As another financial year draws to a close, it’s timely to reconsider portfolio allocations and the outlook for FY23. Here, Christopher Thomas, one of our Fixed Income Directors based in the Melbourne office shares his views on what to consider when it comes to portfolio construction and the year ahead.
With FY22 in the rear-view mirror, it’s a logical time for clients to review thoughts on their portfolio mix across sectors – and also within their bond portfolios.
It’s often stated that unlike many comparably wealthy nations, Australians do not allocate substantial capital to bonds/ fixed income. Perhaps as a result, bonds are seldom front-page news. Adding to this we have seen two decades of asset price inflation (good news) and a benign environment for consumer price inflation, and ipso facto, interest rates. Not big news.
Putting aside the ill-advised yield curve management exercise of 2020-2021, the Reserve Bank of Australia (RBA) and its Governor have been making front-page news, so what is going on here? They’re not alone in undertaking the “big unwind” and higher rates have resulted for all types of debt.
Certainly, it is tempting to look at floating rate bonds in the current times of more volatile pricing. These bonds have their income adjusting with interest rates and the bond price is quite stable. However, it is worth noting they could provide disappointing returns if the economy does not steam ahead, and the RBA doesn’t head along a very aggressive tightening path.
So, how can we hedge, while achieving an income stream at a good premium to the RBA’s inflation target? Bearing in mind the outturns for inflation have averaged 2.4% annually over the past 20 years, returns north of 4.25% are worth serious consideration. When looking for opportunities at times of instability, sage advice is to ignore the noise and focus on the basics. That is, fundamentally robust issuers that are well placed to see out the volatility.
The truth is that no one knows how long this will go on for, however stronger, higher rated issuers will always be better placed. Up until recently there was little value in the A-rated (or better) part of the market. This has turned around dramatically and has opened the door to issues that we haven’t considered for a number of years.
A similar fate has befallen Sydney Airports 2030 issue with the traded price falling from $162 to $146. At this new price this bond provides inflation uplifts and an extra 2.75%. This would equate to a yield in excess of 5.00% over the next 8 years. However, with inflation currently at 5.00% and projected to reach 7.00% at the end of 2022, buyers can expect that near term this bond will return much more than 5.00%.
The Tasmanian Government 2046 offers a once in a decade opportunity for those with a ~20-year timeframe to get income certainty without credit risk at AA+ rating above 4.50% while for those with shorter investment horizons, the Sydney Airport index linked bond is also at very attractive levels.
It’s worth noting that longer dated bonds are more sensitive to interest rate movements, which will impact the capital price. However, if an investor remains comfortable with a bond’s individual credit quality, then they should also be comfortable looking through capital price movement. Bonds also have a specific repayment date when the issuer has to repay the full principal back to bondholders.
With volatility and uncertainty set to continue as we move into FY23, it’s worth considering portfolio allocations, in particular to riskier exposures. The move higher in rates has created attractive opportunities in higher rated bonds, which provide more a more defensive portfolio exposure. Investors looking to protect portfolios against inflation or have a longer-term regular income stream are able to achieve this with bonds.