Fixed income investors had been touting the market was headed for a crash well before COVID-19 swept over Australian shores. When it did, it put the spotlight on this sometimes underestimated market. Eliza Bavin, Financial Standard writes.
While almost everyone agrees having a fixed income segment in your portfolio offers diversity and a safety net, it may not come as a shock that in the lead up to the most recent market crash, those portions were not large enough.
Similarly, it may come as no surprise that many investors, financial advisers, and everyday Australians don’t view fixed income as a particularly interesting investment choice, despite it being incredibly important.
Perhaps this is due to the fact that the big four banks dominate the Australian market, or because it is viewed as a solely passive investment that is meant to be set and left.
However, if there was one thing the recent market volatility taught us, it’s that fixed income is necessary – we just need to figure out how to compete on the global scale.
Domination of the big four
There is no doubt, amongst almost every investor, that Australian fixed income market is lacking diversity and this is due to the stronghold the big four banks have.
Mark Mitchell, director at Daintree Capital, says this has been an ongoing issue that he feels has stifled the local market.
“It has been a longstanding complaint of fixed income investors in Australia that the market is largely dominated by financials with only modest amounts of corporate and residential mortgage backed securities (RMBS) issuance,” Mitchell says.
“A lot of that is driven by the fact that corporates have historically been able to get funding from both domestic and foreign banks operating in Australia or have been able to issue larger size deals with longer tenors in offshore markets.”
Robeco’s managing director and head of client portfolio managers, fixed income based in the Netherlands, Maurice Meijers says the current market circumstances allow for plenty of stock picking opportunities but describes the Australian fixed income market as “narrow”, resulting in a lack of breadth.
“To truly benefit from the valuation opportunities in credit markets, an active, flexible and unconstrained strategy will likely yield the best results,” he says.
“One reason for this is that some sectors or segments of the market are better represented in one region than another.”
Franklin Templeton is one company that takes a particularly active approach and managing director of Australian fixed income Chris Siniakov says that while the banks do have a tight grip, if you’re active there is always opportunity.
“The banks have certainly got a strong foothold here, but they have a strong foothold in other parts of the world as well,” Siniakov says.
“Unfortunately, in places like Australia the banks are heavy intermediaries, so they play that function and it is an important role, but they dominate it.”
Siniakov says this has resulted in our capital markets not prospering in the way they might in somewhere like the US.
But while we might be slow to change, Siniakov says it is coming. He points out that a decade ago there was always an element of international companies coming to Australia and borrowing from the Australian market.
“Some international companies’ issued bonds in Australian dollars, such as European industrials and US financials, so a pretty vanilla credit space,” Siniakov says.
“But over the last 10 or 12 years that has expanded much more broadly, even just geographically.”
Siniakov says those who issue on the Australian market include Latin America, the Africas and most importantly for us, the Asia Pacific region.
“I think this is where it will continue to evolve. As the Asian economy grows and reaches its potential over the coming decades they will increasingly become greater participants in global financial markets,” he says.
“Australia will be a beneficiary from that in terms of diversification of individual countries, industries and companies across the Asia region.”
Siniakov says there is plenty of opportunities in the future, but it’s just a very slow burn.
“It takes a long time for this sort of new opportunity to grow within the traditional context.”
Gopi Karunakaran, portfolio manager – interest rate and credit strategist at Ardea Investment Management, feels that while there may be a perception of good diversity from Australian fixed income portfolios holding a large number of different bonds, the reality is not as good.
“This is because the performance of those bonds is largely driven by the same narrow set of underlying risk/return drivers,” he says.
“We saw this lack of diversity play out in the March quarter when many segments of the Australian fixed income market became highly correlated around the same themes, like recession fears, and all incurred losses together as equities fell.”
Genuine risk diversification, Karunakaran points out, comes from investments that have different underlying risk/return drivers.
The issue is that those opportunities lie overseas, and with the big banks having a monopoly on the local offerings, investors have fewer options.
Troy Theobald, financial adviser and founder of Robina Financial Solutions, says this has been an ongoing issue for himself and his clients.
“The issue lies in that the fixed income sector moves in the same direction. You could have a number of different managers, but they’re not really giving you diversity in the underlying investment,” Theobald says.
“That is what you need to look through and question, and the worry is around what other risk people are walking into if they then move to other areas.”
