Positioning the key amid continuing fixed income uncertainty

A Money Management roundtable has signalled that judging duration exposure remains a key factor in the fixed interest space in the face of continuing uncertainties in the US and elsewhere. 

Mike Taylor (MT) 

Managing editor, Money Management 

Christopher Joye (CJ) 

Founder, Coolabah Capital 

Libby Newman (LN) 

General manager, income and multi asset, Lonsec 

Damien Wood (DW) 

Principal, Spectrum Asset Management 

Brad Bugg (BB) 

Head of multi asset income, Morningstar 

Andrew McKee (AM) 

Financial planner, Australian Unity 

MT: I think the best place to start will be in determining the panel's view on the  outlook for fixed interest over the remainder of this year and moving into 2017.  And, oddly enough, we do have a US election in that period. I'll start off with you, Chris. 

CJ: Yeah, okay.  So I guess we look at fixed income from two perspectives, one is risk-free duration and another is the credit component.  So here in Australia, if you look at the Composite Bond Index, the two key return risk factors are risk free duration and credit. 

In relation to risk free duration, we've had a negative view for some time really predicated on core consumer price pressures building in the US as a function of the jobless rate falling below the five per cent level.  So it's currently at 4.9 per cent consistent with the Fed's view on full employment.  And if you look at inflation in the US, the three main measures outside of the Fed's preferred proxy, which is something called the PCE Index, the three other main measures of core inflation in the US are currently all, year-on-year, between 2.3 per cent and 2.7 per cent. The Fed's got a two per cent target.  And the PCE tends to lag these indices. 

The PCE printed this week at 1.7 per cent in an upside surprise.  The Fed's not forecasting that the PCE hits two per cent until 2018, the end of 2018.  So our view has been for a while that US inflation will surprise on the upside and that will force a re-rating at the long end of the yield curve. We think the term premium in the US is far too small.  So it's about - the current term premium, that is the difference between the 10-year yield and the one-year yield, [which] is currently about 200 basis points smaller than its historical average.  And it's only being - I think - we think at fair level, currently based on global PMIs for 10-year risk-free rates in the US is about 2.2 per cent.  They're currently about 1.7 per cent so we, again, are of the view that the long end needs to normalise. 

So this is bad news for duration, bad news for risk free rates because they're so heavily distorted by global quantitative easing (QE).  So the outlook for fixed income from a duration point of view [is] very negative.  However, increasingly we're seeing inside investors decouple the two - so looking at floating rate credit or swapped no duration credit and then duration.  So our view on credit in Australia, we only focus on the credit in Australia, is positive. 

So the quick summary there is that if you look at every asset class, if you look at Aussie equities, global equities, if you look at Aussie residential property or Aussie commercial property, all those asset classes look heinously expensive, vis-a-vis 2007 pre-GFC level is terms of, for example, PE multiples, price-to-income ratios and yields. 

If you look at A-rated spreads here in Australia, non-financial corporate spreads, if you look at BBB-rated spreads and if you look at financial spreads, they're all way above their 2007 marks.  And then if you adjust by cash rates or if you adjust by government bond yields then obviously everything looks cheap because long-term cash rates and long-term risk-free rents are so low.  So our point is [that] the outright spread levels are much higher than they were in 2007 in contrast to almost every asset class.  So we've argued that Aussie credit has actually got quite cheap and, along with volatility, does that mean one of the few cheap asset classes that exists? 

The final point in relation to that is financial credit. 

Financial credit is even cheaper again.  What's interesting is if you look at Aussie financial credit spreads [is that] the blow-out in 2011/12 was actually worse than the blow-out in 2008/2009.  So the GFC really, in some respects, occurred in 11/12 and the blow out in spreads in February, given what was happening in Europe and also given some of the hysteria prompted by Bronte Capital around a sub-prime crisis in Australia, the blow-out in Aussie financial credit spreads was actually, in senior CDS and sub-CDS and cash sub-markets, not quite as bad but almost as bad as the GFC in 08/09. 

So our view is credit has been pretty cheap.  It was certainly cheap in 2015, it was very, very cheap in early 2016.  It's coming back to fair value now but we think the outlook for credit is okay, particularly if rates are normalising on the back of real economy strength.  So obviously if we've got a massive inflation crisis, that's going to be negative for credit but, in the short to medium-term, we've got a positive view on credit and have had for about 18 months. 

MT: Libby? 

LN: Yeah. I probably agree with you on the US view.  In Australia and, I think, in other parts of the world - there's probably pressures building the other way. Europe is still in a bit of a basket case, Brexit's obviously going to weigh on the UK economy so I think there are other pressures. 

I think de-synchronisation has occurred and Australia is still one of the few bond markets that's got a decent credit rating and a positive yield.  So I still think there's some technical support for our bond market even in the face of US inflationary pressures and a less rosy scenario for that market. 

On the credit side, I'd probably agree that, in terms of shorter dated investment grade credit I don't know that it's a screaming 'buy' but I still think it remains reasonable value given a carry. 

There's other parts of the credit markets that have been a bit heated, I guess, that we'll probably be watching a little bit more closely but I think [with respect to] shorter-duration credit, [we're] probably a little bit more positive on the Aussie bond duration. 

I think for the last few years lots of people have been going 'yields have got to go up, yields have got to go up' and some years you're right and some years you're wrong but it's been surprising that duration is still working even at negative yields. 

MT: Damien? 

DW: Pretty similar comments to Chris.  I mean, we're probably less, I'd say, slightly negative on duration risk than the US and that would then dovetail to being slightly negative on Australian duration.  We think, though, the risks are heavily skewed on the negative. 

As Chris alluded to, there's some building inflation pressure which, therefore, if it's going to come out, is only going to be very negative.  Like him, [we are] also very positive on credit spreads in Australia.  We see them cheap versus global credit spreads.  For example, you can get an extra 50 to 75 basis points for BBB in Australia versus a BBB offshore.  We think they're about historically normal credit spreads and, most importantly the default risk in Australia looks very low.  Australian corporates haven't gone on a debt binge as other parts of the economy may have and the debt serviceability of Australian corporates, as a whole, is very, very strong. 

MT: Brad? 

BB: Yeah, I think not to sort of echo everyone's comments but we're pretty cautious on duration risk, both here and in the US going forward.  We worry that all the central bank action is losing its effectiveness and the world has to now think about alternative measures to go about providing the stimulus the world needs to push global GDP growth back towards trend.  That's probably going to be inflationary so we'd agree that there is the real risk of inflationary pressures going forward. 

So if you're in the duration space, we would probably favour inflation-linked government bonds over nominal bonds at the current time.  In the credit space, yeah, we agree Australian credit is a bit of a stand-out.  It's probably because of all the central bank activity we've seen around the world.  We've got Japan, we've got Europe and now the UK buying corporate paper.  So, yeah, that's artificially depressing spreads in those parts of the world.  So, yeah, I think our credits, whilst we have a concentrated market, does offer some pretty good value at the current time. 

MT: And, Andrew, you're the resident and perhaps token financial planner here. 

AM: Token financial planner.  My view comes from the point of view of client portfolios and how you construct them.  I think there's a likelihood that global interest rates will be increasing over the next period, 6, 12, 18 months and that means the risks are not symmetrical in that market so be cautious about having exposure to duration in client portfolios.

Ultimately, with a 10-year outlook, the US fed starts to move on interests rates, you'd expect those longer-dated yields to reflect a more normal future as opposed to emergency interest rate settings that they're currently reflecting.

Click here for part two of this roundtable: Making sure defensive portfolios are defensive
Click here for part three of this roundtable: The reality of lower return expectations