Will 2019 be a good year for bond investors? In this note Asmita Kulkarni, Director Investment Strategy Group explores some key themes
Making predictions at the beginning of a year is always difficult, but big 2018 events, which left investors feeling vulnerable, gave us a glimpse of what 2019 might hold.
At times trading conditions last year were quite tumultuous. We expect this trend to continue with sporadic peaks in volatility and periods of illiquidity.
In the current environment we would suggest investors focus on the whole portfolio with particular attention to:
- Capital preservation
Focusing on your bond portfolio - we would suggest a core holding should be made up of lower risk, high conviction positions. The yield erosion from this can be balanced by holding high yield bond positions that generate excess return.
Key themes include:
- Reduce risk, prefer higher grade investments to high yield.
- US rate hikes are nearly complete and the chances of a hike here have reduced, so we suggest re-evaluating longer dated, longer duration fixed rate bonds.
- Make sure your portfolio reflects your risk tolerance.
- Consider sectors where our Credit Research team has an Overweight recommendation such as Infrastructure and Financials.
We expect increased uncertainty to continue creeping into markets. Uncertainty usually leads to volatility and we believe events such as the equity market correction seen in late 2018 will become more frequent in the short to medium term.
Periods of temporary reduced liquidity are also likely to start becoming more frequent.
When a market is illiquid, it takes longer to buy or sell a bond or the spread between where a security can be bought and sold widens.
Historically, bond markets have been less volatile than equities, though high yield (HY) bonds do exhibit higher levels of volatility than high grade or investment grade (IG) securities. The market expects credit spreads will creep higher over the course of 2019.
However, it is a worthy reminder that as long as a company remains solvent, investors know the exact amount of capital they will receive back at maturity, which is not the case for equities or hybrids. Wider credit spreads will also mean new issuance should come with higher coupons.
Our Credit Research team has recently updated its Macro and sector outlooks for 2019.
The broad theme from the reports is that company fundamentals are stable for now, however when the credit cycle turns, refinancing activity will become difficult for lower rated companies.
The challenging operating, economic and geopolitical landscape could also see defaults rise from low levels observed over the past two years.
Reflecting this operating backdrop, our Credit Research team has an Overweight recommendation on Infrastructure and Financials, a Neutral recommendation on Industrials and Underweight recommendation on Property.
Portfolio construction in 2019
With increased volatility we would expect to see opportunistic investment options from time to time as securities present relative value. However, we believe they will most likely will be higher yielding and should not form the core holding of your bond portfolio. Rather, these securities should be used to generate excess return.
The core holding of a bond portfolio should be in investment grade rated bonds.
Current investment grade favourites include:
- Pacific National
- Senior RMBS
- Sydney Airport
We prefer high yield bonds in non-cyclical industries such as:
- Newcastle Coal Investment Group (NCIG)
- HCA Healthcare
If you are a new investor, our sample portfolios provide a reference to how bond portfolios can be constructed with different risk tolerances and provide a guide to specific individual securities that we favoured at the time of constructing these portfolios.
With the US largely through its rate tightening cycle and Australia unlikely to raise rates in the short term, we think it is appropriate to now consider lengthening portfolio duration and allocating more to fixed rate bonds.
Finally, it is important that investors give consideration to confirm that their investment portfolio reflects their individual risk tolerance.
To discuss this further please contact your Relationship Manager or us in the Investment Strategy Group at ISG@fiig.com.au.