Market Insights and Education & Resources

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The income game has changed and Pendal’s income strategies have evolved to look very different to traditional income portfolios. Pendal portfolio manager AMY XIE PATRICK explains

LOW YIELDS and skinny corporate bond coupons are not the makings of a traditional income portfolio.

That’s the challenge that many bond-only income products face today.

A 30-year bond bull market has been a massive boon for income portfolios heavily reliant on credit. In a falling yield environment, you can reap the full benefits of corporate bond yields -- and many investors have pushed into riskier and high-spread exposures.

This has been very supportive for credit as an asset class. But the game is now changing.

The 30-year bond bull-run has come to a close. Inflation is the market zeitgeist. Any traditional income portfolio will lack the necessary levers to confront it.

Rising bond yields need to be hedged. Those hedges eat into the already scant levels of income such portfolios are now generating.

A rising yield environment will also cause more dispersion in the performance of credit. Portfolios that have loaded up on lower quality offerings in recent years are likely to see more headwinds.

That’s why Pendal’s income strategies look very different to those traditional income portfolios.

Other levers needed

High-quality credit serves as an essential income building block, but the overall portfolio needs other levers to manoeuvre through different market environments.

If the environment is inflationary, there need to be other sources of income besides fixed rate credit.

The Pendal Monthly Income Plus Fund currently has a 19% allocation to Australia equities, with room to add further.

This is not only a way to help the portfolio keep up with the reflation narrative. The income from equity dividends frees us from relying heavily on accruals from fixed rate instruments.

As a result, the Monthly Income Plus Fund’s exposure to interest rate risk is the lowest it’s been for more than five years.

Importantly, should sentiment suddenly turn more bearish, de-risking will be far easier in equities than in credit due to its liquidity advantage.

In the Pendal Dynamic Income Fund, a 20% allocation to floating rate emerging market sovereign exposure helps generate additional income, while capturing the spread compression opportunity as investors seek portfolio diversification from asset classes such as Emerging Markets.

Similarly, the Dynamic Income Fund’s interest rate exposure is currently minimal.

Having non-traditional levers to gain additional exposure to income and market upside has given us the luxury to not chase lower quality credit deals when they come to the market.

Instead, cognisant of the rising yield environment, we are running higher-than-normal cash balances that are waiting to be deployed at more attractive yield (and hence income) levels.

Flexibility via multiple levers, a focus on quality, and agility on interest rate exposures are the makings of a resilient income portfolio.

Most investors are now aware of climate change risks. But biodiversity preservation may be an even bigger and more immediate issue. EDWINA MATTHEW explains

WORLD leaders including Scott Morrison fly into Glasgow on Sunday for the United Nations “COP26” Climate Change conference.

We will soon know if they deliver net zero targets that are sufficiently ambitious to keep global warming to 1.5 degrees — meeting the Paris Agreement adopted at COP21 in 2015.

But net zero emissions by 2050 is not the whole story.

As Glasgow ramps up for COP26, the southern Chinese city of Kunming is just winding down after another COP (or Conference of the Parties) which focused on conserving biological diversity.

At COP15, 195 countries pledged to reverse biodiversity loss by 2030 at the latest and agree on a framework to protect species and their habitats.

Biodiversity may not be as attention-grabbing as climate change. But it is a critical part of the overall solution and directly impacts many industries.

Agriculture. Medicine. Insurance. Real estate. Tourism. To name a few.

Half of the world’s total GDP — or some US$44 trillion of economic value generation — is moderately or wholly dependent on nature and its services, according to the World Economic Forum.

“Climate change is a very complicated issue, but biodiversity is on a whole other level,” says Pendal’s Head of Responsible Investments, Edwina Matthew.

Twin crises

Climate change and biodiversity loss are inter-related, “twin crises”, says Matthew.

Climate adaptation strategies such as protecting and restoring natural habitats offer defence against the physical impacts of climate change.

Nature-based solutions are also part of the broader universe of carbon removal projects underlying the carbon credits or offsets that are part of net zero strategies.

But climate change itself is destroying our natural capital (soil, air, water and living organisms) and biodiversity ecosystems -- as seen in Australia’s Black Summer bushfires.

“Encouragingly, governments, business and investors are starting to understand that nature and climate can’t be separated -- and that nature-related impacts and dependencies need to be considered alongside climate-related exposures,” says Matthew.

“We need to invest in mutually reinforcing solutions. A 1.5-degree pathway cannot be achieved without major investments in natural capital.”

Industries threatened by biodiversity loss

Agriculture is the most obvious example of an industry threatened by loss of biodiversity.

