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Rethinking the role of fixed income right now

December 14, 2020

The low interest rate environment is a conundrum for investors in fixed interest markets. Most have been left grappling with how they should think about yield and risk, and how they can optimise their defensive allocations in this environment.

This was the focus of the discussion on fixed interest that was part of Channel Capital’s Asset Allocation Virtual Series.

At the start of the session, moderator Sue Wang, Senior Fixed Income Portfolio Manager, Mercer asked the panellists how investors could extract income from an asset class increasingly heading towards zero or negative yields.

“In the search for yield, manager selection becomes extremely important. Pick a manager that has credit discipline and that can identify industries and businesses that can actually weather cycles,” said panellist Bob Sahota, Chief Investment Officer, Revolution Asset Management.

“Yields are very low and income levels we leaned on in years gone are not going to be there, which means managers are going to be asked to work a lot harder and alpha generation is going to become very important,” said panellist Charles Jamieson, Chief Investment Officer, Jamieson Coote Bonds.

“There is still some runway left for Australian government bonds. In historical terms they're statistically cheap versus the RBA cash rate, they are actually a little bit cheap which is quite staggering,” he added.

Jamieson says the question is whether Australia will join its counterparts in New Zealand, Canada and England and move to negative rates.

“Zero is no longer the lower bound and certainly hasn't been the lower bound for some time now,” said Wang, noting that capital security is considered to be a completely non-negotiable element of fixed income. “Investors don't want to stomach losses.”

Sahota agreed that security is key in credit markets.

“The security in the capital stack comes to the fore when you have a dislocation. It means you've got all the equity the sponsor has provided in that capital structure as your shock absorber for any losses. We like industries that through a cycle are extremely stable and robust such as healthcare, consumer staples and mission critical software.

“These are the industries we are really focused on because we know the market's always in cycles and the best you can ever do as a fixed income or private debt investor is pick up your coupons as they come or your interest payments on the loan and get your money back at the maturity of that loan. If you bear that in mind in every investment you will be able to deliver returns with capital stability.”

Fixed income for different life stages

When it comes to the role fixed income should play, Jamieson said it differs for different investors. “Some want income, some want diversification, some are very focused on the capital guaranteed nature of it. The diversification element is a bit ‘choose your own adventure’ in terms of the other risks you are looking to insulate. Are you looking to put ballast into the portfolio? Is liquidity something you are interested in if you get vast changes in markets that are likely to trigger changes in asset allocation? Diversification is something you need to think about.”

Sahota noted diversification is especially critical in an illiquid asset class such as private debt. “In Australia the market is not as deep and broad. But you don't want to have bits of every deal because some of them are going to blow up. What you need is discipline and the credit skills to sift through the universe of opportunities and do deals with a high conviction, with a great deal of analysis. This gives us confidence we are going to get our money back.”

Sahota noted private debt is set to become a mainstream asset allocation in Australia in the same way it is in the US and Europe. “At Revolution Asset Management, we believe that as the market matures here in Australia and New Zealand, this will become a more reliable and mainstream asset class as the market slowly develops in time.”

Fixed income allocations – defensive and growth

Wang explained that Mercer takes a very nuanced approach to fixed income portfolio construction, splitting allocations into ‘defensive’ and ‘growth’ fixed income buckets. As to how much investors should allocate to each fixed income sector, this tends to depend on investment objectives, risk and liquidity tolerance and time horizon.

On the topic of why investors should use specialist managers for their fixed income allocations, all the participants noted the importance of this within portfolio construction.

Jamieson says one of the major problems with composite fixed income funds is that investors trust the manager to invest in whatever they believe is appropriate but often don’t make the re-allocations when they should.

“During the onset of Covid-19, we saw so many managers that hadn’t changed their allocations, whilst the information was around for some time. This was disappointing for investors. In this scenario, where there are government bond holdings with corporate credit holdings – the entire fund structure can become compromised. Clearly as the credit market evaporates as it did in March where there is no market to sell to, invariably asset managers blow out their sell spreads and investors lose any optionality they have to extract liquidity.”

Generating income from the defensive part of the fixed income allocation as well as insuring the non-correlated nature of the overall asset allocation piece is key. Particularly in times of market stress, where AAA government rated assets can provide investors with much needed liquidity and capital preservation. It really does call for specialist managers who have got repeatable ability to generate an active return above an index through the cycle.

As Jamieson noted: “There is a lot more to it than a one size fits all fixed income allocation. Active and specialised managers can really deliver excess returns.”

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