I'm Jorden Brown, and this is Capital Ideas. At a recent industry conference, the statement bonds are back was made a number of times. And while that might well be the case, I'm still hearing some scepticism from advisors and investors after what happened in 2022. Today I'm joined by Haran Karunakaran from our investment specialist team. We plan to explore why it's important to get beyond these myths and realize the value in fixed income right now. So welcome, Haran.
Haran Karunakaran: Thanks, Jorden. Glad to be here.
Jorden Brown: Okay, we've mentioned 2022, why don't we start with what happened there?
Haran Karunakaran: Yeah, that's the obvious place to start. 2022 was clearly a very rough year for bond investors. And it's important to unpick that as you think about how to look at bonds going forward. The key thing I'd highlight, I think is how unique a year 2022 was. It was a year where bonds and equities both sold off at the same time. And to see that happen in a single calendar year, you have to actually go back about 50 years. So, it's a very, very rare thing. And what caused that to happen? Well, the way I see it is, we were coming out of a period of about a decade of very easy monetary policy, quantitative easing zero rates, we all know the story. And a lot of that was unwound in the period of 12 to 18 months. So, we saw one of the most aggressive rate hiking cycles we've ever seen. And that naturally, led to a sell-off in bond markets, and also equity markets. The other thing that was really unique is this rate hiking cycle happened off a base of almost zero. So normally with bonds, there are two elements to their returns. One is the income yield that you're getting, which is pretty steady. And the second is price appreciation, which is more volatile – that income yield provides a good buffer against the price volatility, except when the income yield is near zero. So that disappeared. So, that was a pretty unique environment in 2022. And I think as we look forward, we see a very different scenario. Global bonds were yielding less than 1% year ago. Today, it's about 5%. So that income buffer is back, and it's much stronger. So, that will provide a lot more diversification within the bond portfolio going forward.
Jorden Brown: With 2022 in the rear vision mirror, what do you see happening in fixed income markets right now?
Haran Karunakaran: Well, I think you said at the beginning, Jorden, bonds are back. That's really what we think. And for me, it's the first time I think, in about 15 years that I've actually been able to say that, as we look at the environment today, I think that income buffer we talked about is really the crucial thing to keep in mind. The consequences of the Fed and other central bank's raising rates over the last 18 months is the starting point today is much better yields 5-6% on high quality bonds. Why does this matter? Well, I think there are three reasons. One, the obvious one is it gives an income stream to investors, particularly important for those retirees, pre retirees who are relying on that income stream to finance their lifestyle. Secondly, that buffer I was talking about, you know, 5% starting yield gives you a lot of protection against rates rising a bit further, and prices going down. So, if you think of that 5% starting yield, we actually think over the next 12 months, it's hard to see a scenario where bonds provide significantly negative returns. And the third thing is diversification. Diversification is a key role bonds play in portfolios. How that works in practice, is when the economy is going, going bad, equity markets tend to sell off, central banks will step in and lower rates. And that gives you an uplift in bond prices. And you get a negative correlation between equities and bonds. When central bank rates are at zero, there's no room to lower those rates. So, you lose a lot of that diversification benefit. Today, the RBA cash rates at 3.85%. Fed funds rate at 5.25%. Plenty of room for those rates to come down if there is a is a severe recession. So, we think that diversification role that has largely disappeared for the last decade is now also back. So just to sum up again, three things that we like about bonds now, the income stream, the buffer against price volatility, and the diversification role they can play in portfolios.
Jorden Brown: Okay, with that backdrop, how should advisors be thinking about fixed income portfolios right now?
Haran Karunakaran: Well, let's start with our broader macroeconomic view. I'd say overall, we're quite cautious. Inflation around the world is starting to trend down. That's been the big problem that economies have faced over the last year or so. But it's still well above where central banks would like them to be. So, we've seen in the US as an example, inflation go from 9% to around 5%. The Fed targets 2%. And that last gap closing that last 3% is the toughest bit in controlling inflation. So, there's a scenario I guess, where central banks will keep having to do things to keep inflation under control. And that's going to be challenging for the economy. So, on the economy, our view is that we're likely – more likely than not – to see a recession in the next six to 12 months. Obviously, that'll be challenging for the more risk- oriented parts of investment markets, equities, etc.
