Is this time different for bonds? - Portfolio Construction Podcast
Is this time different for bonds?
Kellie Wood, Fixed Income Fund Manager at Schroders
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Bond markets are adjusting after yields moved sharply higher in the first quarter of 2021. Schroders Fund Manager Kellie Wood explores the trends set to shape markets in 2021, and explains why she believes the repricing of bonds represents a healthy reset.
Paul O'Connor: Welcome to the Netwealth's Investment Podcast series. My name is Paul O'Connor and I'm the head of investment management and research.
POC: Today, we welcome Kelly Wood from Schroders, who is a fund manager in the Australian fixed income team. Schroders is a global asset management business, managing in excess of one trillion Australian dollars of assets under management, at 31 December, 2020, on behalf of institutional and retail investors, financial institutions and high net worth clients from around the world.
POC: Schroders invests across a broad range of asset classes, including equities, fixed income and alternatives. The manager employs more than 5,000 people worldwide, operating in 65 different locations across Europe, the Americas, Asia and the Middle East. Schroders managers 5.9 billion in Australian fixed income as at 31 March, 2021.
POC: Kelly joined Schroders in March, 2007, and is the co-portfolio manager responsible for the Schroder Fixed Income Core Plus Strategy. As a senior member of the fixed income team, Kelly has an important role to play in the development and implementation of fixed income strategy across the teams product set.
POC: Prior to Schroders, Kelly spent seven years as a director with UBS Global Asset Management's portfolio management and fixed income investment team, and hence has a solid background in bond market strategy, portfolio management, and execution. Kelly holds a master's in finance from McQuarry University and a bachelor's degree honours in economics and finance from the University of Woolongong.
POC: Schroders Sydney-based fixed interest and multi-asset team is comprised of 13 investment professionals and is led by Simon Doyle who's the head of the Australian Fixed Income and Multi-Asset. Kelly's a senior member of the team and is responsible for global macro research and broader interest rate strategy across Australian and global bond markets.
POC: The team manages a number of active fixed interest strategies that include more traditional benchmark aware, fixed income, plus also absolute return strategies across both credit and bonds.
POC: There are 8 Schroder funds on the Netwealth super and IDPS investment menus, including two fixed interest funds, which are Australia's fixed income and absolute return income funds.
POC: Bond yields have been falling now for over 30 years, which has created a tailwind for capital gains and strong returns for the asset class. However, as yields have fallen to record low levels, including negative yields in some offshore markets, can the asset class continue to generate returns we have grown accustomed to?
POC: This outlook has resulted in many investors starting to question the traditional defensive role they have played in portfolios, and has resulted in an increasing allocation to floating rate credit strategies. Switching out of bonds addresses interest rate risk, but allocating to credit strategies increases credit risk and reduces the diversification benefits that bonds have traditionally played in diversified portfolios.
POC: So investors have some difficult decisions to make, and with the spike in bond yields in February this year, is inflation finally returning or is this due to global supply chain shortages brought on by the COVID induced economic slowdown?
POC: These are the challenges that Kelly and the investment team at Schroders need to manage, so it will be interesting to hear her thoughts and insights into these challenges that we all face, and structuring an appropriate fixed interest portfolio.
POC: So maybe to commence Kelly, can you explain to our listeners how you arrived at managing fixed interest portfolios with a specific focus on government bonds?
Kelly Wood: Cheers Paul, and thanks for having me today. Now I've worked in fixed income for over 20 years, I'm passionate about it because it directly ties into the macro economic trends that equities normally follow. I also really do like the mass of bonds.
KW: I started my career as a graduate at AMP Capital back in 2000, where I spent a lot of time rotating between different asset classes. And I really found fixed income quite fascinating. I then moved on to UBS as a fixed income fund manager, here I learned everything you needed to know about bonds.
KW: I then decided to move to Schroders to really help build out our fixed income capability, where I've spent the last 14 years managing diversified fixed income strategies.
POC: Yeah, well it's interesting. I must admit, I've always found fixed income the most intellectually challenging asset class to get your head around, because not only do you need a global macro top-down view, you then also need to understand each security that you're purchasing.
POC: So it really requires a broad skill set. And as you say, a healthy and sound understanding of mathematics there. So maybe then moving into the questions, bond markets are adjusting after yields moves sharply higher in the first quarter of 2021, and the yield curve began to normalise. Do you believe this time is different for bonds and can you explain why the repricing of bonds represents a healthy reset?
KW: Yes. Now bond markets have been undergoing this readjustment, and to us, this repricing of bond yields really represents a transition phase and a healthy reset. We're seeing income levels being restored and bonds are becoming a lot more attractive as diversifies at higher yields.