Asmita Kulkarni, director – investment strategy at FIIG Securities, says in comparison to offshore markets, like the US and Europe, Australia is also dominated by government, semi-government and bank bonds.
“If you look at how pension funds are structured and look at the OECD global pension statistics, it shows that compared to the rest of the world Australian pensions are more invested in equities,” she says.
“That’s because of structural elements like dividends and franking credits, so we tend to put a lot more into equity and property.”
Kulkarni says FIIG has been originating a number of various bonds for companies that need access to capital and have been bringing those to market.
She says we will likely start seeing a lot more of that, as we move forward.
“Hopefully the government is also considering broadening the corporate bond market and potentially making it available to a broader investor base,” Kulkarni said.
“We are lacking in terms of offerings, but that is somewhat driven by demand, so hopefully as we educate more investors we should start to see more corporate issues in our market.”
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Accessing corporate bonds
Australia has been slowly adopting longer term corporate debt and a greater diversity of names, but it has taken a decade or two to get there.
Jay Sivapalan, head of Australian fixed interest at Janus Henderson says we still have some way to go to match the deepest and most diverse bond markets such as the US or Europe.
“High yield and loans markets are also more liquid and larger, including broader in diversity of industries and issuers offshore,” he says.
“Looking forward, with a growing savings system increasing its proportion of assets to the pension phase, a very natural and healthy place for relatively safe income is corporate debt.”
Sivapalan believes Australia’s corporate debt market is catching up, but it needs to be more inclusive of a greater range of industries, longer tenors and a wider participation by investor segments.
“Low risk options are plentiful in the Australian marketplace as is investment grade corporate debt,” he says.
“By the very nature of our banking system and maturity of the corporate bond market, Australia does have less available options in very long tenor corporate debt and lacks a fully developed high yield market.”
The list of fixed income investors who feel the Australian market is lacking goes on and on, but there is always an exception to the rule, and the exception in this case is Garreth Innes, head of Australian fixed income at Aberdeen Standard Investments.
“When it comes to the corporate bond market, the profile closely resembles the actual economic output of Australia – not a whole lot of manufacturing, but strong representation from banks, property trusts and couple of supermarkets and telcos,” Innes says.
Innes does concede however, that not all of the newer options have come from domestic sources.
“The market has enjoyed the recent introduction of a number of global champions that have decided to issue in Australian dollars; tech giants like Apple and Intel, a host of US and European banks and global auto manufactures,” he says.
And Innes must still admit the local market has been lacking particularly, he says, in the high yield space.
“Most Australian companies that have a sub-investment grade credit rating head over to the US to launch their bonds, as the US high yield market is much deeper and liquid,” Innes says.
“We have had a few companies issue local deals in recent years, but you wouldn’t call it a market just yet.”
Innes says our domestic credit default swap market is also fairly illiquid compared with global competitors, with many single-name contracts hardly worth looking at given the difficulty in executing in reasonable size.
Competing on the global scale
It seems Australian fixed income investors are almost forced to look offshore if they want to find the best options.
“Australian investors are spoilt for choice when it comes to high quality, local managers,” Louise Watson, managing director and head of distribution for Australia and New Zealand at Natixis Investment managers, says.
“However, when considering a whole of portfolio approach they should also consider the benefits of global diversification.”
Global mangers offer diverse insights across multiple characteristics and are often well placed to complement local manager’s skill.
“We believe current valuations in global fixed income markets could offer compelling opportunities, especially for global, active managers,” she says.
Alessandro Pagnai is vice president, portfolio manager and head of the mortgage and structured finance team at Loomis, Sayles & Company, based in the US.
He leads the group in developing investment strategies for mortgage pass-through, asset-backed, residential and commercial mortgage-backed securities.
Pagnai says a well-functioning securitisation market can help jumpstart the economy, something that is high on the list of priorities for nations around the world given the current circumstances.
“First, keep in mind that most securitisations are designed to eliminate idiosyncratic risk for investors by pooling together hundreds or thousands of loans and transforming previously illiquid loans into liquid securities,” he explains.
“A well-functioning securitisation market plays an important role for both borrowers and lenders; it provides lenders with liquidity and balance sheet capacity, enabling the flow of credit to households and businesses of all sizes.”
Pagnai says this ultimately lowers the borrowing costs for consumers and businesses, providing a flow of credit to support the financing of houses, cars and other goods and services which can ultimately help get the economy back up and running.
