By IMAP Team

Investors have just come through the worst first half year in the global fixed income market since indices began. According to Adam, about half way through June 2022, the fall in the market reached three times worse than any other drawdown in the first half of a calendar year, and finished at about two times the worst.

“The big driver of this was interest rates,” he says. “This drawdown that we recently experienced was different from other historical drawdowns, which were driven by capital loss and credit impairments. Instead, a return to interest rate normalisation drove the drawdown, and not a permanent credit impairment or capital loss.

“And it hasn’t just been the global bond market. Global equity markets are down 20 per cent, bonds drew down about 10 per cent, credit spreads widened - there were very few places to hide in global financial markets in the first half of 2022. And what was driving that was the rapid response by central banks to very elevated and unanticipated inflation.”

According to Adam, this period has been particularly challenging for households, with increased inflation making food, energy, and accommodation particularly expensive for households. This combination of rapidly rising interest rates, lower asset prices (like equites), wider credit spreads, and elevated commodity prices, has driven a very rapid tightening of financial conditions.   

However, despite this tightening of financial conditions, Adam believes there are opportunities for bonds to play a more important role in portfolios by delivering: income, diversification, and capital preservation. He adds that from extremely low levels of interest rates, delivering all three of these key principles of fixed income is difficult to do, but with higher interest rates, the ability to deliver all three in a portfolio is much stronger.

For the first time in many years, high quality bond portfolios are offering yields comfortably above long-term central bank inflation objectives. Core bonds are yielding 4-5 per cent and more credit-focused bond funds are yielding 6-8 per cent.

“So, after a challenging period of searching for yield and income for investors, the higher adjustment in interest rates - and some of this has been a widening of credit spreads - has really opened up that opportunity set,” says Adam.

According to Dr Isaac Poole - Chief Investment Officer at Oreana Portfolio Advisory - when it comes to income, investors need to consider the huge variety of bonds available in the market.

“We have a tendency to call all bonds defensive, but they’re not all defensive. Some bonds focus on income, high yield, and floating rate loans. They all have specific roles they can play within a portfolio,” says Isaac. “When you’re thinking about income, there is an opportunity to build a diversified income stream that hopefully will be more resilient to the types of inflationary and recessionary scenarios that might play out in the months ahead.”

Oreana has identified opportunities in moving down the risk spectrum back towards government bonds, knowing that whilst there is some risk, investors are getting reasonably good income (relative to history). Risk is now lower, given where yields have got to over the last six months.

“Therefore, we think it’s appropriate to be thinking about government bonds to balance out some of the credit risk, if the environment does take a turn for the worst,” says Isaac.   

Another important aspect of using bonds is for their diversification benefits within a portfolio. The common expectation is that if risker parts of a portfolio, like equities, perform poorly, then bonds will provide a natural counterbalance and generally do better - but not always, as was demonstrated in the first half of 2022.

However, historically, that low or negative correlation does tend to work. In times of drawdowns and recessions in global economies, bonds generally provide some protection and capital preservation in a portfolio.

“If inflation expectations remain anchored around the 2 per cent objective of central banks, bonds typically provide that low or negative correlation for asset markets,” says Adam. “At PIMCO, we believe that bonds, at these interest rate levels, provide portfolio diversification. We think that prospective five-year average returns are now closer to 6 per cent for a typical 60/40 portfolio, which is fairly close to its long-term average, considering how far back we have come in interest rates and equity prices.”

Michael Karagianis - Senior Consultant at JANA Investment Advisers - believes that bonds have been significantly affected by central bank policy, to the extent that the bond market has been distorted. He says the drive to increasingly lower yields has been a major factor that has helped propel equity markets to higher levels.

“Our view going into this period over the last couple of years has been very short duration. Duration management is very important in terms of the way you address bonds. If you had been in a conventional long bond portfolio over the last year, you were down -10 per cent and at one stage, even -16 per cent. There’s not a lot of diversification in that type of structure,” he says.

“However, if you had been in a floating rate structure, you would have either isolated yourself from the worst effects of those negative returns - and perhaps even got a positive performance out of that environment. But that is a very unusual situation.”

As JANA has seen bond rates rise, it has lengthened duration because it recognises the benefit of diversification coming back in to play.

“In a worst case market environment, where we were to get, say, a more severe recessionary outcome, then we think bond rates at around 3.5-4 per cent would give you a reasonable capital buffer offsetting the risks you have in your equity portfolio,” says Michael. “I agree that bonds have a greater role to play in diversification and duration.”

