Fixed income in a period of uncertainty

By Jayson Forrest

Michael Frearson (Real Asset Management) and Dale Pereira (Pendal) discuss how advisers and portfolio managers should manage the fixed income component of their portfolios, particularly in an environment where inflation is uncertain.

In a speech earlier this year, RBA deputy governor Andrew Hauser criticised overconfident rate forecasts by politicians and commentators in a speech titled, ‘Beware False Prophets’. It was a compelling speech, where he cautioned against making overconfident predictions about Australia’s economic outlook. The speech was targeted at critics of the RBA, who despite advocating for either higher or lower rates, were overconfident in their cash rate calls. 

Despite the message from the RBA that it wasn’t thinking about lowering interest rates any time soon, Michael Frearson, CFA — Director, Head of Fixed Income at Real Asset Management — believes Australia is at the peak of the rate cycle and growth is starting to slow, which will prompt the RBA to move on rates.

“The interest rate cycle is starting to shift, with the U.S. beginning its easing cycle in September this year. While Australia is expected to maintain its current rates through the rest of 2024, the next three to six months could be tough for the Australian economy, as the full impact of those rate hikes finally takes effect,” says Michael. “With household savings dwindling, wage growth slowing, and global economic pressures mounting, it’s crucial to consider how best to manage investment portfolios in a changing rate cycle.”

Speaking on fixed income at the 2024 IMAP Independent Thought Conference, Michael says the market is already pricing in a rate cut for December 2024, although Real Asset Management (RAM) expects the RBA to begin cutting rates in February 2025.

Michael says with the potential transition from monetary tightening to easing on the horizon, there is a compelling case for making strategic adjustments to optimise a portfolio’s fixed income investments.

“To prepare for this, we’re adding to duration by using, for example, fixed income ETFs, which provides longer duration bond exposure for retail investors,” says Michael.

Dale Pereira — Head of Client Solutions at Pendal — accepts that while the market is still dealing with inflation, he believes we have returned to a normalised inflation cycle, which will provide investors with greater investment opportunities in the fixed income space. He agrees with Michael that in this type of environment, duration is probably the best opportunity for investors in fixed income.

“I believe Aussie duration will outperform. Aussie bonds don’t have the same type of issues that, say, the U.S. has with massive (fixed income) issuance and a lack of buyers,” he says. “The RBA has been staunch in its position to not cut rates this year, despite what’s happening globally with other central banks. However, there’s no doubt that with the Federal Reserve cutting rates, Australia will also be forced into rate cuts, which hasn’t been priced aggressively into the market, so there are opportunities for investors.”

Dale believes one of the reasons why the growth in fixed income ETFs has been so strong, is primarily because the income from equities has not been as good as it previously was. As an example, he points to the resources sector, where companies have had to reduce their dividends due to cashflow issues, the global price of resources, and a slowdown in demand from China. He adds that even industrial companies haven’t generally been increasing their dividends.

“And with valuations stretched, what has traditionally been a great source of dividends and income for investors, is starting to disappear. So, fixed income seems like a much safer place to get real yield of 2-2.5 per cent, which even in a duration asset, is fairly attractive,” says Dale.

It’s a view that Michael supports. “Investors should be adding to duration in their portfolios, where there are some great opportunities to get above average returns. We particularly like subordinated debt, where valuations are quite strong, which is a good addition to a diversified portfolio.”

According to Michael, yields are currently at their most attractive point in 15 years, and with the view that an easing cycle is approaching, RAM has been progressively adding to its duration position due to both the more attractive value on offer – Australian government bond yields are above 4 per cent – and RAM’s view that rates are likely to fall.

“However, managing fixed income in this environment requires careful consideration of credit risks,” says Michael. “As rates remain high, the likelihood of further economic challenges grows. To mitigate these risks, we continue to favour floating rate credit, particularly in subordinated debt and ASX listed capital securities from very high-quality banks. These securities offer attractive yields in the 6.5-7.5 per cent range and are expected to provide stability as we navigate potential volatility in the months ahead.”

Michael adds the biggest risks in fixed income investing — default risk and illiquidity — must be carefully managed, particularly as we approach the tail-end of the interest rate cycle. His advice for advisers with their fixed income allocation is to keep things simple, by focusing on quality income streams within transparent investment-grade portfolios. “If the structure of a fund or security is unclear, then it’s often best to steer clear,” he says.

Dale acknowledges there is currently a lot of interest in the private credit market, but he says there are inherent risks in this asset class that investors need to be aware of.

“A lot of private credit has been written over the last 4-5 years at low rates, but when it comes to refinancing that private credit, the interest bill has gone up and not down as expected. So, as we move into a potentially slowing economy, there could be a lot of problems with refinancing,” he says.

“That’s probably where the real issue is with private credit. Therefore, when positioning your portfolios, you need to consider: how tight are the lending companies with funding; how tight are their restrictions on borrowing; and what is the quality of the asset being financed? And in terms of liquidity, if investors want to redeem at a certain point, can that actually be facilitated?”

There has been a lot of talk recently about Australia being in a ‘per capita’ recession, but what is the likelihood of the country actually going into a full recession?

While Michael believes a recession is still possible, he says the economic signs — such as inflation starting to fall and real wages beginning to grow — suggest Australia will most likely avoid recession.

“We also believe recession is unlikely because the Government keeps spending,” says Michael. “The fear that drives markets globally really depends on what’s happening in the United States. In the U.S., there has been a definite shift towards the outlook for growth, rather than inflation, which is positive for markets.”

Dale agrees there is still the potential for a mild recession in Australia, but considering the Federal Government’s fiscal balance sheet, he doesn’t see any reason why the Government wouldn’t continue to spend, in order to prop up the economy. However, he adds, if needed, then “200bps of rate cuts should be enough to kick-start the economy”.

Dale Pereira is Head of Client Solutions at Pendal; and

Michael Frearson, CFA is Director, Head of Fixed Income at Real Asset Management.

They were part of a panel discussion on ‘Fixed income assets in a period of uncertain inflation’ at the 2024 IMAP Independent Thought Conference in Melbourne.

The session was moderated by Laurice Considine — Head of Strategic Accounts and Asset Consultants at Perpetual.