bonds have again proved their effectiveness and justified their continued inclusion in diversified portfolios. And (as usual!), the forward-looking list of risks against which you might want portfolio diversification remains long: ongoing high leverage that continues to stymie the global recovery, deflation, financial asset valuation risk, elevated political risk etc. However, it’s imperative both that the fixed income asset class is used sensibly, and that individual fixed income portfolios are managed carefully.
The Schroders Fixed Income Fund remains defensively positioned in light of the developments above. We continue to hold less duration than the benchmark due to extended longer-term valuations of government bonds (we are short mainly in the US where the case for monetary tightening is strongest and in Europe where valuations are worst), and to be cautious on credit risk given that spreads are now back to fair levels, the US credit cycle is deteriorating, and technicals are mixed. Our exposure to cash remains elevated.
Our credit allocation sits at about a double benchmark weight, but is low both relative to the portfolio’s history and in absolute terms. While credit is favoured by a continuation of the low-volatility economic environment and by ongoing central bank market participation (which in addition to encouraging buying of riskier assets also dampens volatility, making carry trades more attractive), it’s likely that our next moves will be to reduce, rather than add.
The most significant change to report is our recent buying of Australian duration. Alongside a cyclically weak nominal growth environment, low inflation outcomes continue to plague the RBA, and were the primary driver for both the May rate cut, and a forceful downward revision of the Bank’s inflation forecasts that flag further easing. We bought a combination of government, supranational and inflation-linked bonds to take our Australian duration to 4.80 years (our longest historically), part of which is paired against shorts in US Treasuries and German Bunds that total 1.0 years. Our relative preference for Australian bonds helped the portfolio deliver strong returns in May, in line with the benchmark, in spite of our material aggregate underweight duration position.
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