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For many years, allocators have been underweight fixed income thanks to the ultra-low-interest-rate environment. But is the time now to start adding back the asset class and duration as investors anticipate a more volatile environment to come? Can fixed income now be used for its defensive nature as it was intended? In this Citywire Australia special, we speak to fund managers and wealth managers about how they’re tackling fixed income in their portfolios given recent yields have not been seen for the past 10 years and what parts of the asset class are now attractive. We asked asset consultants how they were advising clients on increasing allocations and what role the asset class would play going forward. What is clear is that fixed income is emerging from its ‘boring’ status but allocators will need to keep an active eye on it rather than setting and forgetting.
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Fixed interest’s role as a defensive lever has been called into serious question over the past three to five years, particularly when yields have been low or even negative, but recent market moves might be bringing the asset back into favour, according to asset consultant Frontier’s head of debt and currency Andrew Kemp. ‘There was a real sense from investors that they were questioning how much downside protection you would get from the bond allocations,’ he said. Kemp has been with Frontier for six-and-half years and has led the debt and currency team for four years, having previously worked for Axa, AllianceBernstein, BDS Bank in Singapore and asset management company Chimaera Private.
We have experienced a significant increase in interest rates and bond yields to the point where bonds are re-establishing themselves as a diversifying lever
Economists are fretting about a new recession, driven by the Fed’s relentless rate hikes, and bondholders are demanding a far higher premium for holding short-term debt.
by Dan Purves
Fixed interest: time for the comeback?
Andrew Fisher, Australian Retirement Trust
He explained that the problematic thing about fixed interest was that in the ultra-low interest rate environment it had a high correlation with equity performance, nullifying its effect as a diversifier. And Kemp’s view seems to be shared by institutional investors. The $230bn Australian Retirement Trust’s (ART) head of investment strategy, Andrew Fisher, explained that his fund had done research on this in the aftermath of the Covid-19 market correction and had concluded that fixed income had indeed been limited in its capacity to insulate portfolios, with lower-yielding bonds being less effective as a defensive exposure based on the ultra-low-yield environment in late 2020. In response, ART lowered its allocation to bonds and increased its strategic allocation to foreign currency, with its research supporting the latter’s ongoing diversification benefits. While Kemp believes the correlation will remain elevated for a little while longer, he thinks it is worth reconsidering fixed interest as a defensive lever in a portfolio given the rapidly changing market environment. A key decision from a strategy level is when to allocate back into long duration assets. ‘The defensive levers in bonds have been downgraded quite significantly in terms of the size of the portfolio. But with the change in yields we’ve upgraded our view from one that was pretty negative a couple of years ago to one that’s still negative, but less so than it was,’ Kemp said. He observed that he was starting to see more large funds making higher allocations back into the core fixed interest for the defensive attribute that it provided. This has been the case at ART, with Fisher noting an increase in allocations to fixed income. ‘Over the course of 2022, we have experienced a significant increase in interest rates and bond yields to the point where we believe that bonds are quickly beginning to re-establish themselves as a diversifying lever from a portfolio construction perspective and we would view fixed income as a growing rather than shrinking lever from that perspective – albeit from a low base,’ Fisher said. ‘By contrast, the deterioration in the Australian dollar sees foreign currency becoming a shrinking lever in our portfolios with the Australian dollar having less capacity to fall from current levels to insulate portfolios.’
Darren Langer, Yarra Capital Management
So if you’ve been underweight in fixed income it’s probably getting to a point now where things are starting to get attractive
Difficult timing
Kemp noted that it is an incredibly challenging environment for investors, with central banks treading a fine line between slowing inflation without tipping economies into recession. Consequently, the business cycle – and the likely path of corporate earnings and default rates – is difficult to interpret, which makes knowing what to do with corporate credit difficult. ‘You’re never going pick the perfect entry point. So I think it’s just a matter of them making smaller allocations as a result,’ he said. Kemp deviates from the consensus view when it comes to speed of defaults in the next couple of years. ‘Focusing on low-yield bonds, the financing requirement is actually relatively low in the next year,’ Kemp said. ‘So it could be that we’re at a stage where we’ve got relatively elevated yields in some of these markets and the default premium that was priced in might be slower to eventuate, and it could be that it’s a more pronounced worn-out default cycle this time around.’
