26 May 2022, 4 min read
Financial markets are undergoing some active upheaval with rising inflation resulting in the Reserve Bank of Australia (RBA) deciding to marginally raise the official cash rate target by 25 basis points.
Australia has long been a haven for financial stability and economic security and even fighting a global pandemic for two and a half years, the Commonwealth Government managed to ‘buy’ its way out of a recession and is now seeing strong growth on the other side. But as financial conditions tightened globally and the probability of recession has heightened by 2024, there is pressure on the Australian economy to stay strong and avoid any lag affect.
One area of interest in the financial markets is fixed interest markets, their performance to date and what impact inflation may have on their performance in the future.
“The recent history of fixed interest markets in Australia and Europe is interesting,” Osvaldo Acosta, head of fixed interest assets, Insignia Financial, says. “During the COVID-19 period global governments and central banks had to stimulate their economies in order to avoid a deep recession.
“Yields went into historical lows and in some European markets, into negative territory.
“Now, as we are moving out of the pandemic, rates need to go back to more neutral levels, which is going to be painful for fixed interest markets and growth assets.”
The Bloomberg Aus Bond Composite 0+ Index1 has fallen 5.55% over the past 12 months to March 31, 2022, this is a worrying sign for the future.
“As yields are moving higher, this has caused bond prices to fall,” Acosta says.
As for the future of fixed interest markets, with interest rate rises expected to be announced regularly over the next 12 to 24 months and experts estimating the RBA’s cash rate target to reach 3.5%, this will in-turn slow down the overheated housing market and impact upon cashflow of businesses and individuals alike as cost of financing increases.
“If central banks start to remove liquidity from the market, then it is going to be quite painful for growth assets,” Acosta says. “So, in our view, it is going to be very tough environment for all types of assets.
“We are starting to move our portfolios to a more defensive strategy. We are looking into sectors within our portfolios that are going to be more volatile, that are more vulnerable to that removal of liquidity, where asset prices are likely to be more unstable. We are investing into sectors that are less sensitive to higher rates and inflation, moving up credit quality and increasing the liquidity in the portfolios.”
Currently, 10-year Australian government bonds are yielding 3.5%, which is an attractive level for a risk-free bond. Bonds look set to become an appealing investment option now and into the future.
“Bonds are exhibiting the characteristics you’d expect from the asset class,” Acosta says. “They are producing good and stable income and proving to be a good diversifier in an overall portfolio. We have done some stress-tests in the portfolios and if we were to experience another GFC-like event where equity markets are down 35% or more, bonds, because of their current yield, could give you double-digit returns.”
“If you hold a bond to maturity, and that bond doesn’t default, not only are you getting the income through the life of that bond, but you are also going to get your capital back. So, it is important that investors have a long-term focus in this asset class.”
“Investors are now getting a good income for less risk and that is important.”
Bonds can be a strong option for retirees and those investors who previously hadn’t considered them. They are a good diversifier in multi sector portfolios where you have a mixture of growth and defensive assets.
Go with the experience
Fixed interest is a complex asset class requiring experience and technical expertise and that’s what the investment team at Insignia Financial, who manage portfolios across the suite of funds branded OnePath, IOOF and MLC Asset Management, pride themselves on.
“We think it is really important to understand the risk-return drivers in building a portfolio in this asset class,” Acosta says. “That’s been part of our success in the return that we deliver to our clients. We have a long track record of providing higher risk adjusted returns than our competitors for our IOOF MultiMix Diversified Fixed Interest Trust2 and that’s because we invest in sectors that deliver - we spend a lot of time understanding the risk under the bonnet of our portfolios.”
“Our investment philosophy is that the market is constantly moving so your portfolio needs to adjust. If you go back to March 2020 we had a full re-pricing of risk assets resulting in both equity and credit markets being down, so we used our risk budget at the time to invest in sectors that we felt were going to provide a very good return over the next two years.”
“If we had stayed passive, we wouldn’t have made those rotations and our investors would have suffered but they didn’t, their portfolios performed well.
The investment team took an active approach, moving into high grade credit, leveraged loans and other credit sectors that were higher yielding, and reducing long-dated bond allocations as these securities would be impacted when yields started to rise.
Looking back, this produced better returns than the passive strategies. But over the past six months, the team have been reducing the risks within their portfolios and rotating into higher liquid bonds because yields are more attractive.”
“What we are doing now is improving the credit quality of our portfolio, which will improve the yields by undertaking more liquid strategies,” Acosta says. “Right now you want to be positioned defensive, high-quality and with more liquidity within the portfolio because if there is a market dislocation, you want to be in sectors that are less volatile.”
“For us, the way we position in the market at the moment is to think about improving the liquidity in the portfolio, so, if those dislocations happen in the market, we are able to deploy our capital into areas that offer very good risk-adjusted returns.”
When interest rates start to rise investors immediately become nervous. Depending on the array of diversity within their portfolio, they know it is time to become proactive and try to stay ahead of the game rather than being reactive, which usually results in moving too late.
“There’s going to be a heightened level of uncertainty within the market over the next 12 months and the impact which that causes,” Acosta says. “What investors need to think going forward is to stay the course within this asset class, as it needs to be viewed with a longer-term perspective over different economic cycles.”
1 This index is designed to measure the Australian debt market and is a market value weighted composite of Treasury, Semi-Government, Supranational/Sovereign, and Credit indices.
2 Source: Chant West Implemented Consulting Survey March 2022. The IOOF MultiMix Diversified Fixed Interest Trust is ranked number 1 for all periods (3 months, FYTD, 2, 3,5, 7 and 10 years) except 1 year.
This information is current as at 9 May 2022 and is issued by IOOF Investment Services Ltd (IISL, we, us, our) ABN 80 007 350 405, AFSL 230703 as Responsible Entity of the IOOF MultiSeries, IOOF MultiMix Trusts, IOOF Cash Management Trust, MultiMix Wholesale Trusts. IISL is part of the Insignia Financial Group of companies, consisting of Insignia Financial Ltd ABN 49 100 103 722 and its related bodies corporate.
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