How to get your head around fixed income

How to get your head around fixed income

Article featured in the AFR

Fixed income returns over the fiscal 2022 year were the worst on record. When share markets experience returns like that investors have understandably become conditioned to look for bargains, but fixed income markets don’t necessarily work the same way.

Any well diversified portfolio will include defensive holdings designed to reduce its overall volatility and cushion the effects of falling share markets. Fixed income investments normally play that role, and that typically means allocating to government or corporate bonds, which are two very distinct markets, driven by different factors.

Because bonds issued by governments of developed nations are almost certain to be repaid, the price they trade at is not normally influenced so much by their credit rating as the outlook for inflation in their home country. If the market expects inflation to rise, investors will demand a higher yield to compensate, which requires a lower price and vice versa.

By contrast, while inflation also plays a role in pricing of corporate bonds, credit risk is the biggest issue, that is, the risk the company defaults and you don’t get your money back. Consequently, corporate bond prices are more sensitive to the outlook for recession, when company earnings come under increased pressure. The more investors are worried about recession, the higher the premium, or credit spread, to investing in risk-free government bonds they will demand.

Andrew Papageorgiou, managing partner at Realm Investment House, explains, “Just like bargain hunting in the share market, there are short and long-term considerations for fixed income investing. However, unlike the share market, fixed income markets have nuances that are only revealed through information that’s tough for non-professional investors to get their hands on.”

For example, in considering whether it’s a good time to invest in Australian government bonds, it helps to know that, according to the swaps market, inflation is currently forecast to average 2.6 per cent over the next 10 years. If the 10-year bond is yielding 3.15 per cent, that gives you a ‘real’ yield (after inflation) of 0.55 per cent. Is that a fair return? The average real yield over the past 15 years was 0.8 per cent, which makes it look a little low, but the post-GFC average has been 0.13 per cent, which makes it look much better.

In the US the current real yield on 10-year bonds is minus 0.05 per cent, which sounds pretty lousy, but the post-GFC average has been minus 0.17 per cent. Still, with the uncertainty around inflation, a negative real return is tough to swallow. For instance, in June, the real yield was 0.5 per cent, but since then inflation expectations have tumbled.

Meanwhile, credit spreads, or the risk premium, for Australian corporate bonds are as high as they were during the March 2020 COVID crisis. Papageorgiou points out that’s not a good reflection of the current perceived risk of recession, especially compared to the crazy time of early 2020, but is more to do with technical factors. So parts of that market look attractive, particularly compared to the US, where credit spreads are much less generous.

For the longer-term outlook, Damien Hennessy, of Zenith Investment Partners, says the current market signals around whether inflation has peaked, or economies will recess are so mixed that it’s difficult to view fixed income as a set and forget strategy right now. He points out that bond yields in June spiked to levels where he recommended reducing underweight positions but have since fallen again making them less attractive.

For investors who are game to increase their allocation to fixed income, just like with shares, there are passive and active options. Rather than trying to pick individual bonds, which introduces concentration risk, a fund will provide diversification. For passive investors, Vanguard offers both Australian and international government bond ETFs, credit ETFs and blended ETFs.

For investors who prefer to leave the decisions to professional managers, there are many to choose from. A good adviser will be able to help with curated recommendations.

For investors who see fixed income markets as just too uncertain, one option for the defensive portion of a portfolio is cash, which also provides flexibility for picking up bargains. However, with inflation currently many times higher than the bank interest rates on offer, it is guaranteed to lose purchasing power.

Portfolios always benefit from holding defensive assets to protect them against volatility, and over the past 40 years the long-term decline in interest rates has been very kind to smart investors. However, just as with equities, the uncertain outlook for inflation is a game changer.

At Steward Wealth, we went underweight both government and corporate bonds a few years ago and instead invested into ‘private credit’, that is, deals that are not open to the public at large and are usually senior secured mortgages over building and property developments. These loans have the dual benefits of not trading on public markets, so their value doesn’t go up and down like a bond, and they typically pay generous interest of between 5-8 per cent per annum.

