The role of fixed interest strategies in an ultra-low rate environment

Dr Laura Ryan - Head of Research at Ardea

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In this episode, Dr Laura Ryan, Head of Research at Ardea, joins us to discuss fixed interest and specifically whether duration strategies can still provide diversification in portfolios in the current ultra-low interest rate environment.


Paul O'Connor (POC): Welcome to the Netwealth Investment Podcast series. My name is Paul O'Connor and I'm the head of investment management and research. Today we have Dr. Laura Ryan from Ardea investment management, who is head of research and responsible for both the client's solutions and portfolio research teams. The client solutions team undertakes independent quantitative research to help clients solve investment problems, while the portfolio research team is responsible for developing value-add recommendations to drive portfolio performance and improve client outcomes. Laura is an internationally published academic and previously was senior vice president of quantitative research, and a member of the Australian senior management team at PIMCO.

With 21 years experience, Laura has worked for the Commonwealth Bank, AMP Capital and is a lecturer in statistics at the Australian National University. Laura holds a PhD in statistics from ANU, a master of quantitative finance from the University of Technology Sydney and an honours degree in actuarial studies from the ANU. Ardea is a specialist fixed interest investment boutique with a focus on delivering consistent alpha through an investment process supported by a highly intuitive risk system. Formed in 2008 by its four principals who all previously worked together at Credit Suisse, Ardea has a successful track record in managing fixed interest portfolios from traditional defensive products, inflation linked bonds, and also benchmarked unaware and objectives based solutions. Ardea are based in Sydney and it's majority owned by employers and managed over $13.4 billion in assets as at August last year across a suite of active investment strategies.

The Ardea Real Outcome Fund is available on the Netwealth Super and IDPS investment menus. The fund is an absolute return strategy that seeks deliver consistent defensive returns by exploiting pricing anomalies between like securities across fixed income markets. This is commonly referred to as relative value investment strategies, and the fund has the potential to provide stable and uncorrelated returns, irrespective of the direction of the market, such as rising or falling interest rates, or the environment, such as deteriorating or improving credit conditions.

Today's podcast will focus on fixed interest and specifically, whether duration strategies can still provide diversification in portfolios in the ultra low interest rate environment we now live in. Duration is an approximate measure of a bond's price sensitivity to changes in interest rates. If a bond, for example, has a duration of four years, its price will rise by about 4% if the yield drops by 1%, and its price will fall by about 4% if the yield rises by 1%. Duration management has been the core strategy used by active fixed interest managers in an attempt to outperform, and is often erroneously thought to have a negative or inverse relationship to equities, i.e. when interest rates are falling, this is usually due to a slowing economy, and is an environment when equities can typically perform poorly, but a fixed interest manager, long duration, can generate strong returns.

This has an overall effect of dampening the actual equity risk in a diversified portfolio. Because of this relationship, diversified portfolios have historically allocated to equities and bonds as their core exposures. As a result, a portfolio constructed for a retiree would traditionally include a higher allocation to government bonds, as compared to say a younger person's superannuation portfolio who has many years working ahead of them. But with yields at historic lows, can we still rely on bonds to be the safe haven asset to protect us from equity market downturns?

We're fortunate to have Laura with us today who's certainly well qualified to talk about fixed interest duration, and we'll specifically discuss how the ultra low interest rate environment may be impacting on the behaviour of government bonds, and as a result, whether we can expect duration to play the same defensive role as it has historically. Important, we will also discuss how a longer term investment horizon impacts on the whole risk and return trade-off for bonds. So to start with, Laura, how were you and the Ardea team coping with adjusting to the impact of COVID on the workplace, and assume you've spent a fair bit of time working from home over the last few months?

Dr Laura Ryan (DLR): Yes, definitely, Paul. Actually, we were quite lucky. We had a pretty strong kind of work from home ethic. Our CEO works, I guess, 90% of the time from home. So he's a big fan of making sure that we can all do that as well. So when it came time for us to work from home permanently, it was pretty seamless.

