As markets adjust to the new norm of unconventional policy measures, we discuss trading implications and how best to position portfolios.
This document has been prepared by FIIG Investment Strategy Group. Opinions expressed may differ from those of FIIG Credit Research.
While it’s too early to call 2021, a year of recovery, investors should have a somewhat clearer picture of what’s in store.
Last year central banks and governments demonstrated they’re willing to do whatever is necessary to stabilise their respective economies, which looks set to continue throughout this year.
Domestically, the Reserve Bank of Australia (RBA) has lowered the key overnight cash rate, 3-year yield curve target and bank lending facility rate to 0.10%. It has also extended its bond buying program by $100bn from mid-April.
Unconventional monetary policy measures such as these have had widespread implications on markets and investor sentiment. In this article we focus on what this implies for fixed income portfolios.
Recent market movements have highlighted that not only can financial markets and central banks can be at odds with each other, but investors seeking ongoing income from their fixed income portfolios shouldn’t be overly concerned about such movements.
Headlines of late have discussed the relatively sharp yield curve steepening, as longer dated Australian Government bonds have sold-off in price. At time of writing, the yield on the Australian 10-year benchmark Government bond has more than doubled since November.
However, this volatility does not impact the issuers’ legal obligation to pay ongoing interest and principal repayment at maturity, and such market swings are only relevant for investors who require monthly mark-to-market valuations.
The current market and steepness of the yield curve has presented many buying opportunities in a range of fixed income instruments.
Fixed coupon bonds
With current RBA stimulus measures, we see value in longer dated fixed coupon bonds over floating rate exposures for portfolios, although a well-balanced portfolio should always have an allocation to both types of instruments, along with inflation linked bonds. In our view, an allocation to floating rate notes provides a readily available pool of capital which will be far less sensitive to base rate movements (hence provides more price stability) and can therefore be readily redeployed as new opportunities present themselves.
Yields on short dated Australian Government bonds are anchored by yield curve control, however longer dated Australian Government bond yields have drifted higher on positive sentiment, market positioning and heightened inflation expectations. The 10-year Australian Government bond yield has lifted above its pre-COVID-19 levels, as it prices in a future state of normalised monetary policy. Many commentators still see this move as premature.
Traditionally a rising rate environment we would expect a preference from bond investors for floating rate notes, and resulting steepening of the yield curve would result in lower capital values on fixed coupon bonds. However the current steepness of the yield curve offers opportunities in longer dated fixed coupon bonds for a number of reasons.
With central bank bond buying programs draining the supply of bonds from the market coupled with strong demand from bond investors seeking higher returns, credit spreads, particularly on investment grade corporate bonds, have tightened and we believe this trend will continue over the year.
The credit spread is the additional amount over the risk-free rate investors are paid for the perceived creditworthiness of the issuer of the bond. Keeping in mind, that as credit spreads contract, yields will also tend to compress and there is a capital price appreciation on fixed coupon corporate bonds.
The chart below shows the yield on the AT&T 2028 bond, an investment grade fixed coupon corporate bond, continuing to tighten against the widening of the 10-year Australian Government bond yield. The AT&T 2028 bond price has been relatively stable compared to that of higher rated government bonds.
In addition to this, the steepness of the yield curve means there is a larger differential between certain maturities. As a bond approaches maturity, the benchmark risk-free yield will also decrease, and the price of the bond will become less volatile. Importantly, as the RBA continues its yield curve control (YCC) for short dated securities, one end of the yield curve is anchored and the other may rise as we have seen, but also fall again in times of market distress.
To illustrate, while the RBA’s yield curve control is maintaining a yield differential of less than 5 basis points (bps) between the 1-year and 2-year maturity, the difference between the 6-year and 7-year is much wider at 30bps, assuming all remains constant, the price of a bond would rise as we move through time to reflect the lower risk-free rate. This strategy is referred to as ‘rolling down the yield curve’.
The table below shows the 10-year Australian Government bond currently yielding 1.05% more than the 2-year bond yield, but this differential is expected to grow to 1.20% by the end of 2021. With the passage of time, the significant drop in the benchmark risk-free yields will see capital appreciation. This along with credit spread tightening is expected to offset any capital price weakness from yield curve steepening.
In terms of portfolio allocations, all longer dated fixed coupon bonds (Australian Government bonds, corporate investment grade and higher yield bonds) will benefit from ‘rolling down the yield curve’. We prefer larger core holdings to be of investment grade quality, as investment grade bonds exhibit lower levels of volatility than high yield bonds, although they are more exposed to duration risk.
Only corporate bonds exhibit credit spread tightening, although despite this and the sell-off in Australian Government bonds, they remain important in portfolios to hedge against volatility. When the economic outlook is optimistic, Australian Government bonds tend to sell-off (as is the case currently), however in times of uncertainty they will protect a portfolio and will improve in price.
