Fixed Income

Patience over exuberance

We don't know the catalyst, but we observe compressed risk premiums...

10/05/2017

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

Outlook and Strategy

Our outlook remains cautious across several dimensions. Firstly, while bond yields have risen somewhat (from their lows in mid-2016) and correspondingly our return expectations have lifted, the new return expectations remain modest. We now expect US and Australian government bonds to return about 2% p.a. over the next 3 years, as the capital impact of a small expected rise in yields partially offsets the moderate income represented by the starting yield. Both the expectation that bond yields should rise and the small expected returns imply that government bonds remain expensive.

Secondly, having continued to perform strongly in an environment of ongoing subdued macroeconomic volatility and ongoing central bank accommodation (in spite of the laboured efforts of the US Fed to lift rates), valuations of riskier assets have moved back to expensive territory. Credit spreads have recently returned to post-GFC lows. While the expected excess return of credit assets over government bonds remains positive (as the current extra spread available still compensates for both defaults and expected spread widening), the gap is becoming both marginal and, given the uncertainties around forecasts, low conviction. 

In some ways, the recent moves have helped restore the balance between traditional defensive assets (such as government bonds) and riskier assets (high yield corporate credit or emerging market debt). Whereas 12 months ago government bonds were expensive and risky (in a forward looking sense) and credit was cheap and relatively less risky, today the relative outlook is more balanced.   However, we’re probably only at a halfway house. Government bonds as a standalone investment remain expensive, and while the appeal as an investment relative to other assets (including cash) has improved, we’d like to see them cheaper still before making material portfolio shifts back in favour of government bonds/duration. 

Having said this, triggers for possible market repricing remain hard to identify. In general, the economic cycle looks okay if unspectacular. While debt levels remain elevated in both developed markets (DM) and now emerging markets (EM) economies, system instability appears unlikely soon. There are risks around central bank policy unwind, though this is likely to be managed gradually. Politics remains short-term noise only, with an ever-diminishing half-life. In conclusion, we don’t know the catalyst, but we observe compressed risk premiums in markets and consider patience rather than exuberance the preferred approach.

Hence our broad positioning within the portfolio remains reasonably defensive. We continue to run lower and better diversified interest rate risk than the benchmark, running a relative short duration position in Australia and outright short positions in both US Treasuries and German Bunds. With Australian and particularly US bonds having improved in relative value, we own more US duration than at the start of the year but are looking to again tilt shorter in Germany, which we rate as the most expensive bond market, and where cyclical dynamics are becoming less bond friendly. Additionally we’ve neutralized our yield curve flattening exposure in Australia and taken partial profits on our long US inflation position, but broadly remain better positioned than the benchmark should yields move higher, curves steeper, or inflation expectations lift. 

Equally in credit our exposures are moderate and high quality given the tightness of spreads. While Australian investment grade credit remains a slightly better prospect than government bonds at current levels, and the favourable carry environment potentially can prevail for some time, we have continued to edge our exposures lower as spreads have tightened. Our current benchmark-sized position is the lowest we’ve had in many years. While Australian Residential Mortage Backed Securities (RMBS) remains a core holding, other possible allocations such as global investment grade credit have little appeal at current levels. We’ve also recently slightly reduced our exposure to semi-government and supranational bonds, at tight spread levels to government bonds.

We’d welcome a market repricing (careful what you wish for!) that would allow us to reposition more constructively. Until this happens, the combination of our reasonably elevated cash position, and our interest rate and credit positioning, leaves us defensively positioned and focused on protecting capital.       

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