More changes
Other changes are also under way. Within debt there had been continued change with private markets, and both Australia and globally it had come a long way, Kemp said. ‘The investment opportunity is becoming more and more understood. I think we’re seeing a lot more people and investors looking to establish some kind of allocation for the long term. Sometimes these things take a lot to percolate through, but investors continue to look to broaden the way that they allocated to their debt portfolios,’ he said. ‘If we move away from the defensive stuff and talk more about the growth phase of debt investments there’s views around how the high-yield bond market has changed relative to the leveraged loan market, for example. ‘Once high-yield bonds were viewed as quite a high-risk proposition and loans were lower risk, but it is now transitioning the other way. There has been slippage in the in the overall credit quality in the loan market, bearing in mind these are very large markets core to the funding of a lot of businesses. ‘If you’ve got a loan, you’re essentially paying a higher rate of interest than if you had issuance in high-yield bonds from a number of years ago at quite low and fixed levels. ‘There’s interesting things happening under the surface in terms of the structure of these markets, and all of that is really going to be tested with what is likely to be an uptick in default across some of these markets as we go through the next couple of years.’
Andrew Kemp Frontier
It has been a tough few years for fixed income investors but Darren Langer’s advice is to ‘hang in there’ because it’s about to get better. Langer, the co-head of Australian fixed income at Yarra Capital Management, says the twin drivers of inflation and rising interest rates are transforming fixed income markets, creating a ‘shock’ that has initially been destructive for value. But after the shock, he says, should come an improvement that will reward investors already allocated to the asset class and inspire fresh interest from others, disillusioned with volatile equity markets and looking for lower risk along with positive returns. ‘When you have these shocks to the system in fixed income, it’s not like equities where you can have long periods of time when things don’t recover,’ said Langer. ‘The next couple of years after a major shock in fixed income markets is usually pretty good. ‘So if you’ve been underweight in fixed income it’s probably getting to a point now where things are starting to get attractive.’ Yarra’s fixed income focus is focused squarely on Australia, from government debt through to corporate bonds and private debt. Yarra offers four fixed income funds, one of which is the Enhanced Income fund – rebranded as Yarra after the 2021 buyout of Nikko in Australia – which accesses a diversified portfolio of hybrid and fixed income assets. The Enhanced fund and the Yarra Income Plus fund have both returned better than 5% since inception and these more floating rate funds were now seeing good inflows as investors look for returns. Performance at the other funds has been more modest, with the Yarra Australian Bond fund in negative territory over three years but matching its benchmark – the Bloomberg AusBond Composite 0+YR Index – since inception. When rates peak, however, it is likely that investors’ interest will pick up as they look for diversification from equities. ‘We cover the whole spectrum of Australian fixed income, and we basically use the same process, whether we are looking at private debt right through to higher-grade bonds,’ said Langer. ‘We use the same approach to those bonds and with the riskier debt, we are seeing pretty decent yields right across the market now, and we’re at a point where you’re actually getting paid for taking a bit of risk.’
