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.

Want to discuss your investment strategy with a specialist?

Listed property trusts: primed for a rebound

Listed property trusts: primed for a rebound

Property was possibly the worst affected sector when governments around the world pulled the plug on their economies in 2020. Not only did workers stop going into office buildings and shoppers stopped going to malls, but landlords were forced to shoulder the added burden of rent holidays and eviction moratoriums.

Little wonder real estate indices plunged. Locally the Australian Real Estate Investment Trust (AREIT) index fell 39% between the end of January and March last year, while the global benchmark, the FTSE EPRA Nareit Global index (GREIT), dropped 28% (in USD terms).

However, lingering concerns about both delays in returning to work combined with the effect the new paradigm of working from home will have on valuations for commercial property, as well as the impact of the accelerated migration to online shopping on retail values, have seen real estate indices lagging behind the broader share markets’ recoveries following the COVID crash.

The AREITs index is still 14% below its high of last year, while the ASX200 is only 1% away. Likewise, GREITs have managed to get square with last year’s high, but they’re a long way behind the 19% increase in global shares.

These differences offer smart investors the opportunity to buy what some strategists are describing as the only cheap sector left. Tim Farrelly, a highly regarded asset allocation consultant, recently wrote “Despite pretty severe assumptions on the outlook for rental growth, such as a fall in real office rents of 45% and a fall in real retail rents of 20% over the next decade, the overall impact on 10-year returns is not nearly as catastrophic as might be expected, as markets appear to have priced in these falls and more.”

Indeed, Farrelly’s 10-year return forecast for AREITs is 6.8% per year at current levels, while the forecast for Australian shares is 4.8%. Likewise, Heuristic Investment Systems, another asset allocation consultant, has a 10-year forecast return of 6.25% and an overweight recommendation.

While AREITs do offer compelling long-term value at current levels, our domestic market does suffer some limitations. It is highly concentrated, with the top 10 companies accounting for more than 80% of the ASX 300 AREIT index, and just three sectors, retail, industrial and office, making up more than 60%. The superstar of Australian property trusts, Goodman Group, alone is almost one quarter of the whole index.

By contrast, global REITs not only offer the compelling value, plus, at more than A$2.4 trillion, the total market is more than 19 times bigger than Australia’s. The top 10 companies account for less than 25% of the index and the biggest single company is only 5%.

Most importantly, there is abundant diversification, including to sectors that offer leverage to some of the most important structural themes in global markets. If you want to gain exposure to growing digitisation, 3% of the index is data centres; or e-commerce, 12%  is industrial; for demographics, healthcare is 7%, and for urbanisation, 18% is residential.

According to Vanguard, global property was the best returning asset class in the 20 years to 2020, with an annual return of 8.5%. Resolution Capital, an Australian GREIT manager, also points out the asset class enjoyed lower earnings volatility than global equities.

Despite that history of strong returns, 2020 was its worst year since the GFC at -17%. By contrast, however, this time the fall was not because of excessive debt or weak balance sheets, it was a classic exogenous shock. With the progressive relaxation of government restrictions, conditions are in place for a strong rebound.

An added attraction is that historically REITs have been a terrific hedge against inflation, since both rents and property values are typically tied to it. This may sound counterintuitive if you’ve come across the popular misconception that REIT valuations are inversely affected by bond yields, that is, when yields rise, values fall.

Chris Bedingfield, co-portfolio manager of the Quay Global Real Estate Fund, points out that, “Over the long-term, there is actually no correlation at all between REIT valuations and bond yields. However, over the short-term, it seems there are enough investors who believe it that it becomes a self-fulfilling prophecy.” Notably, over the March quarter, GREITs returned more than 7% despite bond yields rising sharply.

To gain exposure to GREITs, you can buy an index fund, such as the VanEck Vectors FTSE International Property ETF (REIT.ASX), or, if you’re wary about the potential for COVID risks, you can choose an actively managed fund from the likes of Quay Global Investors or Resolution Capital.

Why hybrids offer defensive potential but have strings attached

Why hybrids offer defensive potential but have strings attached

This article appeared in the Australian Financial Review.

