Amy Xie Patrick: Fixed income investing in a zero-rate world
How will the journey from deflation to inflation impact portfolio construction, defensiveness and income in this zero-rate world?
On May 28, 2020, Pendal’s Head of Bond, Income and Defensive Strategies Vimal Gor and senior team members Amy Xie Patrick and Tim Hext and outlined the implications for investors in their half-yearly “Lighthouse Series” live webinar.
This is a recording of Amy’s presentation which addresses fixed income investing in a zero-rate world.
Watch the video above or read the transcript below.
This presentation will focus on what bonds are supposed to do in your portfolio.
What do we want from our fixed income portfolios and how do we make sure that in this disappearing yield world, your fixed income allocation is still able to do the jobs that you need it to do?
Looking at the chart below, this really is what underlies the income problem we are all having.
What we’ve shown here is starting yield at the beginning of every crisis you’ve had since the tech crash in 2002.
In the yellow bar is the starting yield in Australian government bonds. The 10-year part of the curve.
In the purple is the US. Obviously what happens in Australian yields is governed quite a lot by what goes on off shore as well.
Now, time and time again, and especially in the more recent crises, you’ve seen that all these yields have come down and it’s a structural trend that’s been happening for a long time.
But what it means is that at the beginning of every crisis, we’ve got seemingly less and less room to play with.
So a lot of investors that we’ve spoken with, not just over this most recent period, although this most recent period has clearly accelerated things further, but over the last three, four, five downmarket cycles in equities, what use really is bonds to me, when yields are this low? Can bonds still be defensive?
And the answer to this is, even through that period in 2018, when the Fed was incredibly belligerent about that hiking cycle, when push came to shove, when you saw stress in the equity markets that negative correlation still comes through.
But what’s really obvious at these very low yields is that there’s just a glaring asymmetry in terms of where yields can go. Not to say that we don’t think they can go into negative territory.
Quite clearly they have gone into negative territory in certain parts of the world, but with yields being quite so low, what we say is that now more than ever, you need your fixed income allocation to be constructed in a very active way.
Active not only in terms of the direction that you face, and whether you’re long or short bonds, but also active in the way that you think about your overall fixed income portfolio composition as well.
Now, as yields have come all the way down, the role of fixed income is to be a defensive part of your portfolio, but it’s also supposed to generate income, because led by risk-free yields, income levels have been coming down across the world, what you’ve seen is our response to it, which has facilitated this to happen.
The chart bellows illustrates the growth in global debt, that’s been issued mostly by way of bonds through a multiple of different sectors.
As you can see, post the GFC debt was growing all over the world anyway, during the GFC, but post the GFC, you had a massive shift down in global rates equilibrium.
And all of a sudden, you had this massive savings glut.
It’s normal to see savings books come out at the end of every crisis, every pandemic, and every war.
And so all of these were looking for yield and income — at first relatively safe and good yield and income, but eventually as yields continue to fall, we look for more and more.
Most of this debt expansion in the world has been taken up by corporates, not so much government debt.
Government debt has obviously grown as well, but a lot of the growth in bonds and bond debt that we’ve seen in the world has essentially been us investors saying to these corporates, please give us more. Please issue more and more because we have certain return targets, we have certain income targets.
If it means that we need to be holding less high quality portfolios, if it means that we need to reach further out on that liquidity and that risk curve, then so be it.
Probably for most investors that consideration of having gone down the quality spectrum, isn’t front and centre in their minds, because that is buying the overall return hurdle or that overall yield hurdle has been front of mind.
A key problem with the way that fixed income portfolios shifted in the pre versus post GFC era. In the pre GFC era fixed income was largely considered to be a purer asset class. The dominant sub asset class of your fixed income piece was really high quality government bonds.
But obviously as yields continue to drift lower, they don’t offer you enough income. They don’t offer you enough yield. So you reach further and further up the curve and off shore, especially what you’re seen is that investment grade no longer is synonymous with that same high level of quality that you used to see before the GFC era.
Now that means a very important key difference in terms of the way your fixed income portfolio behaves. In the pre GFC era when investment grade as an asset class was truly viewed as quite a safe haven asset class. What you saw in times of equity market stress was slightly negative correlation to equity markets.
So investment grade belonged with that high-quality government bucket in terms of offering that safe haven portfolio, that safe haven allocation. But now, as we have seen, these investment grade entities become victim to this quality drift, this ratings drift down the quality spectrum.
In the post-GFC era, what you get with investment grade credit is actually positive equity beta, and on top of this, what a lot of global asset managers also been happy to do is to harvest more carry, more yield, more return in their portfolios, by sacrificing liquidity in those portfolios.
