With the end of most central bank's quantitative easing programs and the normalisation of cash rates, is now the time to buy bonds again and to increase duration positioning in portfolios?

Since central banks commenced explicitly targeting inflation in the mid 1980’s, cash rates and bond yields have fallen creating an environment where fixed interest portfolios have been predominantly long bonds but now the short and long end of the yield curve is rising. 

In this episode, Clive Smith, Senior Portfolio Manager at Russell Investments, joins the show to discuss what drives bond market returns. Discover why the change in bond market dynamics has created a 'double whammy' for bond investors and the key resulting factors to keep in mind when considering portfolio allocations for the remainder of 2022 and beyond.

Transcript

Paul O’Connor:

Welcome to the Netwealth Portfolio Construction podcast series. My name is Paul O'Connor and I'm the head of investment management and research.

Today, Clive Smith from Russell Investments joins us, who is a senior portfolio manager, based in Sydney.

Good afternoon, Clive, and welcome to the Portfolio Construction podcast series.

Clive Smith:

Good afternoon, Paul.

Paul O’Connor:

Clive is a senior portfolio manager with Russell Investments, and his responsibilities include researching Australian fixed income managers as well as managing Russell Investments, Australian fixed income and cash portfolios. There are 11 Russell Investments diversified strategies available on the Netwealth Super and IDPS Investment menus, including seven managed funds and four managed models or SMAs. The diversified strategies all allocate to Australian fixed income and cash that Clive works on.

The return of inflation has created challenges for investors, and none more so than fixed interest portfolios. Since central banks commenced explicitly targeting inflation in the mid 1980s, cash rates and bond yields have fallen, creating an environment where fixed interest portfolios have been predominantly long bonds. But now this trade has come to an end as both the short and long end of the yield curve have started to rise. Bond yields this year particularly, have risen strongly, mainly driven by inflation and obviously the central banks' response has been to sharply increase cash rates. The outcome of this to investors is that the Bloomberg Australian Composite Bond index has fallen by over 12% in the 12 months to 30 June, whilst the Global Aggregate Index is down 9.33%, which are the worst returns from these indexes since 1994.

The return of inflation has also resulted in an end to most central bank's quantitative easing programs or extraordinary monetary policy, and impacted obviously then on equities valuations, and particularly growth stocks. So the first six months of 2022 has certainly been a turbulent period for investors. On a positive note, the normalisation of cash rates must be, I guess, considered positive for investors as zero bound rates really can't be sustainable over the medium to long term. And with the Australian 10 year bond yield above three and a half percent, is it time to buy bonds again and to increase duration positioning in portfolios?

So with all of that in mind, I'll certainly be interested in Clive's views on what drives bond market returns, why the change in bond market dynamics has really created a double whammy for bond investors, and what are the key factors advisors really need to keep in mind when considering portfolio allocations for the remainder of this year and beyond.

So perhaps to start with, Clive, can you provide the listeners with a few comments on, I guess, your life journey to being a cash and fixed interest portfolio manager with Russell Investments?

Clive Smith:

Well, I really started at Russell nearly 20 years ago, and basically a lot of my career has been in fixed income, not just at Russell, but when I started with Westpac Investment Management as a trainee money market dealer, back in the late eighties. So it's been a long path in terms of experience in the industry, but I think as we'll touch on in the podcast, it's also interesting that a lot of this period has been an experience of fixed income markets in one particular type of environment, and that has been benign inflation, falling interest rates, and potentially we're starting to see the point now where that type of dynamic has started to reverse.

Paul O’Connor:

Yes, well, I guess noticing your academic background as well, having a master's in economics, I guess I've always been of the view that a good fixed income portfolio manager, not only needs to be good at selecting a security, i.e., the bonds or the credits, but you've also got to have a top down view. You've got to have a really strong understanding of global GDP and inflation and where interest rates are headed. So I think certainly, your background makes sense to me how you ended up in fixed interest and not being a hedge fund trader, jaunting around the world, going long and short over companies there, Clive. So yeah. Yeah, I think your background certainly suits very much to the world of fixed interest.