But, he says, after the GFC investors have been naturally fearful of entering the US housing market.
“The large-scale, low-cost access to AAA funding that enabled private securitisation to compete with government-backed options has not returned to the market and we do not anticipate it will,” Pagnai says.
“Instead, the RMBS market that emerged consists of a large variety of smaller sectors representing niche exposures to various portions of the single-family housing market.”
He says this includes loans to self-employed borrowers, that have been through some form of modification, and to investors who rent the underlying home.
“This variety allows an investor to choose the portions of the consumer and housing stock that they believe are fundamentally attractive and can provide a diversified source of return to an investor’s portfolio,” Pagnai says.
However, Franklin Templeton’s Siniakov says that it is unlikely Australian retail investors will be able to access these more niche asset classes, as it’s simply too difficult in our current domestic market.
“The challenge for retail investors is that they actually need intermediaries between them and the eventual market and asset classes,” he says.
“The value chain; financial advisers, research houses, fund managers, we’ve all got a role to play in educating but also taking responsibility for the decisions on what the ultimate exposure to this asset class is, and I don’t think there is any getting around that.”
But in the US, Pagnai believes the residential mortgage market will continue to thrive, despite the current economic issues facing the world.
“Market valuations typically overreact during periods of high uncertainty, discounting much more pain than will likely materialise. As uncertainty fades, prices often come roaring back,” he says.
“Recoveries have yielded outsized returns; holding and adding to credit allocations through downturns has been rewarded handsomely in the past. Security-specific opportunities open up.
“Fear, forced selling and other factors create dispersions that credit pickers can potentially capitalise on.”
Pagnai says an interesting sector to watch within securitised credit is consumer asset-backed securities (ABS).
Employment figures are generally a key driver of performance for these assets and with unemployment at historic highs, the short-term outlook for many parts of the sector is bleak.
“While remittance data lags, early indications already show declines in prepayments and increases in payment extensions,” Pagnai says.
“However, we believe payment modifications and government stimulus payments to consumers will limit actual loan losses. This may very well be a rewarding contrarian bet to make.”
Watson agrees the securitised credit market is certainly one example of where investors can capitalise on mispricing in credit markets.
“We believe the speed of the recovery will vary globally and there will be a divergence in performance of sectors and regions,” she says.
“There is a strong opportunity to create value both by investing Credit Dislocations strategies which have the ability to rotate when opportunities emerge through the recovery, along with individual credit sectors which are supported by government stimulus.”
Brian Matthews is the managing principal for the Payden & Rygel Global Income Fund, based in the US.
He says the securitisation market in the US allows for significant investment opportunity when compared to Australia, or the rest of the world for that matter.
“The securitisation market in the US is broad in scope, including collateral types such as consumer and commercial ABS, residential and commercial mortgages, and collateralised loan obligations,” Matthews says.
“This opportunity set allows investors to achieve objectives across both the credit quality and maturity spectrum.”
Matthews says the maturation of the securitisation market has fostered interest from the global community, improving both transparency and liquidity.
“In recent years, Australian investors have increasingly viewed the US securitisation market as a good opportunity to improve diversification and reduce correlation within a portfolio that more readily contains traditional asset classes such as corporate credit or equities.”
Looking outside the banks
While it is fair to say the Australian market is somewhat lacking, it hasn’t stopped others from taking a different approach.
Crescent Wealth is Australia’s only APRA-regulated Islamic compliant super fund, actively avoiding investments in industries such as gambling, alcohol, tobacco, weaponry, and importantly interest-earning organisations.
As chief investment officer Jason Hazell explains, there are opportunities to have a fixed income element to a portfolio while avoiding the banks and insurers.
“As you can imagine, the asset allocation of Crescent Wealth is quite different than your average super fund,” he says.
“Beyond the banks and insurers, we also avoid highly leveraged sectors of the economy and we have particular debt to total asset limits in our portfolio that we can’t go above.
“We also try to avoid speculation, so we like to invest alongside our companies with a long-term perspective.”
Hazell says these limitations lead the fund to have a bias towards tangible assets, particularly those with a strong community benefit and positive social impact.
In the fixed interest space, Crescent instead invests in sukuks; an Islamic financial certificate that complies with Sharia law that is similar in fashion to a bond, however involves asset ownership instead of debt obligations.