When the best term deposit rate you can get is below 1% from a bank you may never have heard of, the chance to get 4% or better on a hybrid security from one of the big four tends to grab your attention. The problem is, of course, those attractive rates come with all kinds of strings attached.

After emerging 25 years ago as a handy solution for companies to raise money and for share market investors to be able to access higher yielding securities, hybrids have become an entrenched part of the Australian market. However, while they can readily play a role in a smart investor’s well-structured portfolio, they are devilishly complex. There is a variety of structures and features requiring issuing documents that can run into the hundreds of pages, enough to prompt government websites like Moneysmart to describe them as ‘very risky’.

The ‘hybrid’ label is because they blend elements of debt securities and equities, that is, they are part bonds and part shares. Typically they promise to pay a rate of return, which you can think of as an interest rate, for a certain period of time, and at the end of that period, the investor gets the original face value of the security, which is normally $100, in shares.

The interest rate is usually quoted as a margin above the 90-day bank bill rate. Companies with a lower credit rating will have to pay a higher margin, just like a corporate bond. The rate can be fixed at a specific return, or it can ‘float’, meaning if the bank bill rate goes up or down, so too does the interest rate the investor receives. And hybrids commonly incorporate franking credits as part of the yield.

The rate a hybrid pays when it’s issued will normally be set by the issuer’s investment bankers going out to the market and testing investor appetite. Then once the security is trading on the market, the rate an investor receives will depend on the price they pay for the hybrid.

The part that makes hybrids complex and risky is the equity element. No two hybrids are the same, and the obligations of the issuer and the rights of the investor, can vary considerably. Some hybrids allow the issuer to stop paying any interest if it falls into financial difficulties, and some place the investor’s rights to recover their money in the event of the company failing behind all other creditors.

The theoretical price a hybrid security should trade at is determined by the combination of its starting margin over the bank bill rate, its different equity-type features and the length of time before it matures. The longer the time to maturity, the more time there is for something to go wrong and so the higher should be the interest rate.

The upshot of all these features is that hybrids are normally a lot more volatile than pure fixed income investments, but not as volatile as shares. When the ASX 200 fell 37% in February and March this year, the Betashares Active Hybrids ETF (HBRD) dropped by just over 15% and is now getting back to its pre-COVID levels, while the broader share market is still 14% below it.

Andrew Papageorgiou, a portfolio manager at credit investing fund manager Realm Investment House, said, “While hybrid prices do fluctuate, they are underpinned by solid mathematics. Like all securities, from time to time prices can be considerably above or below where we calculate they should be, which creates opportunities.”

This begs the question: if a self-directed investor doesn’t have access to the maths, how do they know when hybrids are cheap or expensive? The various stockbrokers that help sell new issues usually publish research showing the basic valuation measures, such as the current yield, and some of them may offer recommendations.

It’s worth bearing in mind, however, those brokers get paid commission to sell hybrid IPOs (an exception that was carved out from the recent reforms that saw LICs and LITs stop paying commissions), so there is an overarching question of conflicts of interest. There are other websites, such as yieldreport.com.au, that publish tables as well. Papageorgiou says a very rough rule of thumb is that normally bank hybrids, which dominate the Australian market, should generally trade at a margin of about 3.2 to 3.3% over the bank bill rate.

A few years ago Australia’s bank regulator, APRA, introduced clauses into bank hybrids enabling them to stop interest being paid or even to compulsorily convert the hybrids into shares if the bank’s senior equity falls below certain levels. ASIC expressed great concern that investors wouldn’t understand the risks and that hybrids were being marketed as an alternative to term deposits. To be clear, buying a bank hybrid is nothing like placing a term deposit with the same bank. A term deposit is government guaranteed (up to $250,000) and its value doesn’t change on a day to day basis.