POC: So you're all well accustomed to using Microsoft Teams and the other forms of software that we're now all experts in that we might not have used that much probably six months ago. Traditional fixed interest strategies have generated strong returns in recent years as longer term bond yields have fallen due to a weakening economic outlook. For example, in the last five years, the Australian 10-year bond rate has fallen from around 3% to 0.83% and simply passively this would have generated over a 20% capital return in addition to the yield that the bonds are paying. Interest rates seemingly cannot go much lower as highlighted by the RBA's move to non-traditional monetary policy such as quantitative easing. So Laura, can duration still add value on a forward looking basis?

DLR: Yeah, it really depends what you mean by value. So if you mean, will they be shooting the lights out with respect to their returns then probably not because you've really hit the nail on the head there. We're at historic lows, 120 year lows actually. And over the short to medium term for bonds to really provide some solid returns, we need interest rates to go into negative territory. And most central banks are really reluctant to do that. So that's the return part of the value equation, but the other part is diversification. And that's a little bit of a different story, which I think we're going to get to in the next few years.

POC: Yes. Look, can you explain, how duration provides diversification in a portfolio?

DLR: Yeah, so there's two ways. The first is if they are negatively correlated with equities and then the other way is if they exhibit volatility that's lower than equities, and both of those things can be important and are important, but there's one that's actually much more important than the other and I think it will probably shock some of you.

POC: So one of the investing rules of thumb is that duration is consistently negative correlated to equities. Is this correct?

DLR: No. And I think this is one of the biggest myths in our industry. So the correlation between bonds and equities or duration and inequities is actually time varying. So it can be very strongly negative, but it can varying. So it can be very strongly negative, but it can actually be really strongly positive as well. So that means that relying on the correlation to be negative, with respect to portfolio construction and diversifying your portfolio, it's not constant. So you can't really rely on.

POC: Yeah, it's an interesting issue you raise there, because a lot of people building diversified portfolios, I guess, the starting point is, how much do we put into equities and how much do we put into bonds, because of that view that they're negatively correlated to equity. So it's very interesting issue raised there, Laura.

You mentioned one of the benefits of duration is that it exhibit's lower volatility than equities, which brings diversification benefits to the portfolio. Can you explain what you mean by lower duration volatility? And is this really important?

DLR: Yeah, so volatility measures how much the returns moved around. And in general, over time, we've seen that bonds, AKA duration, exhibit lower volatility than equities. And whenever you combine assets in a portfolio, suppose you've got an equity heavy portfolio, 100% in equities, and then you combine that with, maybe, say, 20% of bonds. So you reduce your equity holding down to 80%. Because bonds have a lower volatility than equities, it means that the volatility on the overall portfolio will actually decline. So, in general, if you're combining assets that have different volatility profiles, that means that you'll get.

POC: And I guess, in the end, what that means to the end investor is that it smooths the overall return out of the diversified portfolios. So it's an interesting point you raise there, Laura.

We've seen periods recently where equities have gone up in value, but the interest rates have fallen. So even if the lower correlation assumptions do not hold, is there a benefit to be had by including duration in a portfolio, as long as its volatility is lower than equities?

DLR: Yes, absolutely. And this brings us back to the first question about the negative correlation assumption between bonds and equities or duration and equities. So long as bonds exhibit volatility which is lower than equities, regardless of their correlation with equities, they will still provide diversification. And as you've mentioned, that means that you're getting a smoother return profile on your portfolio. And I think that's a really, really big busting of that myth, in terms of the negative correlation assumption. So long as you think that bonds are going to be displaying lower volatility than equities, then they should be providing diversification.

POC: And I guess we're seeing that over the last three or four years, whereas I mentioned earlier, the Australian 10 year bond yield has come down significantly, but we've seen equity markets continue to go up. So I think it's an important point to make there, that, at times, you can get strong returns out of both equities and bonds in a portfolio. So is it true that the longer an investors timeframe, the greater the argument or case for duration or bond allocations in a portfolio?