The agriculture sector accounts for a quarter of Australia’s exports (and employs 60 per cent of the world’s working poor).

Scientists estimate $US577 billion of annual crop production is at risk from loss of pollinators like bees.

The Worldwide Fund for Nature says 60 per cent of the world’s coffee varieties are in danger of extinction due to climate change — a sector with more than US$80 billion in global sales.

Nearly half of all medicines are derived from natural sources.

“We’re also starting to see scientists linking the transmission of animal disease to humans because of a breakdown in biodiversity buffers,” says Matthew. “We had SARS, now we have COVID.”

The UK Treasury’s Dasgupta Review on the Economics of Biodiversity released earlier this year says the “devastating impacts of COVID-19 and other emerging infectious diseases -- of which land-use change and species exploitation are major drivers -- could prove to be just the tip of the iceberg if we continue on our current path”.

Much of global tourism is linked to natural attractions. The Great Barrier Reef brings in $A1.5 billion a year in tourism and fishing.

The loss of wetland buffers for flood-prone areas can expose real estate and insurance companies to higher risk.

Nature also helps regulate the climate itself — as we acknowledge in the development of nature-based carbon offsets.

What it means for investors

Just as investors now understand the risks posed by climate change, so too natural capital and biodiversity considerations are starting to creep into the investor engagement and corporate reporting agenda.

“It’s twofold,” says Matthew.

"It's about understanding biodiversity loss as a top-down, systemic issue -- as a threat to the global economy -- as well as understanding and managing bottom-up, company-specific natural capital and biodiversity-related exposures.

“It’s also about holding companies to account for their impacts, as we do for climate. What role do they play in adverse outcomes for biodiversity and natural capital? How are companies embedding these considerations into their own governance structures and risk management frameworks?

"And to what extent are they dependent on natural capital for their own business? How do they think about biodiversity loss and related policy and regulatory trends and shifts in key stakeholder expectations?

“A lot of the learnings we’ve had from climate change are starting to play out in the natural capital space.”

The good news is, companies are starting to respond.

“We are seeing efforts in mining, property and finance to build understanding around dependencies and impacts in business models and supply chains.”

Biodiversity and land management reporting is already a feature in some company public disclosures.

“Just last month BHP acknowledged evolving stakeholder expectations about its efforts to achieve nature-positive outcomes during an ESG investor roundtable.”

The newly launched Taskforce on Nature-related Financial Disclosure — supported by the United Nations and endorsed by G7 ministers and financial institutions — is setting up a risk management and disclosure framework for organisations to report and act on nature-related risks.

The taskforce supports a shift in global financial flows away from “nature-negative” outcomes toward “nature-positive” outcomes.

Opportunities

Similar to the transition to a “low-carbon economy”, a transition to a “nature-positive economy” also offers economic opportunities.

There is potential for almost 400 million jobs and some $US10 trillion in annual business value by 2030 across three socioeconomic systems (food, land and ocean use; infrastructure and the built environment and energy and extractives) according to WEF.

Pendal clients are exploring how they can direct capital to support nature-positive outcomes, Matthew says.

“They have a fiduciary and financial interest in the wellbeing of the economy as a whole. They expect active managers like Pendal to exercise our ownership rights on behalf of our clients to encourage the protection of natural capital.

“They are also seeking opportunities for how they can allocate capital to support and scale nature-positive outcomes."

Pendal will "continue to work with our clients and other stakeholders to build understanding around biodiversity loss and access to nature-positive investment solutions to help tackle the next sustainable investment challenge," Matthew says.

Download: A Pendal guide explaining the impact of climate change on business and investing

About Edwina Matthew

Edwina Matthew is Pendal’s Head of Responsible Investments. Edwina is responsible for maintaining our leadership position in the provision of sustainable and ethical investment products.

Edwina is actively involved in the implementation of the UN-supported Principles for Responsible Investment. She also represents the company in working groups with a number of industry associations and initiatives relating to responsible investment.

About Pendal Group

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

We believe sustainability considerations ultimately drive higher and more stable investment returns over the long term.

Pendal Group has a proud heritage in responsible investing, extending back decades. Our specialist responsible investing business Regnan includes highly experienced ESG research and engagement experts and offers a growing range of investment strategies.

Some of our responsible investing strategies

Contact a Pendal key account manager here

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ASX small caps have outperformed the top 100 companies over the past year. But investors need to be increasingly aware of ESG factors which often go under-reported. Pendal’s LEWIS EDGLEY and DAMIEN DIAMANT explain

SMALL CAPS provide a chance for investors to diversify portfolios away from the more mature behemoths that dominate the top end of town.