KW: So last year bonds were really under pricing the stronger outlook for growth and inflation. We saw the first quarter of 2021 deliver some very sharp rises in yields across developed bond markets, and that was really in recognition of a much stronger recovery. But this time is different.
KW: Now the natural processes that normally drive recovery after a severe downturn are really being turbocharged by large fiscal and monetary stimulus, and as the global economy transitions from recession to recovery and into expansion, we are going to overheat, especially in countries like the US. And the conventional response to stronger than expected growth, coupled with steep declines in headline unemployment rates, would have really steered monetary policy towards tightening in anticipation of higher inflation. But not this time.
KW: Central banks have really been, I would say, tripling down on highly accommodative policy, and bond markets have started to really challenge this view, bringing forward, rate hikes on the expectation of this big surge in growth and inflation this year.
KW: So what are the two main themes that will distinguish Q2? And we are seeing a boom in global growth that's finally arriving, and secondly, the inflation overshoot has started to materialise. We are really focused on how much of a cyclical overshoot can actually be priced in markets as we move through this second quarter. Because economies are going to accelerate with maximum policy support.
KW: So you asked Paul, where does that leave us? Fixed income, I would say, is at somewhat a halfway point. At these high yields, income levels are being restored, bonds are becoming more attractive as diversifiers. Relative value is also appearing, aided by reducing hedge costs and steeper curves.
KW: Our view is that fixed income is undergoing this healthy transition and it's certainly becoming more valuable, and we are looking to get more constructively positioned on portfolios.
POC: Where does that leave the government, the federal government's QE programme? And I guess the aim of that to suppress yields, but clearly the market has moved in another direction earlier this year.
KW: Yeah, that's right Paul. You look at the RBA today, we have the decision. And we really think it's time for monetary policy to be recalibrated. We've seen fiscal policy recalibrated, and we do think the RBA will start to shift its tone.
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KW: We expect them to abolish yield curve control and to use more flexibility in terms of the recovery by using their quantitative easing programme. But that certainly won't stop yields rising. And I think we do need to be positioned for an environment where we are expecting higher growth and higher inflation this year.
POC: So what have been the lessons that have been learned from last year and how did Schroders navigate portfolios through the crisis of 2020?
KW: So Paul, let me start by saying last year was the most exciting year for markets. I was loving the volatility and I would certainly do it all again in a heartbeat, but there were some lessons from last year and it's pleasing to say that we were on the right side of the volatility.
KW: Firstly, valuations do matter. Credit markets at the end of 2019 were expensive, so coming into the crisis we were very defensively positioned and we had very little exposure to credit risk. And this protected our portfolios from large capital loss as we saw credit spreads really widen out aggressively in March last year.
KW: Secondly, last year really showed us that you had to be in the right assets at the right time. We were well positioned coming into the crisis, we had around 70% of our portfolios in government bonds and cash with very little credit exposure.
KW: Thirdly, you had to be dynamic. To be able to move quickly to position for the collapse in markets was crucial, to then be back investing when valuations were restored. We made a very big portfolio rotation out of government bonds into cash and credit markets.
KW: Fourthly, in a macro shock, correlations do matter. Bonds provided very good diversification to risky assets, even at very low yield levels as cash rates collapsed to the effective bound.
KW: And fifthly, you need to be able to access a diversified global opportunity set. As we move through the recovery of markets, it was so important to be able to diversify into those asset class that actually lagged the broader recovery. Markets like Asian Credit or emerging market debt. And lastly, last year, liquidity and preservation of capital was paramount in the defensive asset class.
POC: And in terms of liquidity, I'm assuming with a fair cash and government bond holding there, it wouldn't have been a concern for yourself. You were referring to liquidity in the credit markets.
KW: Yeah, that's right Paul. We were well positioned to provide liquidity to our clients. We had over 70% of our fixed income portfolios in government bonds and cash, and our clients... We were there for our clients And in a time when credit markets were closed, you couldn't actually transact. We could provide our clients with a lot of liquidity in a volatile environment.
POC: So what does fixed income look like in a post COVID world and what are your main areas of focus in your own to make the funds investment objectives?
KW: So investors look to fixed income for two main reasons, diversification and income. Firstly, on diversification, owning bonds at low yields has been less effective. Over the last year we've been seeking diversification in other ways, trying to access less correlated betas like US securitized debt and emerging market bonds, which I'll talk on this later.