Those loans carry their own risks, which have become evident this year with several high profile construction companies going bankrupt. However, we are in regular contact with the lenders and feel comfortable with their assurances that their screening and due diligence processes have become even more stringent. At the same time, the commercial banks have reduced lending to the sector which is throwing up lots of very attractive opportunities at higher rates of return.

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Why you’ll make more by focusing on a portfolio’s total return

Why you’ll make more by focusing on a portfolio’s total return

Article featured in the AFR

Australians love their dividends. And what’s not to love? Those semi-annual dividend deposits are one of the great benefits of investing in a capitalist society.

John D. Rockefeller famously said, “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in”.

One of the most popular strategies for investors, especially retirees, is to buy high dividend paying shares with the aim of generating sufficient income to live on while hopefully leaving the portfolio principal intact.

While this holds obvious appeal, particularly for investors who are anxious about outliving their money, and benefits from dividends typically being far more predictable than earnings, it is a very constricting approach and carries some risks.

High dividend paying companies tend to offer lower growth. Clearly, if a company is paying generous dividends, it leaves less income to reinvest into the company’s operations. While it’s by no means a universal rule, if a company is able to generate a high return on the equity invested into the business it makes more sense for management to do that rather than pay it out as dividends.

That means a portfolio full of high dividend paying companies is less likely to provide as much capital growth as a more diversified portfolio. If the strategy is to maintain the portfolio’s capital value, then that may not be reason to lose sleep, but over time, it does mean the portfolio won’t benefit as much as it may from the share market’s long history of growth. This is especially true during a period like we saw between 2009-2021 where growth-oriented companies outperformed strongly.

An alternative strategy for investing a portfolio can be to take what’s referred to as a ‘total return approach’, which takes account of both income as well as capital growth. The key to this strategy is to feel comfortable meeting target income requirements by paying a ‘dividend’ from the portfolio by harvesting some of the long-term capital gains.

In other words, imagine an investor with a $1 million investment portfolio who needs $60,000 per year to cover living expenses. If the portfolio generates income of $40,000, they would make up the balance by selling $20,000 worth of investments each year.

To illustrate the benefits of a total return approach, let’s presume it’s the start of 2012 and two investors each have $100,000 to invest as part of a larger overall portfolio. The first buys $100,000 worth of Telstra shares, which were trading on a prospective dividend yield of an amazing 12 per cent, including franking benefits.

The second buys $100,000 worth of CSL shares, which were trading on a prospective yield of a modest 2.6 per cent. However, they decide to sell as many shares as required at the end of each year to bring the total ‘income’ to $12,000 (to match the Telstra yield).

How did the two strategies stack up over 10 years to the very end of 2021? The Telstra shares will have delivered a total of $103,721 of income, but for the last four years the investor was forced to sell a total of $20,255 worth of shares to maintain the $12,000 targeted income. The closing value of the holding was $100,761, so the total return was $124,737 (i.e. net of the initial investment of $100,000) for a compounded annual return of a still respectable 8.4 per cent.

For our other investor, despite having to sell a total of $70,179 worth of CSL shares over the 10 years in order to meet the $12,000 per year income requirement, the closing value of $709,109 plus that $120,000 of ‘income’ delivered a total return of $729,109, or a compounded annual return of 23.6%.

Clearly you could hardly choose a more favourable pair of stocks to illustrate the point, but if the first investor had split the $100,000 equally between the big four banks for a target annual income of $10,000, after 10 years the total return would have been $146,498 or 9.4 per cent per year.

The same investment into the iShares S&P 500 ETF (IVV) and again selling shares to fund the required ‘income’, would have delivered a total return of $371,122, or a 19 per cent annual return.

Source:, Steward Wealth

With shares now on sale, smart investors should be mindful of constructing a diversified portfolio that benefits not only from those welcome dividend deposits, but from the inexorable long-term growth that share markets have to offer.

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Why banning short selling is a bad idea

Why banning short selling is a bad idea

The experience of a nasty share market sell off can be made even more stressful for an investor who learns their beloved shares are being short sold by rapacious hedge funds and gun slinger traders. Not surprisingly, with many share markets around the world enduring their worst start to a calendar year for decades, suggestions to ban short selling have resurfaced again.