by Lachlan Colquhoun
Starting to get attractive
Australian resilience
Like many market watchers, Langer and his team are watching closely for signs of a global recession, although they do see some resilience in Australia. ‘The world is definitely going to slow, and a recession is a much higher probability,’ he said. ‘So what we’ve been doing is increasing the quality of credit in our portfolios. We’ve been shortening the duration and trying to basically reduce our risk.’ While focusing on quality, Langer sees the Australian credit market as ‘actually incredibly strong’. ‘Corporates here are in good condition so we don’t think there will be any major default problems,’ he said. ‘But that doesn’t mean that if there’s a recession, we won’t be a little more defensive. ‘I’d say we are investing with the idea that a recession is a possibility and the probably is higher than it was.’ At the same time, with yields high there are opportunities in the market and Langer has been having a good look at local bank debt, ‘which has always been focused on value’. Each of the Yarra fixed income funds has a different risk tolerance, and although investors are ‘getting paid to take risk’ right now, the market was no ‘free for all’ and there was still an amount of caution guiding sentiment. This caution extended to asset-backed securities (ABS), where Langer said he would be ‘a little bit more wary’ about pools of credit card receivables and car loans. ‘We really don’t know how the consumer is going to behave,’ he said. ‘Some ABS asset classes are also not very well developed in Australia. Investors are comfortable with housing markets and RMBS [residential mortgage-backed securities] assets, but once again for us its how far down in the capital structure do you go. ‘We do feel fairly comfortable with housing but there is going to be a decline in house values, given the rise in interest rates, so once again we have to be cautious.’ One of the positives in the ABS world was that there is unlikely to be much new issuance in the market at a time when spreads are sensitive.
Lack of visibility
Amid the market stampede into private debt, Yarra has remained agnostic. Rather than creating a dedicated fund, private debt is combined with other fixed income investments across the Yarra funds. Langer’s view is that private debt has a place in a portfolio but it is no replacement for public debt. ‘There’s nothing special about private debt, it’s just that it’s generally more complicated,’ he said. ‘Some people like it because it’s not being constantly revalued, but the point is that if you actually want to sell it, you don’t have the same visibility over the valuation. ‘Of course, you’ll generally get a higher return on it but it requires a lot more credit analysis because none of the information is public.’ One characteristic that is similar for public and private debt is that if the borrower defaults, ‘you end up with the same outcome, a default’.
Darren Langer Yarra Capital Management
Like many market watchers, Langer and his team are watching closely for signs of a global recession, although they do see some resilience in Australia. ‘The world is definitely going to slow, and a recession is a much higher probability,’ he said. ‘So what we’ve been doing is increasing the quality of credit in our portfolios. We’ve been shortening the duration and trying to basically reduce our risk.’ While focusing on quality, Langer sees the Australian credit market as ‘actually incredibly strong’. ‘Corporates here are in good condition so we don’t think there will be any major default problems,’ he said. ‘But that doesn’t mean that if there’s a recession, we won’t be a little more defensive. ‘I’d say we are investing with the idea that a recession is a possibility and the probability is higher than it was.’ At the same time, with yields high there are opportunities in the market and Langer has been having a good look at local bank debt, ‘which has always been focused on value’. Each of the Yarra fixed income funds has a different risk tolerance, and although investors are ‘getting paid to take risk’ right now, the market was no ‘free for all’ and there was still an amount of caution guiding sentiment. This caution extended to asset-backed securities (ABS), where Langer said he would be ‘a little bit more wary’ about pools of credit card receivables and car loans. ‘We really don’t know how the consumer is going to behave,’ he said. ‘Some ABS asset classes are also not very well developed in Australia. Investors are comfortable with housing markets and RMBS [residential mortgage-backed securities] assets, but once again for us it’s how far down in the capital structure do you go. ‘We do feel fairly comfortable with housing but there is going to be a decline in house values, given the rise in interest rates, so once again we have to be cautious.’ One of the positives in the ABS world was that there is unlikely to be much new issuance in the market at a time when spreads are sensitive.