KW: Secondly, income. High quality, certain income has become very valuable. Last year we saw many corporates make cuts to equity dividends, and fixed income really continues to provide the certainty of income. Now in our portfolios we are very focused on delivering high levels of quality income.
KW: Thirdly, volatility management. And here I'm talking about managing tar risk and liquidity. Last year was all about managing the collapsing growth and the market impact, as well as providing liquidity to our clients. And this year there's a lot of uncertainty about the outlook for inflation that will bring with it a lot more volatility in markets.
KW: And lastly, alpha generation, it's never been so important. Where alpha is more valuable with beta limited, stock selection will be a big driver of returns this year alongside a significant divergence in sector performance.
POC: Yeah, well I guess as you're making the comments there Kelly, I'm thinking about the investment universe and the, I guess growth in opportunities in the fixed income asset class, and really with that volatility comes, I guess the importance that active management and highlights the role that active management can play in managing fixed income portfolios, and particularly during periods of heightened volatility.
POC: So I think it's something that we all need to think about when we're creating, putting together diversified portfolios. Further to my opening comments, does the role of fixed income duration still have a place in multi-asset portfolios, and particularly with such low levels? And have there been any changes to correlations and that impact to diversify risk?
KW: So Paul, we haven't given up on duration for protection for the downside, we are still seeking diversification from fixed income in our broader multi-asset portfolios, despite this higher cost and reduced power. If anything, bonds are even more attractive as diversifiers at higher yields, especially in the long end of curves around the 30 year point where we've actually seen yields move up the most.
KW: The bond equity correlation is expected to stay negative with inflation low, yields are now moving back to where correlations become a lot more powerful, and the importance of fixed income is retained, but we are thinking differently about other diversifies in our fixed income portfolios.
KW: For example, Chinese bonds. Chinese bonds are trading more like developed markets and higher yields offer more downside protection, safe currencies like the US dollar, the Japanese Yen, have been more effective hedges with positive carry.
KW: We've been seeking to own assets that are less cyclical sensitive, and I think lastly and probably most importantly, if you take on less risk then you don't have to hedge it. Owning an expensive asset class and hedging it actually makes no sense. I would rather just not own it.
KW: Just a final comment, Paul. Commodities can replace bonds as equity hedges when the risk is too much inflation, rather than too little growth. So multi-asset portfolios aren't un-hedgeable when rates are low. If the next macro shock could be too much inflation rather than too little growth, when inflation is high enough to threaten margins or the easy money environment we saw back in the 1970s and early 1980s, the equity commodity correlation can turn negative and it can replace insurance value that traditionally comes from a negative bond equity correlation.
POC: Is inflation the only thing that matters to bond markets this year?
KW: So Paul, so far in markets, meaningful inflation, it's all been about this hope and fear rather than the reality of inflation. And now we're seeing expectations for this revival in inflation, they are universal. From policy makers, investors, where we think the only debate now is how high will inflation be, how long will it last? And most importantly, what's going to be the central bank response.
KW: So at Schroders, we are expecting a cyclical rise in headline inflation, we've already started to see that in some of the data prints, and that's really just due to the rising demand and the supply constraints. Alongside that we're seeing big base effects on oil and core inflation should be more stable, but we do see them to be upside risk.
POC: Do you think that it's more short-term then Kelly, this current rise in inflation? Or what should we be keeping an eye on to understand whether it's structural, the increase in inflation?
KW: Yeah, in terms of our view on inflation, they're threefold, I think firstly, the Slack in economies. Really that drives price pressures over the medium-term, and Slack entering 2021 still remains quite large. We know developed economy should actually end 2021 without port above or output and unemployment below it's pre-pandemic path.
KW: I think secondly, back to your question on supply chains and are these shorter term, the bottleneck pressures we're seeing relating to COVID-19 are related to supply chains, they're shorter term. They're not going to be medium-term influences on inflation.
KW: And lastly, just back to the relationship with unemployment and inflation, pointing back to Phillips curves. So even the attainment of full employment in several economies, pre-COVID, mainly in the US, it's still failed to generate 2% core inflation that most central banks actually target. And that was due to structural factors that really started to flatten the Phillips curve.
KW: So over the shorter term, yes, we are expecting higher inflation prints, but longer term we still think Phillips curves are quite flat and that central banks still have a lot of work to do in terms of generating underlying strong, sustainable inflation over the medium term.
POC: So it's... I guess what I'm hearing there, you're probably then keeping an eye on the output capacity in economies, and whether there's wage pressure growth too, which probably would be an outcome of the take-up of any output cap in an economy at the moment there, to then form a view that the inflation's more structural.