DLR: Yeah. So this is a bit technical, so hopefully I do a good job of explaining it. So over the short to medium term, the way that you earn returns on bonds is you need the yields to drop so that the price can appreciate in value. So there's an inverse relationship between yields and prices on bonds. But, over the longer term, the way that you make money out of bonds is through higher yields and higher coupons. So if we do see a scenario where, say the fed starts raising interest rates, over the short to medium term, you'll see some capital losses on your bonds, but if you hold onto those bonds for a long enough period, the increase in the yield and the increase in the coupons that you'll be receiving will compensate you, or negate, the impact of the capital losses over the short term.

POC: So, Laura, in a portfolio with a high allocation to equities, can duration play a meaningful role in reducing the equity volatility, without taking a leave it or [inaudible 00:13:47] exposure to bonds? And is the current duration of the fixed interest benchmark going to be enough to dampen volatility in a high equity volatility portfolio? And if not, why do we even bother with duration?

DLR: Yeah, look, duration and bond exposures will exhibit lower draw downs and lower volatility than equities. And even if you add a small amount, say, 10% to your equity heavy portfolio, that will materially decrease the total portfolio volatility. The issue that we have is that, as yields decline, the compensation that you get for that diversification benefit declines as well. And there's another interesting mechanical result as well. When interest rates decline, that means that the duration on indices will increase, and when duration increases, that means that the sensitivity and the volatility on those indices also increase. So in a nutshell, we have the case where, yes, bonds should be providing diversification because they do exhibit lower volatility than equities. However, we're going to be seeing lower expected returns, and maybe even negative expected returns, and we're probably going to see increased volatility as well.

POC: Can you explain perhaps, for the listener, what you mean there by, as yields come down, the benchmark duration increases? Yeah. Can you explain how this actually works?


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DLR: Sure. So as yields decline, the duration on the bond will increase. And duration, as you mentioned, is a measure of interest rate risk or the sensitivity to interest rate changes. And the way that we measure a market and the risk and return metrics on a market is usually via an index. So I think a lot of your listeners are probably aware of, say, the S&P 500, or the ASX 300. And so if you're in the bond market, you would look at indices like the Barclays Global Aggregate Treasury or the Barclays Global Aggregate Corporate bond. And we would look at what the duration is on those indices, and also what the yield is and the return on those indices. And over time, what we've seen is, the duration on most of the bond indices has been steadily increasing. And if we remember that duration measures interest rate risk, that means that the risk on a bond investment is actually increasing, and the sensitivity to interest rates is also increasing.

POC: Before we bring you the second part of this chat, a little bit about who we are. Netwealth is an ASX listed company established to help Australians take control of their financial futures. With a wide range of super and investment accounts, a huge variety of investment options, and market leading online tools, we can help you manage your wealth, your way. Partner with us to see wealth differently and discover a brighter feature. Visit the Netwealth website to learn more and get the PDS, which you should read before making a decision. Products issued by Netwealth Investments Limited.

So is that simplistically a function that the lower the interest rate, the more a bond issue will try and issue a longer duration bond?

DLR: Yeah, I think that's also a little bit of a demand play there as well. So in a low interest rate environment, investors are really seeking out more yield. And the way that they do that is to go further up in the maturity profile. So they may have invested in five year bonds previously, but to get just a little bit more yield, they might then go out to 10 years as well. But yes, you're certainly right. We are in a super low interest rate environment, so a lot of borrowers are really trying to take advantage of that and so they're issuing really, really longterm bonds. We actually invested in a 100 year bond not that long ago. And yeah, that was-

POC: Who was the issuer of that bond, Laura?

DLR: Oh, that's a German bond.

POC: Aha, yeah. So I think we also saw the Australian bonds, well, 30 year bonds, were issued and sold in recent times. And historically, I don't think there's been a lot of bond issuance beyond the 10 year bonds in Australia, unlike some other markets like the US. So yeah, it's interesting that point around that, the overall duration of all bonds on issuance included in a benchmark, increases as yields drop. So could you see a situation where duration volatility could ever be higher than equities?

DLR: Not really. So we did see a huge spike over the March crisis in yields, but even then, they really didn't exhibit the kind of volatility that you've seen in the equity market. So, maybe over the short term, if we saw some really bizarre events happening in the bond markets, but over the longer term, they're constrained by their term to maturity as well. So as a bond moves closer to its term to maturity, it's price converges to a hundred anyway. So yeah, historically, we've definitely not seen the kind of volatility that equities have exhibited, and I don't expect them to exhibit it.