But research shows such bans are not only ineffective at stopping share price declines, they can even be counterproductive.

Short selling is where an investor sells shares that they don’t yet own, so it’s essentially the reverse of normal share trading. The reason they would do that is because they believe the share price is going to fall, and the profit they stand to make is the difference between the selling price and the price they buy the shares back at. So, if a share is sold at $15 and bought back at $10, the profit is $5, or 33 per cent.

The practice of short selling is often seen as predatory, and the traders who do it as no better than vultures. At the height of the GFC, short selling was banned on various international stock exchanges, including the US, UK and Australia, in an effort to improve market confidence and reduce volatility. ASIC eventually limited the ban to short selling financial stocks.

Then in response to the sharp stock market falls in March 2020, at least seven countries banned short selling again.

However, a number of studies carried out after the GFC to analyse the effectiveness of banning short selling concluded it had little effect on prices but did reduce market efficiency. For example, in 2011 the Federal Reserve Bank of New York concluded that “banning short selling does not appear to prevent stock prices from falling”, but instead “lowered market liquidity and increased trading costs”. The European Systematic Risk Board reached similar conclusions.

The increased trading costs were attributed to the buy-sell spreads on shares widening, in other words, investors paid higher prices to buy or received lower prices when selling. Other studies have found that being able to readily short sell is associated with markets that are more technically capable and boast higher turnover, which is generally seen as a proxy for better ‘liquidity’, that is, the ease with which investors can trade.

Indeed, in an interview at the end of 2008, when the then chairman of the US Securities Exchange Commission was asked about the success of their short selling ban, he said “knowing what we know now, I believe on balance the commission would not do it again.”

In a sophisticated stock market like Australia’s, short selling plays a critical role for many funds that hedge their risk. For example, a ‘market neutral’ fund aims to drastically reduce the volatility of its returns by pairing long positions against short positions and ‘long-short’ funds will use short selling to either protect investors’ capital and/or increase returns.

Funds like these can produce terrific results for their investors, which include mums and dads and SMSFs. For example, one of Australia’s leading long-short funds has a record, over the long-term, of not participating in market falls but capturing all of the market rises.

Because the ASX reports short selling on a stock by stock basis, it doesn’t reflect that most short selling has a corresponding long position paired with it. For example, a fund might buy BHP and hedge the position by selling RIO, not because they think RIO will necessarily go down, but simply that it will underperform BHP.

As for predatory short selling, that is very difficult in Australia because all short positions have to be ‘covered’, meaning the seller has to borrow shares from an existing holder, which incurs costs. So the risk of a hedge fund attacking a small cap company is greatly reduced because borrowing shares in small companies is much harder and more expensive.

Share prices eventually always reflect fundamentals. Successful short selling requires skill, just like successful long investing does. If an investor has the skill to identify that a company’s share price doesn’t match its fundamentals, then it makes sense they should be able to profit from that knowledge. And modern share markets do smart investors a disservice if they ban it.

Have things changed for growth stocks?

Have things changed for growth stocks?

Amidst the carnage of one of the worst starts to a calendar year for share markets around the world, ‘growth stocks’ have taken a ferocious beating.

Growth stocks are those companies whose earnings are expected to be able to grow independently of the broader economy. The classic example is tech companies, where global reach of products and platforms can underwrite revenue and earnings growth even when economic growth is negligible.

The other broad grouping is ‘value stocks’, which are those whose earnings go up and down with the economic cycle.

In the aftermath of the GFC, global growth rates were consistently low and growth stocks dominated share market returns to the point where value stocks experienced their worst ever period of relative underperformance. In the United States, the Russell 1000 growth index more than doubled the return of its value counterpart between the start of 2015 and November 2021.

However, since late 2021, that has sharply reversed with the growth index lagging the value index by around 40 per cent. Some of the highest profile growth stocks that peaked during the COVID lockdown period, such as Peloton and Shopify, fell by more than 90 per cent.

Russell 1000 Growth Index / Value Index

After the shakeout we’ve seen, any smart investor who is remotely contrarian will be sniffing potential bargains. However, before piling into heavily sold growth stocks it’s worth looking at some history and what made the growth stocks perform so strongly in the first place.

