July has been a big turnaround in all markets since the lows of the first half.
In particular, bond markets have begun to price in lower terminal rates (the final rate level when the central banks finish their hiking cycles) due to the likelihood of these hikes causing either a recession or severe economic slowdown.
The US actually is technically in a recession, having just posted its second consecutive quarter of negative GDP growth, although the academics (ruled by politics as usual) haven’t yet declared it officially. It is a strange one though with unemployment still at multi year lows, which is unusual.
This chart of the 5-year Australian government bond yield shows how this has impacted the market – down about 1% since the mid-June highs:
As such the yield on some of the recently included bonds has moved lower – the AAA rated covered bonds from last month being a case in point.
However, with a bumper $1bn new fixed rate issue from NAB coming at the end of the month, which was screaming value, we still managed to make positive changes to the relevant portfolios. We will keep any eye on how this plays out with regard to the fixed/floating mix of the portfolios, but for now the decision to stay in fixed rate bonds looks to have been a good one.
Conservative portfolio:
This portfolio is all investment grade and all AUD.
The current portfolio yields 5.25% and consists of ten bonds of roughly equal weight by value to total an approximate $500k spend.
As mentioned above we are keeping the covered bond in the portfolio for the time being given its credit quality despite the yield coming down pretty significantly in the last month. We will keep this on the radar for switches should any other attractive bonds of similar quality turn up.
The single change this month was the switch of the CBA Tier 2 bond for the newly issued NAB equivalent. Just 4 months longer but yielding 0.8% more, this was a like-for-like switch that delivers value.
At some stage in the future when we see the possibility of recession in Australia (our yield curve inverting would be a strong signal) then we may bring the QTC 2033 bond (or equivalent) back in for the duration, but it feels a little early for this just yet.
Balanced portfolio:
The Balanced portfolio adds higher yielding bonds to the base Conservative portfolio to achieve a higher yield, while maintaining a balance between risk and return, skewed towards preserving capital rather than chasing yield.
It aims to have between 15-20 positions, with the high yielding bonds in smaller parcel sizes (comprising 38% of the total portfolio) to reflect their riskier nature.
The current portfolio has 16 bonds, yields 6.34% and is an approximate $580k spend.
Similar to last month, as the Balanced portfolio is slightly different to the Conservative in the investment grade segment, we didn’t own the CBA Tier 2 bond. This meant that we instead switched out the Macquarie 2027c Tier 2 bond for the NAB. Rated slightly lower, this meant the yield pick-up was around 0.20%. However, this is the way to actively manage bond portfolios.
Rarely should a wholesale shift from one allocation to another take place if the portfolio is well constructed in the first place. Instead, adding incremental yield in a measured way is typically the best way to increase risk adjusted returns over time.
As the portfolio contains a portion of high yield, the continued slight widening of high yield credit spreads has managed to keep the yield of the portfolio up as base rates have fallen dramatically (shown above). This shows the value of an allocation to high yield (again always in a measured way) to maintain/increase overall portfolio yield.
High Yield portfolio:
The High Yield portfolio looks to generate a high yield while still looking to have a bias towards as low risk positions as possible.
This is achieved by good diversification and attempting to identify fundamentally mispriced bonds.
The current portfolio has 17 bonds, yields 8.92% and is an approximate $520k spend, demonstrating the concept of greater diversity in higher risk positions.
The Lucas bond is due to mature at the end of September. With such a short time to maturity the yield on an annualised basis was represented as >22%, and as such not really representative of the actual cash yield which is closer to 2% for the 2 months remaining. As such we removed this position from the portfolio in anticipation of including a new AUD high yield bond should one pop onto the radar.
As mentioned above high yield spreads, particularly in the US, have widened somewhat while base rates have fallen. This reflects the continued pricing in of a hard economic landing and recessionary conditions which are typically linked with tougher times for high yield issuers.
These conditions can also throw up opportunities such as with Nickel Industries. After being repriced dramatically lower due to the short squeeze on take-off partner and major shareholder TsingShan, recent results have shown the company continues to perform strongly and execute operations very well. At a yield of over 10% for just 20 months this looks like a very good risk/reward opportunity.
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