For many years fixed income has been labelled as the ‘boring asset class’ with next-to-nothing returns but now as yields and returns have started to rise allocators have started to turn their heads. However, Citywire AAA-rated fund manager Janus Henderson’s head of Australian fixed interest, Jay Sivapalan, warns that what worked in the past 30 years may not work in the next 30. Sivapalan said in 300 years of data, bond yields in Australia and globally had never artificially reached the lows they had done, in some places negative yields. ‘That’s a really big clue that we were living in extraordinary times and that has to, in my mind, reverse,’ he said. ‘We’re really going back to some of the good things from the past, which is proper allocation of scarce resources and then from an asset allocation perspective for professional, institutional and personal investors a much more balanced view about each asset class and the role it can play. ‘Rather than chasing a 90/10 portfolio, we’ll be going back to a proper 60/40 or 70/30 portfolio.’ Sivapalan said investors would now be looking at higher-quality fixed interest’s ability to influence total return as repricing would lead more to gravitate to the asset class. ‘The defensive characteristic of fixed interest is gradually but surely being restored. That means when the next crisis happens it can again play the role of being negatively correlated or lowly correlated to equities. Obviously, this year it failed in that role because the starting point was ultra-low bond yields,’ he said. ‘When we think about the retiree decumulation stage, fixed interest and the income it can provide is now starting to become really interesting. In today’s language, we can build portfolios of high-quality credit in that 5.5-6% yield, which has been unheard of in the past 10 years. ‘That is something we haven’t had in fixed interest in the past few years. We were struggling to get 1% so it’s really changed the dynamic.’ The Citywire AAA-rated fund manager said today investors could buy government bonds with a real return of about 2%, which was a ‘really attractive proposition’. That overlaid with safe sectors like AAA and AA credit-quality state government bonds, major banks and universities would allow portfolios to build yields of 5.5-6%.
It is far better to drive change from the inside by having open and honest conversations with senior management and the board than to walk away and immediately lose any leverage for change
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This assumes climate policies are introduced early and become gradually more stringent. Both physical and transition risks are relatively subdued
This assumes policies are introduced late, are delayed or are divergent across countries and sectors. There is a higher transition risk
Cimate policies are implemented in some jurisdictions but are insufficient to halt significant global warming. This results in greater physical risk from, for example, extreme flooding, which will seriously affect GDP
1 EJ = Energy of 1 quintillion joules Source: IIASA NGFS Climate Scenarios Database, MESSAGE model.
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Jose Garcia-Zarate, Morningstar
There has been a lot of product development recently, particularly in the fixed income space
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by Jassmyn Goh
The asset class is back in vogue and certainly from an asset allocator’s perspective, there’s going to be greater consideration provided to fixed income
Jay Sivapalan, Janus Henderson Investors
Back in vogue but don’t set and forget
With volatility continuing to rock markets, Sivapalan believes investors will redirect more of their investments towards certainty such as government bond coupons or cash flows. ‘It also applies to areas that are either partly protected by government or regulated by government. The areas we like are toll roads, ports, seaports, airports and the non-discretionary part of retailing where you’ve got a certain nascent demand that needs to be satisfied and the cash flows are protected or regulated by governments,’ he said. ‘I think the asset class is back in vogue and certainly from an asset allocator’s perspective, there’s going to be greater consideration provided to fixed income. ‘However, fixed interest is not an asset class where you can put in the bottom drawer, shut it and pick it back up in another five years.’ Sivapalan explains that one of the most critical aspects of managing portfolios over the next five years is the ability to being nimble and active in fixed interest, especially in interest rate management, or duration, and being sensitive to which pockets of the corporate debt market the portfolio is exposed to. ‘The benchmarks, unfortunately, today are a poor investment portfolio and don’t represent a good investment portfolio in our view,’ he said. ‘As much as I love my own asset class, it’s not the time to just load up and put it in the bottom drawer. We won’t be at that moment until a fair bit of change occurs.’ The fund manager said intermediate-duration and high-quality fixed interest were ‘ready to go now’ and investors and super funds could allocate to those areas today. ‘When they look back in five years’ time they will feel that that was a good allocation to make,’ he said. Sivapalan noted winners would also be borne out of the energy transition from a local perspective given the government’s emissions reduction commitment. ‘Some entities and investments will enjoy either explicit or implicit government support, or subsidies and these projects are being de-risked from an investor perspective,’ he said. ‘As a senior lender we’re talking to different arms of the government about fantastic opportunities that are likely to come out in the next three years.’ However, the areas that were not ready load up on just yet were longer-duration fixed interest and other areas of lower-quality credit. While long duration was starting to become more attractive there was still a journey to go for investors who were not keen on volatility as it was difficult to pick the peak in bond yields or the trough in prices. Those investors happy with a bit of volatility could start investing in long duration. Lower-quality credit along with private debt could be entered selectively but Sivapalan warned against going all in. ‘That is an area where we haven’t seen the earnings revision cycle come through from corporate Australia or corporates globally. But that should come through in the next 12 months and when that happens we’ll see the bottom in those markets and that will provide a better opportunity for investors,’ he said.