POC: Well considering we've seen volatility of equities hit 50%, or up to 50% losses in under a 12 month period. I think you're right. We'll never see those types of extreme movements in bond valuations over a short term period. In stress, significant market drawed ban environments, does duration provide defensiveness?

DLR: Definitely. And drawdown's an interesting word to use. So that measures what the peak to trough changing value is for an asset class. And generally, bonds exhibit much, much lower drawdowns than equities. And so, just on that alone, then you know bonds would definitely provide diversification benefits going forward.

POC: Well, certainly huge growth in the number of fixed interest strategies that invest purely in credit of varying quality, due to the higher yields on offers. So do you believe this is a valid strategy until bond yields start to normalise? Or are investors simply taking on more risk and ignoring the benefits of duration?

DLR: Yeah, I think most asset classes have a place, but investors really need to think about whether they're getting compensated for the risks that they're taking on. So if we look at the credit market in particular, we know that the credit quality in the market has been steadily declining, so that's a measure of credit risk. So if you've got credit quality declining, you've got an increase in risk, but then, at the same time, we've seen yields declining steadily over time as well. So effectively, what you've got there is an increasing risk, but a decline in the compensation for that risk, and so the risk return trade off is not as healthy as it was prior to the GMC, or even around the GMC.

POC: Yeah, well I have certainly noticed it on the investment menu, the superannuation, and ID payer's investment menu, where the fixed interest options that we have are dominated by credit strategies, and there's less and less duration exposure in portfolios. But this is a trend that possibly started three or four years ago. And unfortunately, I think a lot of investors move purely to credit and they miss the benefits of duration. Back to my earlier comment about the Australian 10 year bond yield dropping. So I think we do need to be a bit cautious in that space, and particularly, the credit tends to behave more like equities in times of duress. So yeah, I think it's interesting the way an investor approaches and has exposure to duration in their portfolio.

DLR: Yeah. I think that the point about credit correlating with equities is really important. So it does exhibit less volatility than equities during benign periods, but then, yeah, you're spot on during crisis periods. It really correlates with equities, which is the exact opposite of what you want from your bond portfolio.

POC: So now, maybe moving towards your crystal ball, there's been increasing debate amongst economists that the RBA will, again, lower the cash rate in coming months. So what Ardea's view?


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DLR: So, Paul I'm going to` would give you the politician's answer, where I answer without giving you an answer. So for us, the level and direction of interest rates is not really that important. So our strategy revolves around identifying mispricing between securities that are really closely related to each other, but they're priced in a different way. But that means that those strategies aren't correlated with the direction of interest rate markets.

So for us, if the RBA raised interest rates or they lowered interest rates, it's not really going to make any difference to how we implement our strategy. So we definitely do pay attention to it, because volatility in markets is an opportunity for us to capitalise on. But it doesn't matter whether those rates are going up or whether they're going down, it still creates the kind of volatility that we can capitalise on.

POC: Yeah, and it's sort of, in my mind, I guess too, the lower the RBA cash rate, the less impact that interests cuts seem to have on an economy. So, yeah, I question whether there's any value really to be had by dropping rates below quarter of a percent, and moving towards that dreaded zero, or even a negative cash rate, that I doubt we're going to see anyway in Australia. But, time will tell.

Inflation linked bonds, fixed interest securities whose principle value is periodically adjusted according to the rate of inflation. So, these bonds decline in value when interest rates rise, and vice versa. What's your view on inflation? And do you think inflation linked bonds have a role to play in client's portfolios?

DLR:  Yeah, I think linkers are a very underappreciated asset class. So, if you think about what a retirement liability looks like, it looks like you paying out a stream of cash flows over time, and those cash flows increase with CPI. So that's your liability profile. And then, if you think about what an inflation linked bond looks like, it looks exactly like your retirement liability. So it pays out coupons, and those coupons are indexed to inflation, so that means that they increase over time, as inflation increases as well. And, in our Ardea Real Outcome Fund, so that's our flagship fund, we have a structural exposure to inflation, and that's because a lot of our clients have a retirement liability that they need to fund. And we want to make sure that there's no unexpected reductions in purchasing power for our clients.