Here on this chart, what we show you is that both in equities portfolios in the yellow line and your bond portfolios, asset managers have generally not prioritised liquidity. Apart from when the crisis hits like the GFC you can see in the purple line all of a sudden managers go to the defensive part of the portfolio, that fixed income part of the portfolio, looking for liquidity.
And it’s not there.
It’s a wake-up call to go back and restore liquidity in that part of their portfolio. But again, since that crisis was a long time ago, this longer term trend of wanting to sacrifice not only quality, but also liquidity in their portfolios, has polluted traditional fixed income allocations with more and more problems as time goes on.
Now, all of these problems with going down the quality curve, and going up the liquidity curve is all the more exacerbated in Australian portfolios. And on this next slide what we show you on the left-hand side, how much Australia remains a global outlier in terms of just how much we don’t like fixed income.
We see no use for it in our portfolios, we like equities and we like property.
And so the key point to make here is that even within that small fixed income piece in the average Australian portfolio, what most investors probably don’t realise or don’t want to think about too much, is how much of that truly behaves like fixed income and how much of that has morphed slightly into the land of equity beta.
And then to the portion that is truly pure fixed income, that is truly defensive, how much of that is really active?
Portfolio Construction within Fixed Income
We mentioned that when yields are this low, you need that active lever to be able to pull, because of that asymmetry, in where yields can go when they’re this low. If all of that pure fixed income allocation is in passive, then you’re not really able to retain a very nimble fixed income portfolio as uncertainty remains quite high.
So in Australia, I think we have an even bigger conflict within ourselves. On the one hand our portfolios, the way we position them, tell us that we want risk, and not so much for the sake of risk, but we want returns, we want yield.
But then when crises hit, we complain that our fixed income allocations don’t do the job that they’re supposed to. But all the while we’ve positioned them to look more and more risky.
So all of that is probably a big spoiler to how I’m going to talk about the way that we approach constructing fixed income portfolios. Particularly with this idea of wanting to test this by a certain threshold in this very low-yield environment.
Now, necessarily we look at fixed income buckets along this risk-reward spectrum like everybody else.
But we do pay a lot more attention to what is the inherent liquidity characteristics of each of these buckets of fixed income.
Because yields are so low, high-quality government bonds, their main job in your portfolio these days, while they do still exhibit some positive carry, because that traditional sense of being able to get, carry and roll out of a pure government bond portfolio is long gone and we don’t think it’s going to come back any time soon.
So high-quality government bonds live in your fixed income allocation, not because they’re your primary yields generator, but because they still act as that defensive part of your portfolio, that pure fixed income part of your portfolio.
So naturally you go up the risk spectrum a little bit, but you stay in what we think is quite important to prioritise -good quality investments. So when you go into the land of corporate credit, while acknowledging that these days, by going into investment grade credit you are naturally taking on more equity beta, nevertheless, you need that allocation to be as high quality as possible.
Why? Because if you’re constructing a fixed income portfolio, presumably you want to be able to rely on that income. And if you’re putting a lot of, let’s say hybrids, into this part of the portfolio, well hybrids aren’t fixed income, bank hybrids exist in the part of the capital structure so that the bank can access that capital when they most need it, and when they most need it, is probably when you, as the security holder, wants your income the most.
And it’s when they’re most likely to switch off the coupons on those hybrids.
So as you go out the quality spectrum, the less you can count on that stability of income from those assets. So here being high in quantity really does matter. High in quality in this piece though, one point to stress, not because you think that this is also supposed to provide you liquidity in times of crisis.
Since the GFC, we haven’t really been able to find liquidity anywhere further than high-quality government bonds anytime the equity market’s been through significant stress. It’s just not the way the world works anymore.
Liquidity in terms of secondary market trading liquidity, all those incentives by banks to provide that liquidity has significantly changed, because of the GFC and all the banking regulations that have come on board since the GFC.
Because yields are so depressed because spreads have been crunched before this Covid crisis you naturally had to reach out that quality spectrum further and go into the land of maybe high-yield, maybe offshore, maybe loans.
A lot of investors talked to us about liking private debt, because there’s no live mark to market. So it seems like it’s not very volatile. I think all of that comes with very obvious risks.
But here we say that when you’re reaching for the higher risk assets, while acknowledging that you need boosters in your portfolio, be mindful of how much that makes up of your overall fixed income allocation.
You want it to complement not dominate your fixed income portfolio.