Financial markets are expecting both the U.S. and Australia to have their cash rates up around 3.5-4 per cent early in 2023, before the possibility of an easing cycle in the back half of 2023. Adam says it’s important to consider capital preservation from this perspective as part of the portfolio construction process, because in order to lose money in bond portfolios due to interest rates, you essentially have to get cash rates beyond 4 per cent.

So, just how restrictive will a 3.5 per cent cash rate be in Australia? The last time Australia was at 3.5 per cent was 10 years ago. For the last decade, interest rate borrowers have experienced nothing but interest rate declines on their mortgage rates.

According to Adam, there are two important things that have changed in the last 10 years that we have to adjust for, if we’re making an historical comparison to how tight it was previously.

The first is a 3.5 per cent cash rate today is equivalent to a 4.22 per cent cash rate in 2012 when factoring in higher end borrowing rates. And secondly, a predicted 3.5-4 per cent cash rate in 2023 will make household debt to household income close to being the most restrictive that Australian households have experienced. That’s because households have leveraged up by 26 per cent over the last 10 years.

“These are the two things that are going to constrain households when you consider the amount of income people need to service their mortgages,” says Adam. “That’s why we think the RBA is going to struggle to hike the cash rate beyond what’s already priced in.

“This is a household sector where many borrowers have never experienced an increase in their mortgage rate. And for many borrowers, they have only been stress tested by banks for a 2.5 per cent interest rate increase on their mortgage. However, many of them will experience a 4 per cent increase in about six months.

“So, it’s going to be very challenging for households next year, and it’s a key reason why we don’t think bond investors are going to lose a lot of money due to interest rate rises from the RBA.”

Isaac agrees that bonds are an interesting asset class at the moment. He says it’s been a challenge over the last few years to speak to clients and investors about the role of fixed income in portfolios.

“We’re come through a period to the end of 2020 where multi-asset managers and consultants were saying it’s the death of the 60/40 portfolio and there’s no longer a role for fixed income in portfolios. But that’s not the case. We’ve had a reset and it looks like the 60/40 model will deliver on its promise and goal for a wide range of investors,” says Isaac.

“The challenge that we’re all facing as asset allocators, portfolio managers and advisers is that a lot of eduction is still required on the fixed income side to get people back to the realisation that you can reduce your risk and get better returns now, and fixed income is a critical part of driving that.”

For the Executive Director and Chief Investment Officer at Lonsec, Lukasz de Pourbaix, it’s the first time in a long while that bonds are starting to look interesting. He says investors are certainly getting more reward for the risk they are taking in this asset class. However, he adds that it is an environment where you need to be selective.

“Bonds are a broad category of assets. High yield markets are very different from where government bonds are today. While you do have to be more selective than perhaps you were in the past, it does create opportunities.”

Although markets are pricing in interest rate hikes, Lukasz believes that on a global level, there are still some X-factors to contend with, like Russia cutting off its gas supplies to some parts of Europe, with gas prices soaring as a result, and some predictions for inflation in the U.K. of around 15-20 per cent.

“So, we’re not out of the woods yet. I think there are still some potential X-factors out there but certainly, the environment and returns for bonds in a portfolio are a lot better than they were.” 

Michael shares the view that bonds are becoming more important in portfolios. However, he believes there is a fundamental conundrum in that bonds are currently offering 3-4 per cent returns and inflation is double that.

“Effectively, what’s happening is that markets are assuming that central banks will get inflation under control and return it to some normality, in which case you are implying a real yield that is positive in the bond market at this point in time.

“However, the danger is that central banks don’t get inflation under control, or they take so long to achieve control that it causes a lot of damage. We could see an elongated period of inflation remaining at elevated levels, and people beginning to reassess what a fair bond rate is, which also impacts equity market valuations.”

Having allowed this inflationary environment to get out of control with excessive liquidity, central banks are now braking very hard. And although markets are giving the central banks a better than even probability of getting out of this environment with a soft landing, the danger is that if it’s not a soft landing, we will experience a much more aggressive slump in economic activity - effectively, a global recession.

“And while that could be very good for conventional government bonds, it could be quite catastrophic for credit, considering the equity risk premia that’s built into credit spreads. So, while bonds are an attractive asset class, they’re not without risks,” says Michael.

Adam Bowe is Portfolio Manager Australia at PIMCO

Dr Isaac Poole is Chief Investment Officer at Oreana Portfolio Advisory

Lukasz de Pourbaix is Executive Director and Chief Investment Officer at Lonsec; and

Michael Karagianis is Senior Consultant at JANA Investment Advisers.

They spoke on ‘The role of fixed interest in portfolio management’ at the IMAP Independent Thought Conference - Sydney 2022.

The session was moderated by Hugh Holden - Senior Vice President and Account Manager at PIMCO.