Alternative outcomes
Sivapalan has been AAA-rated since September 2022 and manages just under $15bn. Over the three years to 31 October 2022 his Janus Henderson Tactical Income fund has a cumulative return of 1.35% and the Janus Henderson Australian Fixed Interest fund has a cumulative return of -8.64% compared with the funds’ Bloomberg AusBond Composite 0+Y benchmark return of -8.64%, according to Morningstar. Over five years, the Tactical Income fund returned 7.12% while the Australian Fixed Interest fund returned 2.21% compared with the benchmark return of 3.65%. Sivapalan has been in funds management since 2001 and says the biggest lesson he has learnt during this time is being mindful of alternative outcomes. ‘I’ve had to learn to be open minded that we can have an inbuilt base case view but we need to be mindful of the alternative cases and what they look like,’ he said. ‘I think about portfolios in the context of “if the alternative case number one played out what would be the return outcome for our portfolios? If the unlikely alternative case number two happens, what does that look like?” ‘From a practical perspective, “when are clients likely to be unhappy but forgiving or unhappy but not forgiving?” That’s something that we’ve had to learn over a long period of time.’ When thinking about how to invest differently while managing a more volatile investment environment Sivapalan said it was to do with drawdown relative to a client’s expectation. ‘It’s really about understanding drawdown, drawdown risk and pretending that the GFC or the European sovereign debt crisis happening tomorrow and thinking through what might happen in your portfolio,’ he said. ‘Then it’s about making sure that the clients and investors are comfortable with it.’
Jay Sivapalan Janus Henderson Investors
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Real estate investment has historically provided a strong inflation hedge, but the consequences of increasing interest rates and the looming recession threat represent counterbalancing concerns in the industry. Mark Power, acting head of income credit funds and head of build-to-rent fund at Qualitas, talks us through the structural changes that could lead to a shift in demand for real estate investment. What does inflation mean for real estate investors? There has been a sharp acceleration in inflation over the past few months. High interest rates can be both positive and negative for real estate investors. An inflationary rising rate environment is highly beneficial for private credit investors as the increase in the base interest rate flows straight through to investor returns. Another important aspect to consider is the equity cushion within private credit, which provides investors with significant capital protection in the event of declining asset values. In the current market situation, we could see debt liquidity dry up in the market, which could increase returns via an increase in risk margins. The downside of the ongoing uncertainty is that asset values can come under pressure. We need to be cautious and patient when looking to attach ourselves to assets that provide a strong inflation hedge. How diversified are your investments and could you please talk more about your investment strategies? At Qualitas, we monitor the diversification of investments very closely and adapt allocation to best position portfolios as per the current market requirement. Our investments are diversified from a composition, sectoral and geographical perspective. In terms of composition of our portfolio we invest in senior commercial investment loans, senior residential residual stock loans, senior debt pre-development land loans, senior debt construction loans. Centrally, we invest across residential, commercial office, industrial and retail markets. From a geographical perspective, we’re very much focused on the Australian eastern seaboard with a heavy focus on the primary gateway cities.
