Head of MIPS Kieran Quaine continues to deliver outstanding results. Kieran changed portfolio allocations substantially over the quarter. We detail quarterly performance summary and Kieran shares his key investment strategies
Summary
The MIPS programs performed strongly during the quarter – a period that encompassed a stable interest rate curve and slightly weaker credit margins. Key exposure statistics and changes over the June quarter period end include:
Note: Gross returns and allocations are relevant for The Bank Bond Program until 8 March 2018, beyond that date a model portfolio is displayed
The Income Plus Program decreased exposure to non investment grade and unrated bonds by 13%, and saw a corresponding increase in senior investment grade exposure. Conservative Income followed suit, increasing exposure to investment grade senior at the expense of subordinated investment grade bonds and the Core Income portfolio allocation was unchanged. This is because Core Income could not invest in RMBS assets, and this is where the other programs derived tactical asset value.
The Bank Bond Program is now split 50/50 between senior and subordinate investment grade from a 70/30 split last quarter.
All four programs have shown positive returns in the last quarter, six months, year and annualised over two years.
Note: Gross returns and allocations are relevant for The Bank Bond Program until 8 March 2018, beyond that date a model portfolio is displayed
Future strategy/ positioning
The Portfolio Management Team (PMT) will extend portfolio duration, preferably at this stage in the highest of investment grade assets, given the view that credit spreads are under (moderate) pressure. Those higher rated assets should outperform lower rated assets. Otherwise, the predominant credit exposure strategy is to hold short dated credit with a high accrual advantages.
Our specific and most notable strategy with regards to credit exposure implementation includes the significant increase in exposure (to 20% target in Income Plus) to the Residential Mortgage Bond Sector (RMBS) sector.
The strategy has been successful in the current quarter as investment grade (IG) and non investment grade (NIG) RMBS has outperformed IG and NIG + unrated (UR) corporate debt. We look to maintain that exposure at a minimum of 15% (for Income Plus) and 6% for Conservative Income.
Key contributors to June quarter end returns
Consistent with our medium term strategy, all investment programs retained a “short duration” and “long (short dated) credit exposure” position during the quarter. This is known as a “short credit spread duration” strategy. As evidenced in our prior report, the PMT did extend duration slightly at the start of the period, in the order of a quarter of a year, believing the steep yield curve shape encouraged investment slightly longer. This was the first duration extension since base interest rates started to rise, post the last easing in monetary policy in August 2016. We stated that the economic evidence suggests the RBA will hold monetary policy at current levels for longer and that whilst the next policy move is still predicted as up, the market had priced that in sufficiently.
During the last quarter, base interest rates rallied (fell) very slightly. So while the duration extension strategy implementation contributed positively to total returns, the capital gain derived was marginal. This is evidenced by the small performance differential of 0.34% for the quarter between the significantly longer All Maturity Index and the shortest of all indices – the Bank Bill Index, see the full report for further detail. Performance returns subsequently came almost entirely from interest rate accrual, with attribution by investment category.
Clearly the decision earlier in the year to allocate a percentage of capital into the RMBS sector has delivered an enhanced return for those investment programs exposed. For Income Plus investors, the PMT has effectively diluted NIG + UR exposure for the purpose of investing in the RMBS sector. It has paid dividends. NIG RMBS delivered almost twice the return of IG corporate exposure. The IG category underperformed the NIG + UR (ex RMBS) asset categories.
Interest rate outlook
The last quarter exhibited low base interest rate curve volatility and the PMT believe the next quarter is likely to deliver the same outcome. As expressed in the last quarterly report, while interest rates have predominantly climbed since August 2016, they have been stable now at the heightened level for an extended period. It would appear there is little clear economic evidence of any significant employment growth, or immediate wage or price pressure to encourage the bond bears. Nor would it seem sufficient evidence of an impending slowdown in the current (albeit moderate) economic growth to encourage bond bulls to invest heavily at current interest rate levels.
Volatility, for base interest rates at least, is likely to remain low.
We expect that given monetary policy is being tightened in the US and Europe, but likely to be stable in Australia for some extended period of time, that it will be the $A that declines as the compensating factor. This has already occurred but could easily extend. The Australian yield curve would, based upon historic evidence, be expected to steepen in such an environment, yet with a AAA rating and a strengthening fiscal position, alongside moderate economic growth and low inflation, the Australian base (Federal government) interest rate curve could justifiably sit lower (below global peers) for longer.
In summary, the PMT will again look to extend duration longer, but will now await any weakness (or rise) in yields before implementation. Again, as per the prior quarterly report, the curve is near steep enough to entice investment longer on the curve.
Credit (margin direction) Outlook
The credit margin widening experienced by major banks in the short end, if extended into long term credit margins, will be a catalyst for change across credit product generally. That change commenced in December 2017 and is now gathering momentum.
The rise in bank bill rates above official cash, heralded, not coincidentally, the beginning of the reversal in credit spreads. The change is marginal to date. That rise is having a minor but continual widening influence for longer dated and lower rated credit. If banks need to pay more margin (excess or higher interest rates above benchmark rates) then those corporations who are funded by the banks, or compete for wholesale funds in the bond market, can expect to pay more if they borrow for longer and/or have lower credit ratings. The PMT however is positive on bank credit margins, believing the margin deterioration will be minimal, and that the accrual advantage will offset any potential (minimal) capital loss. The caveat is that bank (marketable) debt is mostly very short dated (less than or equal to five years).
This is the reason we have stayed with a short ‘credit spread duration’ as a cornerstone strategy – and one that we continue to pursue. As evidenced in the Table above, credit margins for lower rated product, other than RMBS, have widened. But whilst the margin has deteriorated (pushed wider), it has been a small move and not sufficient to offset the advantage of the high yield and therefore accrual advantage that has subsequently delivered a positive return.
Please click here to access the full MIPs June report.
Here is last quarter’s March report.
For more information, please call Marcus Blake on 02 9697 8756 or 0436 345 251