Clive Smith:

Yes, and definitely as we're seeing in markets, these very big, longer term thematics, that are really starting to drive the returns in fixed income and the fixed income cycle and indeed policy reaction functions of central banks, investors probably do need to start thinking very much about these bigger macro type thematics that are impacting on markets at the moment and will probably continue to do so for some time.

Paul O’Connor:

So moving into, I guess the heart of the podcast today, fixed income investors have had a hard time over the last 12 months with losses of 9.3 to over 10%, depending whether it's Australian or international bonds, if you're looking at the aggregate indexes. What in your opinion have been the main drivers of these returns?

Clive Smith:

When we think about, and this comes back to the point we're making about the longer term thematics, as you said, investors have really been hit with the double whammy of rising interest rates, in particular over the last 12 months. And if we try and think about what the drivers of this have been, it really has been the RBA and central banks globally, normalising monetary conditions. And to put some sort of numbers around that, if we think about this normalisation process, it really has seen 10 year bonds rise from just over 1% to nearly three and a half percent, actually peaked a couple of months ago over 4%, while investment grade credit spreads have risen from the sub 100 basis points to well over 150 basis points. And if we think about it, the traditional bond index along the lines of the Bloomberg Global Domestic Aggregate has an interest rate duration of around five and a half years and a credit spread duration of around three and a half years.

So what this has done is this move in interest rates has translated into a very material negative return for investors. And not just this rising interest rates, but also the double whammy of both rising interest rates and credit spreads, as central banks have looked to normalise monetary conditions. Investors also have to keep in mind that whilst this correction has been occurring, it's been occurring from very low levels of outright interest rates. So the level of carry that investors have had to try and protect themselves has been abnormally low. So this is really what's been coming together in a way, in the last 12 months, to really create some of the largest negative returns in fixed income markets we have seen in a very long time.

Paul O’Connor:

You refer to interest rate duration and credit spread duration, Clive, and perhaps for the benefit of some of the listeners, what do you mean by these terms?

Clive Smith:

I think for investors in fixed income, it's important to keep in mind that when we talk about security yields, we're really talking about two components that comprise a yield. The first component we can think of and refer to is just the bond yield. And this is effectively the risk free interest rate. When I say risk free, I mean default risk free, where default risk is effectively the risk that a borrower will be unable to make repayments as they fall due.

So when we talk about this bond yield or risk free bond yield, we're talking about in practise what is a zero default risk security. If it's held to maturity by an investor, effectively they can be pretty much guaranteed that they will earn the yield on the bond. The point I make is when I say risk free, we are talking about default risk that these bonds can still have marked to market changes in valuation as interest rates move over the cycle, but the investor doesn't have to worry about default risk. And generally these types of securities are Commonwealth government bonds. But the point is that these really provide the baseline against which other bonds can be priced.

When we move on to the second component is therefore the credit spread, and this is the additional yield required by investors to compensate for the higher risk of default and is effectively a default risk premium. And this is the additional yield that's required on the bond over this risk free yield to compensate for the risk. So taking these two drivers of yield, when we actually refer to interest rate risk and credit spread duration, we are really referring to the two measures of the sensitivity of the bond price to changes in each of these components. When we think about it, the relationship is negative and I think that's important for investors to understand. So the price of a bond is inversely related to the movement in yields, and the duration by denoting the sensitivity, the longer the duration or the higher the duration of a bond, the more sensitive it is to the change in yield.

Paul O’Connor:

But aren't interest rates and credit spreads meant to assist in balancing each other?

Clive Smith:

Once we think of a traditional cycle, it's very much yes they do, over the longer term, when we think about thematics. You can look at it a couple of ways. One way is to start by considering that there is a tendency towards a high level of synchronisation between the market pricing of credit risk and the economic financial cycle. There's also, it follows a logical, a high level of synchronisation between bonds and the economic cycle itself. So it therefore follows that there is a relationship between bond yields and credit spreads. But digging a bit deeper, the common factor that's really driving this relationship between credit spreads and bonds, it revolves around the policy actions of central banks. And probably it's worthwhile to understand how this linkage occurs to just consider that the central banks such as the Reserve Bank of Australia, they have multiple objectives.