They are often driven by very different themes to the macro factors that typically affect the ASX100.

Pendal Smaller Companies portfolio manager Lewis Edgley points to successful technology businesses, innovative online retailers and companies producing materials used in batteries such as lithium, cobalt and nickel.

“These are new-world businesses that offer exposure to disruptive business models -- much more so than the large cap index,” says Edgley.

Small caps are further up the risk return spectrum relative to their large cap counterparts. But they provide access often to undiscovered companies that can present outsized returns relative to their risk profiles.

The ASX Small Ordinaries index (which measures companies in the top 300 minus the top 100) -- outperformed the ASX100 over the past year.

“Small caps are generally under-researched relative to their large cap counterparts, while offering more attractive growth prospects” he says.

“We find many opportunities to invest alongside business founders and management teams that have significant shareholdings, which creates a strong alignment of interest with investors."

New opportunities

Small caps also offer a continual flow of new opportunities.

“About 20 per cent of the Small Ords listed in the last five years. That amount of refresh in our investable universe means the small cap sector is never stale.

“In the last two years our team has evaluated literally hundreds of new IPOs, the majority of which don’t make the cut… In the last month alone, we’ve had nearly 10 IPOs worth more than $1 billion each come across our desk.

“Investors need to be discerning about which to participate in. Some are blatantly opportunistic, just trying to take advantage of bull market conditions and the broader market’s willingness to discount risks.

“By sticking to our proven investment process we expect to do well on the select few IPOs we’ve recently supported.”

ESG a factor to watch

For all the opportunities, the sector is not without risk. Environmental, Social and Governance (ESG) issues are a significant emerging factor that small cap investors need to watch.

Unlike large companies, small caps often do not have the resources or expertise to measure and report on ESG risks. They can go unheralded in company reports.

“Most of the companies we talk to are not sufficiently resourced to have a fully enunciated plan in terms of how they are going on their ESG journey,” says Edgley.

“We work with companies to provide our insights on what is important from an ESG perspective. We share what we think is important and help them formulate a framework so they can set sensible and realistic targets.

“We find many small caps are doing a number of things that would already rate them well on an ESG screen — but they’re not actually recording and reporting on them.”

City Chic Collective (ASX:CCX)

Pendal small cap investment analyst Damien Diamant gives the example of fashion retailer City Chic Collective (ASX:CCX), an ecommerce company held in the Pendal Smaller Companies Fund.

“We spent time with the company running through their supply chain and actions they’re taking to ensure they have a positive impact on communities.

For example CCX -- which focuses on plus-sized fashion -- has moved to ban raw materials sourced from high-risk regions, such as cotton from Xinjiang.

Xinjiang cotton is regarded as high-quality, but human rights campaigners say it is produced by forced labour.

CCX has also focused on water and waste management, sustainable packaging and recycling.

“We’re happy with the progress made to date” says Diamant. “As a smaller company there are obviously limitations to the resources that go into developing a detailed ESG reporting framework.

“But they have a strong awareness of the risks and are taking a proactive response to ethical trade.”

The small caps team is further integrating ESG into its investment process, says Edgley.

“We’ll continue to work closely with our investee companies to gain a deeper understanding of their priorities in this emerging space,” he says.

“We’re fortunate to have the support of a dedicated Responsible Investment team at Pendal. Their insights and guidance have been invaluable as we embark on this ESG journey."

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The RBA’s Melbourne Cup day meeting will be closely watched after Wednesday’s inflation numbers. TIM HEXT explains why.

IN AUSTRALIA we only get inflation data quarterly, so the number is keenly anticipated.

For the inflation hawks Wednesday didn’t disappoint. For the RBA it looks like a decade of over-estimating inflation has now moved to a new decade of under-estimating.

The headline inflation number was on forecast at 0.8% for the quarter and 3% annually. However it was the underlying number that shows a more concerning picture.

Underlying inflation strips out the top and bottom 15% of moves, usually including fuel and food. Here the number was 0.7% for the quarter. This is the highest since 2014.

While that is only 2.1% annually, markets will usually annualise the latest quarter to get a more current read.

Of course 0.7% means 2.8% — above the RBA target.

Looking under the hood a number of factors were at play.

Fuel prices were up 7%. We knew that already but they have gone up further in October.

New dwelling purchase prices, or building costs, are losing the dampening effect of Homebuilder subsidies. These costs had risen around 5% over the last year but until now this was offset by the subsidy.

Property rates were also up 3%. Household items, usually flat or down, were up 3 to 4%. Maybe its transitory but time will tell.