Methods to increase yield
Accommodative monetary policy has pushed rates to record lows, forcing investors to take higher risk while seeking higher returns. We believe moving down the capital structure for quality issuers, adding selective high yield securities and including Residential Mortgage Backed Securities (RMBS) in portfolios will help generate excess return.
There is a positive correlation between risk and return, where better returns can be achieved by taking incremental risk. Incrementally increasing the credit risk is one way to generate higher returns. Credit risk can be increased by investing in junior ranking securities issued by larger investment grade rated companies or through investing in bonds with sub-investment grade credit ratings or unrated bonds.
The capital structure for a bank or corporate issuer ranks the debt in terms of seniority and risk, whereby lower ranking securities are inherently riskier. After equities, they bear the first losses and are the last to be paid in an administration event. As such, the expected long-term return increases moving down the capital structure.
However, if an investor is comfortable with the credit risk of a company, and believe there is a high likelihood of receiving all coupons and capital back, then likewise there should also be some comfort investing lower down the capital structure for that same issuer.
We see value in Corporate Hybrids and Tier 1 Capital instruments. Each have their own features that investors should be aware of prior to investing. These types of securities are generally issued by large banks, insurers and selected larger corporates with investment grade ratings.
As mentioned earlier, another way to increase credit risk is by adding selective high yield positions to increase returns. Not all high yield credits have been equally impacted by COVID-19, and where some are still facing headwinds, others have recovered from a credit perspective but, in certain instances, their capital price recovery has lagged.
The last traded price and level of liquidity is a good indication of which of the above categories the credit falls into. Also consider the sector exposure of the credit, where FIIG’s Research Team sees a favourable outlook for the property sector and financials, and infrastructure remains a non-cyclical defensive sector.
While there remains ongoing uncertainty, high yield positions should be added selectively in smaller exposures to well diversified portfolios. This will help mitigate the additional credit risk.
We believe RMBS securities present value as they offer a premium over similarly rated corporate bonds, without taking on additional risk. Structured securities are more complex and perceived to be less liquid than corporate bonds of an equivalent rating, and investors are paid a higher return as a result.
This is primarily because of a smaller pool of investors buying these securities and issuers being less price sensitive for lower-rated tranches (RMBS tranches would typically have at least 80% of their notes rated relatively high), meaning that a price differential on a lower rated tranche would have very limited impact on the overall debt cost of the transaction. For example, a BBB tranche in a RMBS prime transaction would represent less than 1% of total notes, meaning a 100bp price premium would impact the overall cost by less than 1bp.
RMBS securities are essentially a larger number of mortgages pooled together, issued via a tranched capital structured and supported by the underlying cashflows from mortgage repayments.
These types of instruments aren’t as widely traded as vanilla corporate bonds due to their structured nature, and at times of market stress there can be limited liquidity. However should an investor remain comfortable with an RMBS position and are investing with a longer timeframe, then the lack of liquidity isn’t relevant.
The chart below shows the return on the Liberty 2021 fixed coupon corporate bond, compared to the Liberty 2017-3 Class F notes RMBS. For the same rating, the RMBS notes offer a higher forecast yield than that offered by the vanilla corporate bond offers.
The RBA Board does not expect inflationary pressures until 2024 at the earliest and as such we see value in longer dated inflation bonds, with the lack of new issuance likely to improve the capital price with growing scarcity.
We consider Inflation linked bonds to be a core portfolio holding, while offering investors a cashflow in step with the rate of inflation, they are also generally of a higher credit quality.
New inflation linked bonds are no longer issued due to funding changes following the GFC, making the existing bonds valuable from a scarcity perspective. Despite the real yields of these bonds being quite low, once adjusted for inflation, they offer yields in most cases above those offered by equally rated vanilla bonds.
While these bonds remain tightly held, we see the longer dated inflation bonds as interchangeable in terms of similar credit exposures and would suggest purchasing where supply is available.
Despite the year ahead being expected to offer more clarity than the prior, there remains ongoing uncertainty and volatility. While the above strategies will help position portfolios to take advantage of trading opportunities, a diversified portfolio remains key no matter what the year may bring.
A highly diversified portfolio (across maturity, issuer, rating, currency, and instrument type) will help preserve capital and achieve returns.
Unlike other asset classes, such as equities, a well-balanced fixed income portfolio will dampen volatility in both times of strong economic outlook and also during times of downturn. Australian Government bond prices will improve with market uncertainty, as investors look to de-risk and seek safer options. Counter wise, high yield bonds will exhibit volatility, and capital price weakness as a result.
In an economic recovery, Australian Government bonds will sell-off in price terms as investors are more confident to take on risk, and high yield bonds and corporate investment grade bonds will see capital price improvement on credit spread contraction.
Constructing a portfolio across a mixture of maturities, issuers, and instrument types, with different currency exposures and across the credit rating spectrum will ensure it’s well positioned for the year ahead.