First, the history: growth stocks smashed value in the late 1990s until the bursting of the dotcom bubble, and then underperformed for more than a decade. So these cycles can go for a long time. Much depends on the macro factors at work.

And those macro factors, in particular what’s happening with inflation, help explain why growth did so well over the past 10 years. When inflation is declining it will normally mean that interest rates and bond yields are also going down. It is also well established that lower inflation helps to support higher PE (price to earnings) ratios, which is what happened through to late last year.

Also, lower bond yields will help support higher share price valuations. When analysts do a discounted cash flow (DCF) valuation on a company’s shares, they will typically base their discount rate on the 10-year bond yield (plus or minus a bit for risk). The lower the discount rate, the higher is the current value of future cash flows, meaning the higher is the price you’re prepared to pay for the shares today.

When inflation started rising sharply, those tailwinds reversed into mighty headwinds. The US 10-year bond yield shot up from lows of about 0.5 per cent to a recent peak of 3.2 per cent, radically transforming the valuation equation for growth stocks, which has been very clearly reflected in plunging share prices.

Over the past 10 years, every time the growth stocks suffered a setback they quickly bounced back, conditioning investors to buy the dip. What might be different this time is the outlook for inflation. If inflationary pressures persist, that will continue to be a headwind for growth stocks.

It’s frustrating to be told the arguments for inflation persisting are pretty equally stacked, but that’s the case. For example, the increase in globalisation that helped to reduce costs over the past 20 years may well be reversing as companies reassess the benefits of more robust supply chains. Also, the very low unemployment level in both the US and UK has seen wages growth settle at around double the pre-COVID level.

Similarly, if Europe follows through on reducing its reliance on Russian gas and oil, that could impact energy prices, plus resources could be diverted to building more renewable energy generation.

On the other hand, the more renewable energy capacity that gets built, the lower will energy costs be, reducing the cost of production. Plus, over the past 50 years betting against technology has not been wise and technologies such as AI and 5G could be transformative.

The upshot is nobody can be certain where inflation will be in a year or two, meaning nor can we be certain that growth stocks will bounce back like we’ve seen in the past. There are definitely bargains, and we may well see a bounce back from oversold levels, but for sustained performance, smart investors could be well advised to hedge their bets by retaining a balance between growth and value stocks.

Have share markets seen the bottom in this correction?

Have share markets seen the bottom in this correction?

Every share market correction throws up opportunities to pick up some bargains. And while those opportunities can make a significant difference to a portfolio, any investment will be tinged with trepidation that the correction isn’t yet over, and no sooner will the buy button be pressed than markets suffer another leg down.

Whilst there is absolutely nobody on the planet that can be certain, a very sound argument can be made that, on the balance of probabilities, it is likely we have seen the bottom in this current correction. That one sentence contains three caveats, which is to underline that no matter how sound the argument appears to be, it is no more than conjecture.

First, that call is much braver in relation to the US market than the Australian, which has benefited enormously from a relatively large weighting in commodity-related companies. Given the US’s influence on global financial markets, this argument focuses on the US.

JP Morgan points out the average share price decline of US stocks to the recent low on 8 March is pretty comparable to past large corrections, as long as the economy doesn’t go into recession. For instance, the average share price decline in the S&P 500 was about 22 per cent (note, that’s different to the decline in the overall index, which was just under 14 per cent), compared to the average seen in previous large selloffs of 28 per cent. For the much broader Russell 3000 the average stock fell 36 per cent this time versus previous averages of 34 per cent, and for the NASDAQ it was 48 per cent this time versus 41 per cent previously.


Bar graph 1: % average stock decline from prior peak if no US recession occurs


The catch is if a recession occurs, the average share price decline for the S&P 500 is 46 per cent, for the Russell 3000 it’s 55 per cent and for the NASDAQ it’s 59 per cent. So the question is whether the US likely to recess?

ClearBridge Investments publishes a Recession Risk Dashboard, comprised of 12 different variables that is updated monthly. At the end of March only one of those variables was flashing red, and one was yellow. Over the past eight recessions, the average was nine red indicators and one green.