The RBA next meets on Melbourne Cup day. What could have been a “nothing to see here” pre-race statement will be keenly watched.

Three days later the Statement on Monetary Policy comes out which will provide their updated forecasts.

No doubt the RBA will play down the impact of one number but inflation is already above their forecast for 2022.

Some upgrades will be required. The confidence in their “no rate rise till 2024” outlook will either be toned down or removed. It will be a step too far for now for 2022 to be in play for rate rises but surely 2023 should be.

Amy Xie Patrick: How Pendal’s income strategies have evolved to look very different to traditional income portfolios

In terms of their current policy actions there will be no changes for now. However Quantitative Easing is reviewed in February, before which we will have the Q4 CPI print.

Also, whether they keep the April 2024 bond at Yield Curve Control at 0.1% is debateable. They can change that any time and given they actually have to put their money where their mouth is with that policy, it may be reviewed sooner.

Overall we continue to hold inflation bonds in portfolios where we can and will continue to do so until the market prices in 2.5% inflation.

After these numbers that day is getting closer.

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In a world increasingly focused on Environmental, Social and Governance issues, many investment opportunities can be found among “sin stocks” working on an ESG transition. CLIVE BEAGLES explains

Improving climate credentials provides investor opportunity
ESG stocks alone provide a narrow universe
Market is more nuanced in how to consider ESG

IT’S common these days for investors to look for companies that tick all the ESG boxes.

But many of the best ESG investment opportunities can be found among so-called “sin stocks” working on catching up.

ESG-related upgrades from ratings agencies are happening more often at mining and oil companies, than other sectors, observes Clive Beagles, a senior fund manager who focuses on UK equities at Pendal’s London-based asset manager J O Hambro Capital Management

“We measure the upgrades to downgrades of companies based on ESG factor. Our fund has a ratio of about four to one upgrades to downgrades. And about half of those companies being upgraded were either oil or mining companies,” Beagles says.

“You might not like the pace some of the oil and gas companies are changing, but you can’t question the fact they’re trying to change.”

When companies are changing, there’s investment opportunities.

“When you invest you are always looking for change,” Beagles says. “You look for change in return on capital. You look for change in operating margins. You should also look for change in ESG credentials.

“If a company is improving its ESG credentials, its cost of capital is likely to go down and its ESG rating will go up,” Beagles says.

Twelve months ago investors, and in some cases management themselves, were categorising businesses around whether they met ESG benchmarks or not.

But it is much more nuanced now, Beagles says.

“I think peak ESG was about last November in terms of not investing in older style, non-ESG companies, and looking for pure play opportunities,” he says.

“ESG and climate change are real but the investment world has become a little more balanced about it. Many companies are trying to move in the ESG direction. But now it is more about trajectory of change, rather than absolute scoring.”

Beagles says there is a place for pure plays in the ESG world, and for impact funds.

“But not everyone can do that and it’s a very narrow cohort of stocks,” he says.

“A much broader approach which can be just as useful and relevant is to encourage companies to change faster. And that’s very much what we are doing.”

Beagles says the shift among investors has been quite marked.

“A year ago, clients might look a bit blankly about investing in an older style company and say ‘they still have coal’. Now they are starting to understand the transition much better.

About Clive Beagles

Clive Beagles is a senior fund manager with Pendal Group's UK-based asset manager, J O Hambro Capital Management. Clive is one of the UK’s most highly respected equity income managers. He has 32 years of industry experience and co-manages the JOHCM UK Equity Income Fund.

About Pendal Group

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Find out about Pendal's investment strategies

Contact a Pendal key account manager

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Pendal's head of multi-asset MICHAEL BLAYNEY takes investors on a whistle-stop tour of the major asset classes and where to find value right now

Listen to the podcast above or read the transcript below

Interviewer Sean Aylmer: I'm joined on The Point podcast by Michael Blayney, head of Pendal’s multi-asset investment team. Michael, essentially your job is to look across asset classes and identify opportunities globally?

Pendal Head of Multi-Asset, Michael Blayney: Yes exactly.

Interviewer: Michael, what's the outlook for equities?

Michael Blayney: Equity markets have obviously had a very strong run. As a result, they have become somewhat expensive to varying degrees. Australian equities [are on] on the slightly expensive side, US equities on the much more expensive side.

Now the counter to that is that earnings have been very strong and we've seen earnings revised up strongly around the world, including in Australia.

The other element is that price momentum is still very strong in the market as well.

So when we put those things together, it makes us a little bit more cautious than we were. However at this stage we're not at a point where we'd be recommending to underweight equities in portfolios.