Many smart people out there are talking about a soft landing, where we kind of thread this needle of bringing inflation down while maintaining economic growth. When we look at history, we find that a really hard scenario to envisage, we've done some studies where we look back at about 70 years of rate rise cycles. And over that entire period, there's only been two periods where rate hikes have not led to a recession, the mid 80s and the mid 90s. And the unique thing about both of those periods was that inflation was actually quite low. So, the central banks were tightening pre-emptively, before inflation could out of control. I think everyone would acknowledge that we're well past that, in today's cycle, the central banks, if anything, they've come in quite late. So, what does this cautious outlook mean for investors defensive portfolio or defensive part of their portfolio rather. I think most importantly, it means the defensive portion is much more important than it has been in the last decade. Over the last decade, an investor has benefited just from being leveraged to equity beta. And it's been a kind of one way ride up in markets going forward, we really think that's going to be quite different. Volatility will come back in equity markets, we've seen that last year, we think we'll continue to see that coming through. And that means it's important to have this defensive ballast to offset some of that equities. The second thing I'd say there, it's really important that the defensive allocation is actually defensive. We've seen a huge drift in portfolios. Particularly in Australia, I think over the last decade away from that true defensive allocation, as people shifted more towards lower quality credit, private credit in some areas as well, as they were looking for yield in a low return and low rate and low return environment. As we look forward, thinking about a defensive allocation, there are two really crucial things to be thinking about. One is capital preservation. So, investing in high quality bonds that are unlikely to default and cause you to lose your capital, that could be sovereign bonds, could also be high quality corporate bonds. And the second is duration. Duration is crucial in a portfolio, it's what gives you your diversification against equities. So, we think now is the right time for clients to start adding more duration into their portfolios.
Jorden Brown: You've just described some potential clouds on the horizon. Would we be better off just investing in TDs?
Haran Karunakaran: It's a good question. Yeah, I've been traveling around the country meeting advisors over the last couple of weeks. And I think that's the that's the number one question I've gotten. So, I'd say the uncertainty that we see affects different asset classes differently. The uncertainty has consequences for equities, which are likely to be negative, you see some volatility there. But actually, the uncertainty is probably going to be positive for fixed income. So, if you're thinking about your defensive allocation, and choosing between term deposits and fixed income, today, I'd say fixed income is probably the better allocation, but specifically, a high-quality fixed income allocation with some duration in it. So, we recently did some analysis where we looked back at about 30 years of rate cycle data and compare the returns and Australian term deposits versus global corporate bonds. And the results are really interesting. So, on average, over a cumulative three-year period, if you invest at the peak of the rate cycle, so just at the point where there's a last rate rise, a term deposit will deliver about 25% per annum over three years, sorry, 25%, cumulatively over three years; investment grade, corporate bonds, will deliver about 45% over those three years. So, that's quite an uplift from investing in bonds or the other way to look at it, quite a lot of returns you're missing out on if you stay in term deposits. Of course, the challenge with that analysis is no one ever knows where exactly the right point to invest is where that peak is. So, then we looked at what happens if you invest too early in bonds. So, while rates are still going up, or if you invest too late, well, after rates have started to come down. Interestingly, investing too early doesn't actually cost you that much. On the bond side, you end up with about 40% returns over that three-year period. On the TD side, it's still the same at about 25%. If you invest too late, it costs you quite a lot. You're down to about 30% on the bond side. And that's because after a rate hike cycle, you typically see cuts which is a tailwind for bond investors. So, overall, I think the environment today is much better for bonds and term deposits. A, because you earn a slightly higher rate running yield on the bonds versus term deposits. And over a few years that can compound into something that makes a substantial difference. And B, as we go into an uncertain economic environment, the odds of rate rises are probably much lower than the odds of rate cuts. And the latter will give you a boost in your bond portfolio.
Jorden Brown: I can see how the math works for sovereigns. But what about corporate bonds?
Haran Karunakaran: Well, for corporate bonds, I think it really depends which part of the corporate bond universe that you're talking about. You focus on high quality corporate bonds; we actually think they'll be pretty resilient through a recessionary cycle. For a few reasons. So, if you just think of the maths first, the basic bond maths in risk off type scenarios like recessions, what you tend to have is a widening of credit spreads, credit spreads today on investment grade credit about 150 basis points. In a recession, you'll typically see them go up to about 200, or 250 basis points in really bad recessions. So that's a widening of spreads or an increase in yields of 100 basis points. That leads to a capital loss if it happens in isolation. But in reality, what will happen in a bad recession is the central banks will likely cut rates as well. So, if you have a scenario where the spreads are widening by 100 basis points, but central banks are cutting rates by say 100 basis points, it nets off to being equal and the impact is net neutral on prices. But you still continue to earn the higher running yield that investment grade credit offers you.
The other thing I would say here is when we look at corporate fundamentals, we see a picture that’s much better than, typically, what you see going into a recession. So, companies have increased the amount of cash on their balance sheets, their overall position much more defensively, they have much less leverage than they did a year or two ago. So, all of that will, of course worsen through a recession. But the starting point is much more attractive than we typically see. And that gives us confidence that the high-quality end of the credit market will have a bit of resilience over a cycle. The low quality and the high yield part non-investment grade part of the corporate bond market is an area we’re a bit more cautious on, so in our multi sector credit funds were typically underweight, high yield. Again, there are certainly opportunities there that you can find, but really only suitable for a client who can weather a fair bit of volatility and has quite a long-term holding period to extract the rewards from that investment.
Jorden Brown: You mentioned duration. A lot of the advisors that I speak to think of duration as almost like a dirty word. Is now an important time to leave that myth behind.