Table 1: Recession Risk Dashboard

Source: ClearBridge Investments

But what about the much discussed ‘inverted US yield curve’, which is where the yield on a shorter dated government bond is higher than a longer dated one, indicating the bond market expects growth to slow between those periods, and the fact every US recession for the past 50 years has been preceded by such an inversion?

Critically, there are dozens of different US government bonds and a myriad of different yield curve relationships. The focus, and noise, has been on the 2-year/10-year bonds, where the gap was recently the lowest in 15 years. However, the most reliable recession indicator is the 3-month/10-year curve, where, at the same time, the gap was at its highest positive differential in 15 years.

Graph 1: Market Matrix US

Bespoke Investment Research of the US points out that, based on historical data, the 3-month/10-year yield curve implies a less than 5 percent likelihood the US will be in recession in 12 months’ time.

Graph 2: 12M out Recession Probabilities using Treasury curves %

Source: Bespoke Investments

It also pointed out that currently about 5 per cent of the possible yield curves are inverted, whereas going back to the 1970s, it’s hit about 80 per cent prior to a recession. That is not to say a recession is impossible, but it seems unlikely.

Graph 3: % of points on the Yield Curve Inverted: Since 1970

Source: Bespoke Investments

In any case, for share prices to suffer the extra leg down, the economy needs to be either in, or on the cusp of, recession. Over the last five recessions (not including 2020, where the government pulled the plug on the economy) the average gap between the US yield curve first inverting and the economy recessing was 17 months, and while those recessions did coincide with significant declines in the S&P 500, the average gain between the yield curve inverting and the market starting to decline was a massive 43 per cent.

Not surprisingly, when Professors Eugene Fama and Kenneth French undertook a study of the predictive power of yield curve inversions they found there “is no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three, and five years.”

A final indicator is the AAII (American Association of Individual Investors) Sentiment Survey, which is based on a weekly poll of its more than two million members. The proportion of respondents who are bullish about the market outlook over the next six months fell to less than 16 per cent, which is one of its 10 lowest readings since inception in 1987, and the lowest level in almost 30 years.

Graph 4: AAII Setiment Survey - % bullish


This is recognised as a strong contrarian indicator. US investment group, Jefferies, looked at the S&P 500’s performance after the ‘bull-bear spread’ (the bullish sentiment reading minus the bearish) dropped below -30 and found the average six-month return is 8.3 per cent and was positive 91 per cent of times (if you take out the GFC it was 12.6 and 100 per cent respectively).

Table 2: SPX Perf, When AAII Bull-Bear Breaks Below -30

The thing is, even if global share markets have seen the bottom for this correction, that doesn’t mean they will look the same as they did. For now at least, inflation has re-entered the investment equation and central banks are threatening multiple interest rate rises, which could see a change in the kind of companies that outperform. Smart Investors would do well to be mindful of the balance between ‘growth’ and ‘value’ stocks.

So where should you look for those bargains? Despite suffering their worst quarterly return in 40 years, bonds are still trading in the 70th centile of their historical valuations (i.e. they are expensive), whereas equity markets are around their 60th, and if you exclude the US, they’re in their 20th. So non-US equities appear to be cheap.

Graph 5: Average valuation percentile since 1990

Indeed, if you use a very basic measure like the next 12 months’ price to earnings ratio (PE), Europe is as cheap as it’s ever been versus the US. 

Graph 6: Europe vs USA 12M Forward Price to Earnings

While technically the US still has much of the momentum, there’s an old saying in financial markets that ‘trees don’t grow to the sky’.

Graph 7: Long Global, Short USA

One area that is more value oriented is resources and commodities, which Australia obviously benefits from. The CRB (Commodity Research Bureau) Index, which covers a broad range of commodities, has risen 28 per cent year to date, and 62 per cent over the past 12 months.

Graph 8: CRB Index

The current correction, like all before them, is definitely throwing up some bargains. The most common risk investors face is waiting for clarity before investing. Financial markets always involve uncertainty, and by the time things are clearer, those bargains are likely to be long gone.