However, asset allocation consultant, Tim Farrelly, argues the kind of market events required to trigger the conversion clauses are so extreme, and APRA is sufficiently vigilant, that investors shouldn’t lose sleep buying a bank hybrid provided they are comfortable holding it until maturity. That way they can ignore the market volatility and enjoy the added yield of a defensive, investment grade security. If you don’t think you can stomach the potential for 15% drops in the defensive part of your portfolio, no matter how temporary, then don’t go there.

Want to find out more about your investment options and whether hybrids could work for you? Get in touch today.

A plain English guide to the financial market effects of the ‘Virus Crisis’

A plain English guide to the financial market effects of the ‘Virus Crisis’

With the inundation of COVID-19 news coverage we’re all having to live through, I thought I’d jot down a few thoughts on a bunch of different topics related to financial markets. Short and sweet(ish).

How does this bear market compare?

While every bear market’s different in terms of the cause, depth and duration, this one stands out because it’s a rare occasion where it started in the real economy and transmitted to the financial markets, rather than the other way around. You could argue the 1970’s OPEC-related slump was similar, but even there, the macro picture was very different with high inflation. That makes it harder to get a grasp of how things might play out and how effective the rescue measures from governments and central banks will be.

Over the last 50 years we’ve seen seven bear markets in Australia (that is, falls of more than 20%), including the current one, with an average decline of 35%. The US has also seen six with an average fall of 42%. The current ‘virus-crisis’ has seen our market drop 34% to the close on 19 March and 29% for the US.

One of the things that makes this different is because the crunch is coming from both the supply side and the demand side. When China shut down, those companies that rely on Chinese manufactured goods for their own business were struggling to fill the gap. And now that more and more of the world is going into quarantining and isolation, consumers aren’t spending. So the proverbial double-whammy.

Where are we up to with this one?

What level of economic slowdown is being priced in by share markets right now is tough to say with any accuracy.

Asset allocation consultant, Heuristic Investment Systems, reckons for the US, in an ‘average recession’ where GDP drops by 2%, a bear market tends to see the S&P 500 fall by 25-30%, and in a deeper recession, like the GFC, the average fall is 40-50%. On that basis, the markets are currently pricing in an average recession.

By contrast, the Bloomberg Chief Equity Strategist, Gina Martin Adams, says the S&P 500’s ‘trailing price to earnings (PE) ratio’, which refers to the earnings that were reported by companies over the past year, which at least has some certainty, is now about 15. Compared that to her ‘fair’ multiple, it implies a worse than average recession with earnings declining 22% over the next year.

What happens after bear markets?

The tables below show how far Australian and US share markets have fallen during each bear market over the past 50 years, how long they took to get back to where the index started, and then what returns were like 1, 3 and 5 years after.

For Australia, the average three year compounded annual return works out to be more than 11%, and in the US it’s an amazing 19%. Given it appears interest rates are likely to stay very low for a long time, that represents an attractive return, and is one of the arguments in favour of a sharp rebound in shares.

Australia bear markets since 1970: extent of falls and subsequent returns
A plain English guide to the financial market effects of the Virus Crisis image1
US bear markets since 1970: extent of falls and subsequent returns
A plain English guide to the financial market effects of the Virus Crisis image2

Why has this bear market been so volatile?

The VIX index in the US measures share market volatility, and the chart below shows it’s hit eye-popping levels in the past couple of weeks, every bit as stomach-churning as the GFC.

Share market volatility has spike to all-time highs
A plain English guide to the financial market effects of the Virus Crisis image3

While it’s almost impossible to get definitive numbers, it appears much of the volatility is coming from so-called ‘systematic strategies’, essentially computer-driven funds that trade automatically depending on all kinds of different variables, like momentum or volatility or depending on what’s happening in other markets like bonds or commodities, and then there are the ‘high frequency trading’ funds that aim to jump in ahead of any trades at all. The chart below shows how sharply some funds have dumped their equity positions.

Computer-driven funds have been very active
A plain English guide to the financial market effects of the Virus Crisis image4

What’s happening in bond markets?

Bond markets have been every bit as crazy as share markets, but in a scarier way. Credit markets facilitate the flow of money around the financial system, with trillions of dollars’ worth of deals being done around the world on a day to day basis. It’s these markets that keep the banking system working properly.