For the Reserve Bank of Australia, they've got the objectives of achieving price stability, full employment, and a general broad, overarching objective, ensuring economic prosperity and welfare. Put another way, and another way investors can actually think about the objective of the RBA, is it really is to set monetary policy to achieve the maximum level of economic growth compatible with its inflation target, where the major policy tool available to the RBA, as with other central banks, is the official cash rate. And it is this interaction of the policy objectives of central banks such as the RBA, which creates a direct link between monetary policy and the economic cycle. And the driver here is really the trade off between the rate of economic growth and inflation.

There's a whole range of factors that can impact on economic growth and inflation, but a useful way to think about inflation is that it creates a speed limit to the rate at which an economy can grow and it's the existence of this speed limit, which means that to maintain longer term economic prosperity, central banks have a bias to manage monetary policy so that it leans against the cycle.

So given such a bias over an economic cycle, increasing bond yields are generally associated with central banks raising official cash rates, which in turn is indicative of stronger expected economic conditions. It follows that stronger economic conditions are in turn positively impacting on the fundamentals for corporations. And this has a positive impact on credit spreads. The end result being that credit spreads will tend to contract as bond yields rise.

The opposite holds for declining bond yields, which in turn are associated with central banks reducing official cash rates in response to deteriorating economic growth, which is negative for credit spreads. So again, we see credit spreads expand as bond yields decline. And the result of this tendency for central banks to lean against the cycle is the generation of a negative relationship between bond yields and credit spreads over a traditional economic cycle. And this offsetting relationship becomes relevant for investors, or even more relevant for investors I should say, given that there is a tendency for investors to be structurally overweight credit spread duration, as this tends to provide investors with one of the more predictable premiums which can be earned in fixed income markets.

And this becomes especially true in a market such as Australia where the credit exposures tend to be high quality. The Australian credit market, investment grade credit market, tends to exhibit low default risk and high quality exposure to credit spreads means that the major risk faced by investors is the mark to market impact from movements in credit spreads. And it is in this context that the traditional negative correlation between interest rates and credit spreads becomes a more important factor for investors as a means of reducing the overall risk within a portfolio. Specifically, investors often utilise longer duration exposures to act as a risk offset to the higher level of credit spread exposure in their fixed income portfolio.

Paul O’Connor:

It's certainly rational, what you're explaining there, Clive, and I guess from an investor viewpoint, I look at it as interest rates are falling, typically it's because economic conditions are deteriorating and hence I get a bit more nervous about my credit in a portfolio, so I will demand a better return effectively and the spreads start to move negatively against the bonds and where the bond yield is going. So, certainly, yeah, it's a complex area to understand, I feel, but it is very important I guess at the end of the day why I think people need to consider and really use a professional manager to manage their fixed interest exposures in portfolios. In your view, has this economic cycle been different? Why has it been different?

Clive Smith:

Well, I think that comes back to what we were talking about before, about one of the reasons why bond markets have generated such poor returns and has been a change in the relationship between bond yields and credit spreads in the post 2019 period. And largely this is attributable to the change in the approach to implementing monetary policy by many central banks as they've adopted quantitative easing. Now, quantitative easing as an arm of monetary policy really refers to, rather than simply altering the official cash rate, central banks begin providing liquidity to the financial markets by intervening directly and purchasing securities.

So quantitative easing can be considered as a non-traditional approach to setting interest rates, to distinguish it from the more traditional approach of simply altering the official cash rate. Now, where quantitative easing becomes much more important for central banks is when it's being utilised as a tool of policy and reliance on it increases where we either get official cash rates approaching very low levels and as we saw with the onset of the COVID crisis and the response to it, interest rates in many countries going to zero. And also it can be very important when central banks need to target policy towards a specific part of the financial system, as opposed to simply trying to stimulate the overall economy.

One of the important impacts of the move to a quantitative easing approach to implementing monetary policy is that the market dynamics have changed, now that the central banks are directly intervening in financial markets to bring around desired outcomes. And critically, movements in credit spreads are no longer simply a byproduct of the central banks' use of monetary policy to lean against the traditional economic cycle. Rather, credit spreads are now being used directly by central banks as a specific target of monetary policy and a lever by which to implement and maintain accommodated monetary policy, so that the lower credit spread is now becoming a specific target. And accordingly, the more accommodated central banks desire monetary policy to be, the more they will intervene directly within credit markets to lower the spread on such securities.