“Sukuk is essentially a certificate sold from a Sharia compliant bank or company and rather than paying interest it pays a profit share,” he explains.
“So, I own a portion of the access or activity that you are planning to use the money for. It still behaves likes a bond in that you are contractually obliged to buy that act from me at the end of the contract.”
Sukuks are not issued anywhere in Australia however and come from emerging markets, like the Middle East, Malaysia and Saudi Arabia.
In a sense, sukuk is similar to emerging market sovereign debt, Hazell says, issued by an Islamic compliant bank that is already Sharia compliant in its own business.
Despite already having a somewhat of a default tendency towards ESG, green sukuks have started entering the market, and Hazall says the Australian government should look to issue its own.
“It’s never done so before but it would open up funding sources offshore from Muslim countries who are interested in investing in Australia,” Hazell says.
“It would be fascinating to see the Australian government issue a green sukuk.”
Hazell says we’re starting to get to a point where superannuation is being opened up for the Muslim community, and despite the strict rules the fund abides by, its conservative nature helped it weather the recent downturn nicely.
“We have a lower risk portfolio, we hold more cash, we exclude negative social impact areas which I think is common sense anyway,” he says.
“Australia is obviously headed in that direction but the market is very slow. So, we’re ahead of that curve and ethical funds have done really well in the COVID-19 downturn.”
Even locally, there are some non-bank options available for investors looking to enter the corporate loan market.
Metrics Credit Partners managing partner Andrew Lockhart says the company set out to create a product that gave a broad range of investors exposure to private market loan assets that was in a vehicle that could be traded to give liquidity.
As a result, it was the first corporate loan lender in Australia to list an investment trust on the ASX in 2017.
“We needed to find a way that investors could get the liquidity from the asset class and still get exposure and generate income,” he says.
“We launched the listed vehicle on the exchange so investors could buy and sell units in the fund to allow for that liquidity.”
Lockhart says that by moving just slightly along the risk curve from bank term deposits and government bonds to corporate loans, investors could obtain reliable returns between 4-10% a year.
He says that corporate loans have a low correlation to other major asset classes including equities, government bonds, hybrids and term deposits, providing an excellent source of portfolio diversification for investors.
“They also have good security, being ranked ahead of equities should something go wrong with the company,” Lockhart says.
“In contrast to most fixed income and term deposits, they can also provide daily liquidity if invested in through an ASX vehicle.”
Regardless of conditions in equity markets, Lockhart explains, Australian corporates still have to borrow and refinance their loans and continue to pay interest on current loans.
Time to redefine
The fixed income market in Australia is going through a phase of change, and the once stock standard defensive allocation is gaining a raft of new options.
Siniakov believes we need to redefine portfolio construction and bring return expectations back down to earth.
He says it’s unfortunate that fixed income in seen as “boring” with its purpose in life to just act as the safety net for the other segments of a portfolio.
“We’re always looking across to our cousins in equities and think ‘what are you doing?’,” he jokes.
“They’re looking at a company like BHP and decidingto buy or sell and waiting for the share price to go up or down, but I could lend money to BHP instead for the near term if I only have short term confidence or years if I’m feeling more confident.”
Fixed income, he says, allows you to take the exposure that you really seek and avoid those that you’d prefer not to have.
“Fixed income lends itself incredibly well to active management, and I think good active managers have shown that over the decades,” Siniakov says.
Globally, we are now in a near-zero cash rate environment, but the expectations Australians have for returns has not changed to suit the current environment.
While it’s not entirely appealing, investors and consumers need to realign their expectations when it comes to their investments.
“A lot of allocation theory is based on research from the mid-1960s and a lot has changed since then. In some areas people are using traditional models that were developed 50 years ago for a different set of financial markets,” Siniakov says.
“I really implore everyone to rethink the way we should be allocating client assets across the spectrum and change the mix of equities and fixed income.”
Theobald says this is exactly what he has been doing with his clients, encouraging them to have a three-year cash buffer, ensuring there are aspects of their portfolio that won’t see negative returns.
“We’d rather reduce risk and the chance of a negative return from that component of the portfolio,” he says.
“That gives our clients certainty and they’re more comfortable understanding that the rest of the portfolio has got a more balanced approach.”
Financial Standard, 30 June 2020. Author: Eliza Bavin.
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