Rather we'd be looking to take risk in areas that are relatively cheaper – to try and find those pockets of value around the world. So for example some selected emerging markets and UK equities would both be examples of that, as would real estate securities.

Interviewer: I’m going topush on the emerging markets. So UK, but what emerging markets do you like at the moment

Michael Blayney: Specifically we quite like Mexico. It has been neglected by investors for a long time. It has started to rally a bit, but it's still at very, very cheap levels. That would be the main one.

Other than that, there are obviously other markets in Asia, which were very cheap, but have rallied more strongly. So they're less of an opportunity.

We'd be a bit more cautious on China at the minute, in spite of the fact that valuations there aren't too bad. Obviously there's a number of significant macro risks associated with China.

So we tend to prefer emerging markets outside of China at present.

Interviewer: Okay, what about credit?

Michael Blayney: Within credit, it’s fair to say that credit spreads – which are the extra yield you get paid to take on the credit risk of lending to someone who's not a sovereign – they have come in a lot since their highs of March last year.

As a result of that, if you look at things like high-yield spreads in the US, you’re really not being paid very much. You’re barely being compensated for what an average default cycle could knock off in terms of your returns.

So at this stage, we're relatively cautious on credit. We do think it still has somewhat of a role to play in investment portfolios, but we would tend to hold a little bit less credit than usual.

We would tend to favour investment grade simply because even though the spreads are tight, the default experience is seldom bad in investment grade. So you're still getting some compensation for the risk that you're taking, but we would certainly shy away from high yield at this point.

Interviewer: Okay, government bonds?

Michael Blayney: Government bonds are an interesting one. Obviously we've seen yields rise very strongly early in the year. They've had a bit of a retracement of that and come back and then they've come back again.

So it's quite interesting now. We've obviously seen markets become more concerned with inflation and that has been reflected in higher bond yields.

Now, the reality is that bond yields in absolute terms are still at relatively low levels. And with the heightened inflation risks due to all of the fiscal stimulus and the re-opening of economies, while we still obviously have quite accommodative monetary policy, the risks of inflation spikes are certainly elevated relative to history.

So we're a little bit cautious on government bonds. But equally they do still serve a defensive role in a portfolio. They're liquid. In time when equity markets sell off, while they don't always provide protection, they do provide protection more often than not.

So we believe investors should maintain some government bonds in portfolios, but should be underweight relative to a normal level of exposure at this point, given the heightened inflation risks.

Interviewer: Okay Michael, what's the outlook for listed real assets, infrastructure and real estate?

Michael Blayney: That's an area of the market that we quite like – selectively, of course. But real estate is an area which suffered a lot with Covid. (Here I'm talking about listed real estate rather than residential, where Covid obviously had the opposite effect).

Listed real estate is a beneficiary of that re-opening, if you think about people going back to the office, going back to shopping centres. Obviously there is a bit of diversification within listed real estate because you do have industrial exposure, which gives you still some exposure to e-commerce.

But overall that listed real estate sector, particularly globally, is looking relatively cheap. We think it’s an area that is potentially attractive.

Also given that while the sector itself is interest rate sensitive in terms of the valuations that the market puts on it, the underlying cash flows tend to have a degree of inflation protection over time.

So we do think it's attractive from that perspective as well.

In respect to listed infrastructure, we like to be quite selective there rather than just buy broad, listed infrastructure indexes.

We do think there's some attractive opportunities, particularly in Europe, to get exposure to listed renewables which generally provide you with a decent yield – be thinking 4% to 6% yield. A little bit of growth as a nice way to get some stability in portfolios because they tend to have quite a low sensitivity to what's happening in the broader market and a reasonable degree of income in a world where income is still very hard to find.

Interviewer: So where is the relative value when we look at equities, credit, government bonds and listed real assets?

Michael Blayney: At present we'd still prefer equities to bonds.

Bonds do provide that diversification in sell-offs and equities are getting a bit expensive. But the reality is that earnings growth is still strong. Economic growth, while it's coming off a bit, it's still strong.

In that type of environment, we would still prefer equities to bonds.

We would prefer listed real estate to broad equities. That would be primarily on the basis of valuations.

Credit’s an interesting one. From investment grade you don't get huge amounts of return, but we would just see some exposure to investment grade as being a way to get a little bit more yield in your defensive assets. But it's something that we wouldn't have a huge allocation to at this point.

Interviewer: Michael, thank you for talking to The Point.

Michael Blayney: Thank you very much, Sean.

Interviewer: That was Michael Blayney, head of the multi-asset investment team at Pendal. Thank you for listening to The Point podcast. I'm Sean Aylmer, have a great day.

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