After the largest bond market sell-off in 30 years, and with risk markets pricing in a higher probability of recession, global fixed interest and credit markets offer significantly higher yields than those offered 12 months ago.
In the 12 months to June 2022:
Global fixed income and credit are diversifying asset classes for Australian investors.
In Bentham’s opinion, some of these assets can potentially offer higher income than cash, with less risk than shares, while bringing diversification benefits that can reduce overall portfolio risk.
Historically, some higher-yielding credit portfolios have provided comparable returns to equities with significantly less volatility, according to Bentham's analysis.
Global fixed income and credit markets are larger than global equity markets.
“Global fixed interest and credit” generally refers to debt issued into public and private markets by governments, semi-government entities, companies or to fund consumer lending (e.g., the RMBS market). There are many different types of fixed interest and credit sectors across the world.
“Bonds” is often used as a generic label for government issuance of fixed-coupon debt – but the universe is much more varied than this, with different risk profiles and payoff dynamics depending upon the sector.
For example, the “quality” of the borrower varies and could be “Investment Grade” (AAA to BBB credit ratings) or “Non-Investment Grade” (BB and below).
Coupons on debt may be fixed rate or can reprice with rising interest rates (“floating rate debt”).
In Bentham’s opinion, optimising asset allocation is particularly important in the current environment because forward-looking, asset-class return profiles differ from the returns realised in the past.
Government bond yields have risen sharply from their record lows, credit spreads have widened towards March-2020 levels, while sharemarkets globally have fallen dramatically from their recent peaks.
The chart below shows yields currently offered by global credit sectors, cash, and government bonds.
When allocating a portfolio across cash, fixed interest, and equities, adding global credit can improve returns for a given level of risk, according to Bentham's analysis, because global credit can perform well at different times to shares, fixed income, and other asset classes.
Interest rates reached historically low yields during the COVID-19 pandemic recession as central banks and governments tried to nurse the economy through a forced shutdown that we haven’t experienced since the 1918 Spanish flu pandemic. These falling yields generated positive returns for fixed-income markets.
However, the stimulus and re-opening of the global economy, combined with supply chain problems and a supply shock from the Russia/Ukraine conflict have produced inflation not seen since the 1970s.
The sudden increase in inflation has prompted central banks worldwide to raise interest rates and forecast many further hikes – seeking to reduce aggregate demand in order to moderate inflation. These rapid rises in yields have generated negative returns for fixed-income markets. But the market is now searching for a top in interest rates.
When yields go up, prices of bonds go down.
Sensitivity to interest rate increases is measured by the weighted average term of a bond’s cashflows or ‘interest rate duration’. A bond with 10 years of interest-rate duration would approximately lose 10% of its value per 1% increase in interest rates (or the contrary if rates fell).
Bond returns have been negative in recent years because global interest rates are rising from low levels, with rather long interest-rate durations.
Typically, the media focusses on (RBA) cash rate rises. But these rises lag the fixed-interest market that looks forward in pricing all the potential interest rate rises that might occur.
Once interest rates have peaked, fixed income returns may be more attractive for certain investors, as there may be capital gains earned as well as higher interest potential, in Bentham’s opinion.
Additional yield is generally available on corporate bonds and loans (global credit). The additional yield is called ‘credit spread’ and this has also increased as the market anticipates more volatility and credit events in a possible recession.
So, there has been not only an increase in interest rates, but also an increase credit spreads, combining to increase the potential overall yield now available for investors.
Bentham believes the current environment requires investors to be very active to avoid pitfalls.
Bentham prefers publicly traded markets that have already repriced for the risk of rising interest rates and a slower economy - in contrast with private markets that have not re-valued to the same extent.
Bentham believes that globally, risks are more fully priced than locally. In particular, Europe is pricing an energy crisis and an economic slowdown.
Bentham prefers the investment-grade space with the premium in asset-backed securities and corporate hybrids offering attractive returns relative to Australian, US, and Emerging Market exposures.
Bentham is cautious on the outlook for Australia, as our economy is more sensitive to rate hikes than other developed markets. Our firm’s portfolio positioning reflects these views.
Bentham believes FY23 could be an exciting year given the opportunity set of fixed income and global credit. Current high yields could potentially generate above-average returns over the medium term (3-5 years), while near-term returns are harder to predict.
We may not have reached the peak in interest rates or credit spreads as yet. So, be careful and active. Also, be careful to invest in assets that have repriced in public markets and deliver higher yields and credit spreads (which are now available).
Bentham’s preference is to invest in credit invest globally with a high level of diversity.
The nature of credit investing means that far greater diversity is required than for an equity portfolio.
Given the significant moves in yields, Bentham has recently re-allocated to fixed income in our multi-sector portfolios for the first time in several years.