KW: Yeah, that's right. The biggest risk to longer-lasting inflation is going to be a sharper rise in wages. And I think one thing we do need to remember is you look at the US economy and wages didn't actually fall away in the crisis. So wages growth in the US is still growing at around 3% year on year, so we haven't actually seen wages collapse which is normally what you see in recessions.
KW: So we're starting from pretty elevated levels, and alongside the shortages we're seeing in labour markets for workers as well as economies moving to a much tighter labour market environment, I think it is time that we do see upward pressure on wages. But that's something we're certainly watching for more longer-lasting return of inflation.
POC: So if inflation does in fact start to materialise in more of a structural sense, what are the best real assets for hedging inflation risks in portfolios?
KW: So just a comment before we jump into what's the best asset to hedge, I think the performance gap between financial assets, and here I'm talking about bonds, credit equity markets and real assets or real estate commodities, it has widened. And it widens when core inflation actually steps up from zero to 3% to three to 6%. And it really starts to balloon when core inflation rises above 6%.
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KW: So equities could deteriorate in an inflation range, that might only be around 3% on core inflation. And that's because the economy is certainly more leveraged now than in the 1970s. So it's more vulnerable to central banks hiking that will eventually come due to higher inflation. And in terms of what are the best real assets to consider for various inflation regimes, it's important to look at what regime we're in, where are the current valuations, and what are the carry on these assets?
KW: And the best hedge is a broad commodity index. And that combines below average valuations with positive carry. Now the next type of assets are oil and energy, then stepping through into emerging market commodities, value verse growth stocks, inflation-linked bonds and material equities.
KW: I think most people think that gold is the best hedge, but the worst is gold. Despite its impressive performance during the high inflation environments of 1970s and early 1980s, it's simply very expensive in real terms. It does offer no yield. And gold today has really been losing to every other traditional asset, it's now losing to that asset of Bitcoin.
POC: Yeah, interesting that. And I think from... I remember seeing that in real terms, the price of gold peaked in about 1980. So I don't know if it has moved above that in, well I guess last year or over the last couple of years, but it certainly went through a 35 year bear market, gold there. So it's interesting, the way investors and investment markets look at that asset.
POC: So I guess how markets respond to eventual policy tightening will depend significantly on the valuations and the risk premia when we enter this policy phase. So bonds, equities, and I guess to a lesser extent credit, have never been considered more expensive in the lead up to an interest rate normalisation. So where do you see the opportunities lie for investors?
KW: Yeah, that's right Paul. I think corporate spreads have largely been I would say undisturbed by the recent rise in bond yields as Marcus markets really focus on growth and positive earnings. And we're now at a point where credit spreads are tighter now than when they started the year. So even though we've seen this improvement in corporate fundamentals, that's obviously good news, but given that spreads have already compressed to historically tight levels, it's going to be hard for them to move tighter, to gain any sort of capital appreciation from credit spreads.
KW: And as a result of this we have started to make strategic reductions to our credit exposure over the past three months, primarily in those markets that have performed the best and are highly exposed to interest rates moving up. So they're assets like global investment grade credit, but also Australia investment grade credit and mortgages. And in anticipation of an increase in market volatility and uncertainty about what will be the response of central banks to higher inflation, we have started to introduce a tactical short duration positioning in US high yield in credit.
KW: So you may ask, "Well, where are the opportunities now outside of credit?" And as an active diversified fixed income manager that operates in a global opportunity set, we are seeing value in asset classes like US securitized debt, emerging market debt, and Asian credit. So it might be worthwhile just touching on a few of those asset classes in terms of why we're including them in our portfolio construction.
POC: Yeah, please.
KW: So yeah, US securitized debt certainly does offer lower correlation to traditional fixed income asset classes, and it does diversify away from corporate credit and provides high quality income. It has much lower volatility and less sensitivity to rising interest rates, which is important in this environment. And it gives us a different source of return. It gives us exposure to the US consumer, housing and commercial real estate markets.
KW: So a lot of positive factors for inclusion in a portfolio. Asian credit, it does provide a high yielding alternative, especially to Australian credit, and it gives us access to Chinese interest rate exposure, which is one of the high growth regions of the world. And the increasing size and dominance and diversity of the region really does create some more alpha opportunities, which if you remember at the start of the podcast, I mentioned alpha has never been so important just because of betas being so depressed.
POC: So in terms of rising interest rates, what level of interest rates do you think is problematic for economies, and particularly with the huge level of government debt across the developed world? And I guess in the back of my mind I'm thinking of the work of Reinhart and Rogoff probably 14, 15 years ago now, talking around public debt and when it becomes a drain on future growth in economies.