Conversely, less accommodated monetary policy delivers both rising credit spreads and interest rates. So really, it follows that under such a non-traditional framework for implementing monetary policy, investors will find that as central banks lower and then raise interest rates, the interlinkage between bond yields and credit spreads will differ materially from what would traditionally be expected. Yet rather than the negative correlation which investors may be used to under a non-traditional approach to setting monetary policy, there will tend to be a positive correlation between interest rates and credit spreads. The result is that the mark to market impacts from changes in bond yields and credit spreads will tend to reinforce each other as the central banks alter their policy settings. And with this increase in synchronisation, investors will effectively be hit with this double whammy of both rising bond yields and credit spreads as central banks have reduced their intervention within financial markets.

And this is exactly what we saw over the course of the last 12 months as the Reserve Bank of Australia set about normalising policy settings in the face of stronger growth and more importantly, higher inflation, which really resulted in central banks bringing forward and more aggressively normalising interest rates as we came out of the downturn associated with COVID.

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Paul O’Connor:

What is the future of the non-traditional monetary policy, quantitative easing, and do you think it will be continued going forward or is it not required, now that cash rates are moving back to a more normal level, which gives ammunition for traditional monetary policy?

Clive Smith:

The cycle is likely to revert back towards more normal relationships as central banks unwind the policies associated with QE, quantitative easing, I should say, and we've already started to see that. Obviously interest rates have started moving back to what are more normal levels, however the normalisation process is ongoing. We've talked about interest rates, we've talked about the purchasing of securities, but there were other policies in place such as the term funding facility, which will take time to wind down over the next couple of years. Just for those that might not be familiar with it, the term funding facility was about a $200 billion programme where the Reserve Bank of Australia lent money directly to the banks at effectively zero interest rates. And the byproduct of that was that banks did not need to go into the debt markets to raise funds during a period of lower liquidity in markets. That will take time to wind off.

So the normalisation isn't something that just is going to occur overnight. That said, with cash rates moving up to around 3% by 2023, I think it's safe to say, this period of artificially low bond yields and credit spreads, it is behind us. Looking at bond yields, the big question going forward is how quickly inflation will return to the target band of two to 3%, and the longer it takes, the higher official cash rates are likely to go. So it's still an unknown. It's fair to say that the jury is still out on the level of official cash rates that will be required to achieve the RBA and indeed globally other central bank targets. And it's fair to say the central banks themselves aren't too sure at what level they were. So this is going to be very much a process of, for want of a better term, trial and error.

Now, turning to credit spreads, look, the correction we've seen to date suggests that the market is not just correcting or more normalising for the reduction in central bank purchases, but is also anticipating the increase in new issuance as the banks are returned to the market following the roll off of the term funding facility and is building a buffer to that.

So whilst there may be some upward pressure on credit spreads, a lot of the normalisation does appear to have occurred. But that's not to say however that there aren't other areas of markets which still need to normalise. And indeed, the term funding facility, has resulted in the requirement for banks to access markets declining materially, and over time they will need to start coming back to the markets. And I think the area we see that most strikingly is with respect to the term deposit markets where banks have remained very selective regarding where they provide competitive or special rates in order to attract funds and as very episodic their demand for it. The result is we probably don't have a normalised pricing of term deposits across the maturity spectrum, and this is where we probably will see a greater normalisation occurring over the course of the next 12 months.

Paul O’Connor:

Well, I guess that has to be good news for investors there, Clive, if you see a normalisation of rates offered by term deposit issuers. I must admit, I've just been doing a review of our platform term deposit offering and the different issuers we have. So it has been quite marked, the waxing and waning appetite for capital from the banks, but obviously impacted as you articulated on the term funding facility of the RBA. While the outlook for bond yields may still be uncertain, does sound like credit is still quite attractive. Is that really the case?