Haran Karunakaran: Yes, I think definitely, this is the time to leave it behind. I can totally understand why for many years, advisors in Australia have shifted away from duration. You know, as I mentioned earlier, in a low yield environment, the diversification potential of duration diminishes a lot. You also weren't getting paid much to hold duration, because yields were so low. So, it definitely makes sense to reduce that exposure. And in Australia, what you saw was clients moving much more into floating rate, credit and private credit, which have less duration. As we talked about earlier, things are very different today, the yields having risen, we’re into a much more traditional environment for bonds. And the thing that I'd emphasise again here is when we talk about bonds as a diversifier in a portfolio, it's really the duration that gives us that diversification, it gives that's what gives it the low correlation to equities. We could talk through the bond math, which is a bit technical, but it's easier to just think about the intuition here. When an economy struggles, and equity markets doing badly central banks tend to cut rates, that's positive for bond prices, bonds move in the opposite direction to equities. And that's the negative correlation there. When central banks can't cut rates, because they're at zero, you lose a lot of that diversification benefits. But now with yields where they are, and central bank rates lifted quite significantly, they have that potential to cut again. A couple of other things that I'd say around the topic of duration. So, one is that it's important to realize that not all fixed income gives you that duration and that diversification. So mentioned earlier, floating rate credit, private credit, both areas really popular with advisors in Australia, you know, nothing wrong with investing in those sectors, but you should just be aware that they don't come with a lot of that duration protection. So, over time will tend to be more positively correlated to equities than a traditional bond portfolio. The second thing, and this is a conversation I was having with a lot of advisors last week, how do you add duration into the portfolio? I think the go-to for many people is sovereign bonds. And that makes sense. That's definitely a valid option. What we actually favour in the current environment is high quality corporate bonds. The reason for that: they're high quality so your capital loss risk is limited. If you look, historically, investment grade corporate bonds have a default rate of about one and a half percent. And on that one and a half percent, you're getting a 50% plus recovery rate, typically. So very, very little risk of losing your money. If you invest globally, in corporate bonds, it gives you significant duration exposure. So, the global corporate bond index today has about six years of duration. So that gives you that diversification that you're looking for. And finally, and probably most importantly, in the current environment is that, on top of giving you that defensiveness, corporate bonds also give you a bit of a yield pick up over sovereigns. So, depending on which market, you're talking about a 150basis point pick up, which again, doesn't sound like a lot, initially, but when you compound that over multiple years, it adds up to a really big difference in a client's portfolio.
Jorden Brown: So right now doesn't investing in bonds lock in a negative return after inflation?
Haran Karunakaran: So, I would say, actually the exact opposite. This is the first time in quite a while many years that I've seen positive real returns or inflation adjusted returns or yields on bonds. I think the important thing to here is here is to understand what a real return actually means and how to calculate it. If you think the current inflation rate of 5% will persist over the long term, then to calculate a real yield on a bond, you would take that yield, say three and a half percent on a 10 year government bond in the US subtract the 5% and that gives you a negative real yield. And that's what many advisors have in their head. But I would argue that not many people actually expect 5% inflation to persist for a long time. If you look at inflation linked bond markets, and what they're pricing in, it's more like a 2% inflation rate over the next 10 years. So again, if you take a 10-year government bond, yielding three and a half percent subtract, that expected 2.2% inflation rate over 10 years, you end up with a pretty attractive, positive, real yield of about 1.3%. So, that's a decent rate of return that you're compounding over many years. And we'll also remember that this is in the defensive part of your portfolio. So, you also hopefully have a good growth allocation, which is going to give you an even bigger boost on your return over inflation.
Jorden Brown: Okay, Haran, we might change tack a little, one of the questions I'm getting from a lot of advisors is around whether to invest domestically or offshore. Is it time to focus our portfolios domestically?
Haran Karunakaran: So, I think there's actually a lot of value investing in the fixed income markets globally. And particularly when it comes to corporate credit. And the main reason there, I think, is the diversity of issuers in the global market versus the Australian market. And the breadth of opportunity that there is for an active manager to find those undervalued bonds that will go up in price. So, if you look at the global aggregate bond index, there's about 16,000 companies that are issuing debt in that index. So, 16,000 opportunities to find attractively valued bonds. In the Australian aggregate index, it's closer to about 200, much smaller scale, fewer opportunities to look for. The other thing I would highlight is that in the Australian corporate bond market, in particular, it's heavily dominated by banks. They're one of the biggest issuers of debt. And for a typical Australian client, what you tend to find is that they have an Aussie equity portfolio, which has a skew towards banks, because banks dominate the equity market, they'll often have a hybrid allocation, which is also linked to banks. And then if you're adding Australian corporate credit on top of that, you're tripling down on your bank exposure. So, I'd be really wary of that sort of industry concentration that you may not be aware that you're getting in the portfolio. And investing globally allows you to just avoid those sorts of risks.
Jorden Brown: I guess in summary, we've got a strong income stream providing a buffer for volatility and a diversification from equities, potential uncertainty is likely to be positive for high quality fixed income. And we're in a more traditional environment for fixed income where duration should provide strong diversification benefits. And I guess finally, bonds are back and hopefully we put a few of those missed to bed. Before we go, we're always trying to get better. So if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@capitalgroup.com. Bye for now.
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