And more of the point you want to be able to implement it in such a way that when you start to get concerned that the market’s are no longer benign, that you can turn this off very quickly.
So, when push comes to shove, do I want to sacrifice liquidity for quality or quality for liquidity?
I would argue that when constructing an income portfolio and you’re going out the risk spectrum, you actually need to prioritise liquidity.
What are the Opportunities?
Crisis brings about dislocation. One of the areas that we do prefer is Australian investment grade.
On the table below very simplistically illustrates the current market spreads in each of these major fixed income asset classes from Australian investment grade, to US investment grade, emerging market sovereigns and US high yield.
What is the implied five-year cumulative default rate at current spreads?
As you can see Australia is a massive stand-out. What this chart is really telling you is that the sell-off we’ve had is about liquidity premiums spiking. It’s about everyone wanting to hoard cash.
It’s not necessarily the case that the market is pricing market genuinely thinks that in Australian investment grade 10% of the index is going to default in the next five years.
Relative to the worst-realised default rates in the history of each of these asset classes Australia clearly remains a stand-out. And unlike some of those offshore investment grade indices, we’ve not seen quality drift to nearly the same extent in Australian investment grade.
Another one to highlight on this slide for us is emerging markets sovereign.
It does belong in that higher risk bucket that we just showed you, but it retains features that are unlike corporate credit, and it’s worthwhile thinking about in terms of making your fixed income portfolio mix if you are going to reach for more risk in that way.
In terms of what’s implied for the next five years for default rates, very high compared to the worst that’s ever been realised in emerging markets.
But to highlight a point, which is perhaps misleading, just because the spreads are so high, is US high yield. Trading around 600 basis points at the moment. Seems amazing in a world of zero rates and cash rates…
But what we see on the left or the right hand side of the slide is that just taking it on face value, Moody’s base forecasts the US high-yield default rates, you can see that even though the market’s widened out a lot, for their base case, and even their optimistic case default rate forecast, the market hasn’t moved nearly enough.
Not nearly enough risk has been priced in and similarly when you look at current breakevens to see how much cushion in available there simply isn’t enough for the potential risks.
Markets have already moved a lot and at current spreads they’re forging another level of cushion. Different thickness of that cushion in different markets, again in Australia, particularly attractive.
And when you compare that with what’s the typical end cycle, move that whole widening move in all of these asset classes in previous historical cycles, you can see relative to what’s going on in the past, what we’re currently going through right now, break evens that are currently embedded look quite attractive, especially for Australian investment grade.
And the last exercise we did here was just taking the most liquid representation of Australian investment grade, which is iTraxx, to look at previous episodes of crises and say, nobody can time getting into the markets at the wides, but let’s say after the first say, 100 basis points worth of widening in that index, had you gone long then, in the GFC, in the European sovereign crisis, and after the China crash in 2015, what would your total return outlook have been like over the next three months, six months, one year and two-year?
And these returns are not been annualised, they’re just total returns. And it’s really just to highlight that outside of the GFC, on a medium-term outlook, these are incredibly attractive medium-term return opportunities to be looking at right now.
And the last point I wanted to highlight is just that, why don’t we think this is like the GFC?
In many ways, this crisis is worse. It’s involving the real economy. It’s a real sort of stop to the global economy and, questions as to whether the policies in place can reignite all of that again. But the crucial difference with the GFC is, in the GFC we had these key points of stresses, that largely pertained to our financial system, that we don’t see today.
And the reason we don’t see them today is partly because of all the regulations that have been put in place since the GFC, but also risk aversion is a little bit higher in the financial world.
So you’re not going to go through this protracted period of forced deleveraging.
This protracted period of forced deleveraging is really what caused those return protocols in the six months to one-year period in the GFC time for investment grade credit and credit as an asset class overall, to underperform for such a significant period of time.
If you don’t believe that the system needs to go through a disorderly and protracted period of deleveraging this time, and it doesn’t seem to be the case, then all the more reason to start engaging with investment grade, a bit more as part of thinking about your income solution.
So going back to my earlier point, because the mix of fixed income portfolios has naturally gravitated to taking on more and more risk, more and more positive equity beta, we’ve got to be cognisant that, all the while you have to be balancing that with still very traditional high quality government bonds and with yields this low, a very active approach to managing those government bonds.
Amy Xie Patrick is a portfolio manager with Pendal’s Bond, Income and Defensive Strategies team
Amy joined Pendal Group in February 2017 to focus on emerging markets and global credit indices. Amy is a Multi-Asset Fixed Income Fund Manager with extensive experience and expertise in emerging markets, global high yield, and investment grade credit.
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