Clive Smith:

Despite the recent poor returns, I think it's fair to say that the normalisation of monetary conditions by central banks and obviously the market's pricing in the potential increased issuance from the banks over the next 12 months or so, it really has provided some of the best opportunities available for more credit oriented fixed income products for some time. If we think about the opportunities, and to put it in perspective, when we think of the spread of investment grade credit, these really returned back to levels last seen in 2012. So on a positive note at a headline level, investors can now lock in some of the highest credit spreads they've seen in around 10 years. And coupled that with the increase in the base yield, they're looking quite attractive. With that said, I think whilst on the one hand the normalisation of monetary conditions does provide opportunities, these should still be approached with a degree of caution.

And the reason I say that is that the return to more normal conditions is not without its risks, as even the central bankers are unclear as to the impact higher interest rates will have on underlying economic conditions. And such uncertainty is likely to manifest itself as heightened concerns regarding the risk that economies will go into recession. And it's fair to say that recently the market volatility has largely been driven by the waxing and waning sentiment between higher inflation on one hand and concerns of recession on the other.

And it's against this backdrop that investors wanting to take advantage of high credit spreads should really remain wary of assuming excessive default risks within their portfolios. It might be tempting for investors to pile in to credit oriented products to take advantage of higher yields, but the potential threat of rising defaults from a possible recession should not be overlooked. And I think, if you take a balance of risks, it's probably fair to say that whilst we have this threat of recession looming over credit markets, maintaining an exposure which is higher quality in terms of issuers, will probably become increasingly important to ensure that the higher yields promised by markets will be realised in practise by investors.

Paul O’Connor:

Maybe to finish, Clive, what do you view as the key considerations that investors should keep in mind when setting their bond allocations going into 2023 and beyond?

Clive Smith:

I think one of the things investors need to keep in mind when looking at their bond allocations and determining them, and this is probably not going to be a great answer, but I think they need to keep in mind the uncertainty of where the economies are placed and policy is placed at the moment. And in weighing those up, they really have to keep in mind the positives and the negatives that we're seeing in bonds at the moment.

On the positive note, there's no doubt that bond markets are offering some of the most attractive yields seen in the last couple of years. The bond yield and the credit spread relationship should be returning to a more traditional relationship. And indeed, with yields over 3%, bond investors are in a position where they have a much higher buffer, with which to absorb future increases in rates should they occur.

So overall it looks pretty attractive for bonds, and investors might be saying, well, yes, we should be having more allocations to bonds because of that. But the main negative remains that the outlook is unclear and finely balanced between higher inflation on the one hand and the potential for policy mistakes, creating a recession further down the track.

And so I think for investors that are looking at fixed income, you want to be in a position that once you weigh up these pros and cons, you want to be able to take advantage of the opportunities available. But at the same time, when structuring your portfolios, remain conservative and probably have a little bit more of a defensive tilt to how you think about your exposures to achieve a balance. There's the old adage, everything in moderation, and that may yet be the best way forward in the current environment and given the overall uncertainties about what may happen over the next 12 months.

Paul O’Connor:

And can I take from your comments there, be cautious on more, I guess lower rated credit in portfolios?

Clive Smith:

Yes. I think in terms of lower rated credit, investors need to be a bit more cautious. This is not to say necessarily that lower rated credit has a higher necessarily will default, but I think in an environment where the markets are going to be very sensitive to the risks of recession and there may be periods of risk off appetite from investors, they are probably the types of investments that will be more exposed to major volatility in their prices and potentially lower liquidity during these periods than the higher quality type credit in the marketplace.

Paul O’Connor:

Clive, thank you very much for joining us on the podcast today. Your comments and insights into fixed interest, and particularly I guess the way you've articulated interest rate duration and the relationship to credit spread duration has certainly been educative, I guess from my perspective, but I'm sure that the listeners also would've found it very educative. And I think it also highlights, again to the comment that I made earlier, that investors really do need to consider, in my opinion, ensuring that they entrust the management of the fixed interest portion of their portfolios with quality and I think more conservative mindsets in the type of manager that you look for. So thank you for joining us today, Clive. We have very much appreciated your insights.

Clive Smith:

Thank you, Paul. It's been great being part of the podcast.

Paul O’Connor:

And to the listeners, thank you again for joining us on the Netwealth Portfolio Construction podcast series. I certainly hope you've enjoyed today's discussion with Clive from Russell Investments, and I wish you all the best and look forward to you joining us again on the next instalment of the Netwealth Portfolio Construction podcast series.