Last week, however, the flow was getting choked off because companies were frantically trying to get their hands on cash. Large companies will typically arrange lines of credit with their banks that they can draw on when needed. If companies think there’s a risk they might need cash urgently, because, for example, their business has all but closed down during a quarantine, they’ll go to their bank and draw all that cash out. But there’s a limit to how much cash banks will have on hand, so when they started getting hit up by their customers, they had to go to the credit markets and try to raise cash by selling bonds. However, when everyone’s trying to raise cash at the same time, a market can quickly run out of buyers, so the risk premium they’re willing to trade at rockets (another way of saying the price they offer to buy at goes down), as shown in the chart below, and that’s how the financial flows were getting choked up.

Credit markets were running out of buyers, reflected by risk premia rocketing
(Chart is of the US High Yield Index Option-Adjusted Spread)
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Fortunately, the central banks were able to ride to the rescue and pump liquidity into the system to calm things down a bit, but we’ve seen similar huge jumps in what’s called ‘credit spreads’ across the whole credit market, right around the world, which is seeing a sharp repricing of corporate bonds.

What are central banks and governments doing?

In current markets, central banks and governments have quite different roles to play.

Central banks are focused on keeping credit markets operating, and between them they’ve promised to inject trillions of dollars to make sure that happens. That was a big part of the package of measures the Reserve Bank announced this week, which included cutting interest rates to 0.25% to reduce the cost of credit and basically saying the rate will stay there for as far as we can see, and it’s making some $90 billion of funding available to banks to lend out for which it will charge them only 0.25%. It also said it’s going to try to make sure the Australian 3 year bond trades at a yield of 0.25% and finally announced it’s going to join the quantitative easing brigade.

The US Fed has also cut rates to basically 0%, so has the Bank of England and the Reserve Bank of New Zealand. The ECB was already there (in fact their rates are negative) plus it said it will expand its balance sheet by €750 billion and allow qualifying banks to borrow up to €2 trillion at a rate of -0.75% – that’s right, they’ll pay banks to take the money from them!

There will be howls from free marketeers criticising the central banks for supporting asset prices, but that’s an unfair characterisation of what they’re doing, which is more like keeping the financial plumbing open to provide a bridge to governments’ fiscal spending.

And governments have certainly said they’ll spend. After years and years of central banks begging governments to open their wallets, we’ve seen what looks like massive programs being announced: $1.2 trillion in the US, £330 billion in the UK, €1 trillion from European governments to guarantee business loans, and, of course, what appears to be a relatively paltry $17 billion here in Australia. While they sound like huge numbers, rest assured, governments will need to do more if they want to backstop their economies.

This may finally be the time for governments and economists all over the world to wrap their heads around Modern Monetary Theory.

When will the market recover?

We’ve been fielding lots of inquiries from clients asking when they should buy but unfortunately there’s absolutely nobody on the planet that can give you a good answer to that question. What I think I can say is the market will start to recover once it believes the odds that we’re through the worst of it go to 50.1%, from 49.9%, but exactly how that can be judged I don’t know. It could be a slowdown in the rate of new cases, or even confirmation that current treatments are indeed working, or acceptance that governments will indeed spend enough to backstop economies.

Given the hopeless execution by the Trump administration in the US you’d have to think they have a long way to go, and here in Australia numbers are still doubling every 2-3 days.

A huge opportunity

One thing’s for certain, share markets are very cheap once again, and the further they go down the higher will be the returns on the other side. If you’re in the lucky position of being able to invest, don’t fall for just buying the most beaten up stocks, who knows, some of them may never recover. Similarly, if you already own shares, you should ask yourself if you’d buy the same ones now. Rather, my suggestion would be to think about the portfolio you wished you’d owned just before things went pear-shaped, and target that.

It’s impossible not to sound cliched, but these are genuinely extraordinary times, especially for Australia. Having endured a summer where it felt like the whole country was on fire, we now have a global pandemic wreaking economic havoc. I wish you all the best and stay safe.