KW: Yeah, I think rising rates always has that risk of a negative feedback loop, from higher financing costs to slower growth due to high leverage. And this impact may matter for housing over the next year or two, but not for the economy in aggregate, just given the level of income support from fiscal packages this year.
KW: In terms of real policy rates and real tenure yields, they're still negative, and business cycles don't end until the real cash rate has actually risen to a level much closer to the rate of real GDP. And those balance sheets that are going to be most vulnerable is sovereign and corporate balance sheets. They are the most damaged by COVID because fiscal transfers were all put to households, they were targeted at households.
KW: So as rates rise, it's these two sectors that are going to be the most vulnerable. And just lastly, equity bull markets don't actually end till the business cycle does. So the equity market shouldn't be threatened until real rates are well into positive territory. And the earnings bond yield framework does yield a similar conclusion, in that, real rates would need to rise by about 100 basis points to reduce this measure of the equity risk premium, and the current spread, I think it's around 5%, is... It's a level typical associated with the outperformance of equities verse treasuries over the subsequent 12 months.
POC: Yeah, interesting, there's certainly some thoughtful comments there, Kelly, in thinking around how you'd structure portfolios. But I think that the key takeout there is that we need to be very focused on inflation, and I guess you need to have a view if you structuring a fixed interest portfolio today for clients there.
POC: So maybe just a final question here, are some interest rate normalisation cycles benign or are they all damaging eventually? And what are the good and the bad news about this cycle?
KW: So Paul, every normalisation cycle has been disruptive, it's really just a question of when and where. So even if central banks are years from tightening policy, the lessons from history is that every normalisation cycle drives material market drawdowns. And as a macro catalyst, central bank cycles are second only to recessions. And with the 2015 to 2018 hiking cycle, as could be with the next one, starting in 2023, 24, the corrections in markets actually come years before the first hike. And we're starting to see that now with QE policy being rethought by a lot of central banks.
KW: So where is the most froth in the market? We would say without a doubt, cryptocurrencies, which has risen by a factor of 160 since 2014, where the fear of missing out has really driven this extraordinary price momentum.
KW: In terms of the good and bad news about this cycle, certainly the good news is we're seeing surge in growth, especially this year it's going to be boom time growth rates. We are likely to see elevate inflation through most of this year, but medium-term inflation, we do see that falling back to within central bank targets. So inflation is going to be relatively tame over the medium-term.
KW: But the bad news about the cycle is that we are dealing with very thin risk premia, and how markets respond to eventual tightening really depends partly on valuations or risk premia entering the policy phase. And as I mentioned before, bonds, equities credit, even gold, crypto currencies, they've never been richer ahead of rate normalisation. So very expensive asset classes.
POC: Yeah, it's certainly going to be an interesting period we're entering over the next couple of years, but I guess too thinking as you were talking there, Kelly, have you got a view on what a normal cash rate or a neutral cash rate may look like going forward?
KW: Yeah, we spend a lot of time on this because for the Australian cash rate in a normal cycle, three to five year cycle, a normal cash rate would be around 3%. I think looking at an environment where we are likely to go back to much lower growth rates besides this year, inflation within central bank targets, it's certainly much lower.
KW: So our neutral cash rate is much lower around 1%, and you look at the neutral cash rate in the US, and that's currently at zero. So we are expecting the neutral cash rates to move up a little, but we're not expecting to be moving back to an environment where we see neutral cash rates around 3%, certainly feels like those days are gone.
POC: Hmm. Yes, it certainly does. I think I even recall when it was four or 5%, the neutral cash rate. So I guess for most of my career in financial services, it's simply been dropping me Kelly.
POC: But yeah, that's in line with I think the whole structural fall in inflation that I had mentioned earlier in the podcast over the last 30, 35 years there. But look, thank you very much for joining us this morning there, Kelly, it's certainly been very interesting to get your insights on the insights of I guess the broader Schroder fixed income team on markets, inflations, inflation, and what you're thinking about in your portfolios at the moment, particularly the comments around more diversifying into looking at areas like Asian credit, US securitize debt, et cetera.
POC: And it certainly, again, in my mind opens up I guess the importance of having a broad investment universe and the important role that active management can certainly play in fixed interest portfolios for our clients there.
POC: So thank you very much for your time and joining us this morning, Kelly, it is much appreciated.
KW: Thanks for having me, Paul.
POC: A pleasure.
POC: All the best to the listener. Thank you very much for joining us and I'll look forward to participating in the next investment podcast series.
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