In terms of expectations for that market, so we don't try to time the exposure to that market. We just keep that exposure on as a structural, constant, consistent exposure. But we do think that most of the upside has already been priced in. So if there are any unexpected inflation movements to the upside, then inflation linked bonds will definitely outperform. What's really interesting is that during the peak of the crisis over March, we saw inflation expectations actually move into negative territory. And that was over five years, 10 years in, even out to 30 years. And then, once we head to the government embark on its fiscal stimulus programme, we had the AOFM coming out in issuing all of those bonds. We saw that maybe the market thought that maybe inflation had more-

Maybe inflation had more to the upside then than the downside. So, those inflation expectations really rebounded and then moved back into positive territory again. Then, we saw the inflation-linked bond market then start to outperform on the nominal.

POC: Yeah. I think the point you made earlier is very prevalent certainly to a lot of the clients on the Netwealth platform, and that is that the aim is to maintain purchasing power, particularly for retirees, and the biggest risk would be inflation to impact on that. So, to have an exposure to inflation-linked bonds, I think intrinsically just makes rational sense in my mind in a portfolio. So, now I'd certainly agree with your views and why Ardea structurally has an exposure to inflation-linked bonds or linkers in your portfolios you offer clients. Finally, should investors consider an active or passive fixed interest solution in their portfolios, given that many active fixed interest strategies have underperformed the benchmark, being the Bloomberg Osborn Composite Index? And I'll probably add there that again, that I think one of the issues there being that a lot of these fixed interest strategies, as I've mentioned earlier, are very heavily credit focused with very little duration exposure. But what's your view on the whole active versus passive debate in your space?

DLR: So, we're an active manager. So, I'd probably give active managers the thumbs up to just. But there is definitely some slicing and dicing that you should do. So, you've mentioned the credit exposure and I think that's definitely something investors should think about. But in general, there is also quite a bit of research to support the fact that active bond managers can bake the index, and that's because the bond market is a bit more inefficient than the equity market. So, I think some examples are we've got really big institutions that are legislated to invest in certain parts of the government bond market in particular, so insurance companies are required to invest in government bonds for regulatory capital purposes. Then, we have hedge funds that prefer to invest in securities like interest rate futures.

And both of those securities are exposed to the same risks. So, in theory, they should be pricing the same. But what we see is that they price very differently over time because we've seen those different institutions have different demand levels for those different securities. So, there's always going to be these kinds of demand in supplying balances in the government bond market, and perhaps in the bond market in general as well. So, that's a little bit different to how things work in the equity market but having said that, you really do need to make sure that you're getting the right types of exposures in terms of credit duration and then exposure to idiosyncratic risk, which is the risk that we have in our portfolio, which isn't correlated with credit or equity markets or duration.

POC: Yeah. Interesting, Laura, there. I think as you're talking through, I'm thinking in my mind that for a lot of investors at the end, that is where the value of a financial advisor can very much assist them with how to structure a portfolio and enhance the structure and appropriate exposure to defensive assets and the top end managers that they will employ in their portfolio. But it's certainly I find a very complex market, the fixed interest market, compared to the equity market. I find fixed interests a lot more complex and particularly given that you need to have a top-down view on the global macroeconomy and then you've also got to have a bottom-up view on every security or every bond or credit that you're buying in a portfolio. So, it takes a lot of work to build a proper diversified bond or fixed interest portfolio.

POC: I think a lot of the points you've made this morning certainly bears that out there, Laura. So, thank you very much. Thank you for joining us and thanks for spending the time with us and I wish you all the best there with Ardea. And yes, with a bit of luck, we might be able to have another podcast next year. It'll be interesting where rates are in another 12 months time there, Laura, but thank you very much for your time.

POC: Thank you for joining us. And to the listener, thank you also for joining us. I certainly hope that you're surviving in these difficult and different times that we're certainly living through. I hope you've enjoyed today's podcast and I look forward to joining you at the next Netwealth Investment podcast series. Thank you and have a great day.

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