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Mark Power Head of Income Credit, Qualitas
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The new reality of real estate: Inflation rates and ESG
Can ESG be a value driver for real estate? ESG has become an important business consideration around the globe. Real estate investors focus more on sustainability. ESG can be so much more impactful as a driver of value for real estate. At Qualitas, we rate every single investment we make using our proprietary ESG rating tool, which is largely a qualitative-based tool and has a three-star scoring system with three being the highest and one considered an underperformer. The tool examines a range of factors, including carbon footprint, contamination of land issues, design standards, materials used, labour practices, governance structures. The business ethics, diversity of the workplace and the board, legal compliance also play an important role at Qualitas. On the ESG front, developers are embracing the construction of highly sustainable buildings, particularly in office and residential build-to-rents. In the coming times, underperforming assets in terms of the ‘E’ have a heightened transition risk, which at the extreme can lead to an asset being stranded. For example, the commercial office market, where you have significant amounts of B and C grade stock which aren’t necessarily fit for purpose in the new post-COVID environment with employers seeking to provide an attractive workplace to encourage people back into the office. What are some of the real estate trends you believe will drive performance going forward? ESG is an important and significant trend that’s gathering pace at an exponential rate. In the private credit space, it is quite challenging to direct developer behaviour around the ‘E’ in ESG and ensure that what they are developing meets the ESG standards. The Qualitas Build-to-Rent Impact Debt Fund is Australia’s first property debt fund to elevate minimum sustainability criteria into its investment criteria. We developed the product in conjunction with our seed investors, the Clean Energy Finance Corporation. It will finance housing that meets strong sustainability standards and reduces greenhouse gas emissions by at least 35% compared with the current building code. Improved energy efficiency means lower energy consumption for residents and asset owners. Industrial and logistics is another trend we’re seeing in the market that we have over the past couple of years, and we think it’s still got a fair way to play out. It continues to attract very large amounts of institutional capital that’s chasing a sector that is struggling to actually produce sufficient stock to meet demand. The third trend is the emergence of build-to-rent (BTR) and the re-emergence of the build-to-sell sectors. The housing crisis where projected housing supply is just grossly inadequate to meet demand. Given the attractiveness of the Australian commercial real estate (CRE) private credit market, we’re seeing increased demand from offshore institutional investors driven by the high domestic demand for residential dwellings. The Qualitas Real Estate Income Fund (ASX:QRI), a pure-play CRE credit fund, can potentially benefit from the shortfall in residential supply. In the September quarter, the Fund recorded a 74% portfolio weighting towards the residential sector due to the increased opportunities in the current environment. While investors may be apprehensive during this period of rising interest rates, QRI has various protections that can possibly provide a hedge to rising rates due to its short tenured loan portfolio (1.1 years) allowing for frequent repricing of loans and a portfolio that comprises of 67% variable loans as at 30 September 2022. The Fund will continue to be shifted to variable rates loans as the remaining fixed rate loans mature. It is likely up to 90% of the loan portfolio will be on variable rates by mid 2023. As interest rate continue to rise these loans provide a solid foundation for potential ongoing attractive returns, taking advantage of interest rate rises to the benefit of its investors. Where are you seeing the biggest opportunities in the private real estate space? With the ongoing market uncertainty and increased volatility, private real estate investing can provide a unique opportunity for targeting substantial above-market returns. According to APRA data, the lending of traditional financiers to CRE borrowers has been decreasing[1], which provides alternate lenders with attractive risk-return opportunities. Secondly, in terms of other opportunities, Qualitas strongly advocates the BTR market in Australia and has deep strategies in both equity and debt. Thirdly, we expect there to be great opportunity in the residential market via the build-to-sell sector, from a private lending perspective, in pre-development land loans, construction loans and residual stock loans. Australia is in a period of significant housing shortfall with many struggling to purchase and rent property. The Treasurer in the Federal Budget highlighted that the Australian Government will increase the permanent migration cap in 2022-23 from 160,000 to 195,000 places. These increases to permanent migration visas will only exacerbate the existing housing supply shortage. With the price gap between apartments and houses at its widest point in 13 years and vacancy rates at an all-time low of below 1% as at August 2022, we expect new apartment stock will be introduced into the system to alleviate the strain on the housing market. These apartments must be funded by someone and with banks tightening their lending requirements. An alternative financier such as Qualitas is well positioned in the current environment.
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