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Fixed Income Update

Lonsec has recently completed it’s Fixed Income managed funds sector review, where Lonsec goes into a detailed assessment of each participating fund manager’s capabilities. A rating/recommendation gets ascribed to each fund formally reviewed, which allows subscribers to assess the fund in both an absolute and relative sense. The resulting viewpoint reports (accessed at the Managed Funds tab in the Members Research Portal) provide subscribers with a greater understanding of Lonsec’s views regarding each participating manager’s investment and management capabilities within the sector, the areas where each manager may have particular strengths and weaknesses, and how these relate to the ability of the manager to add value to investor funds, over the medium-to-longer term. Lonsec views this time horizon as three years and beyond

The fixed income sector review also provides a number of insights into the fixed income asset class, which are detailed below.

Rates

When the previous Fixed Income sector review was released in June 2021, interest rates were on their way down from highs following February’s major bond selloff. The Delta variant of the coronavirus was running rampant, resulting in a worsening economic outlook around the world. This pessimism would continue for several more months, with the yield for 10-year Australian Government Bonds bottoming out in late August at approximately 1.07%. Inflation has been a key point of contention throughout the year, with Central Banks around the world insisting that the currently high levels of observed inflation throughout 2021 are transitory in nature. However, as the world began to open again following Delta, a substantial portion of the market began to take a contrary view, believing that protracted high rates of inflation would force Central Banks to taper their bond purchases and commit to raising interest rates sooner than they envisaged. This inflationary narrative has resulted in a sharp rise in longer term yields following August’s lows, with the yield for 10-year Australian Government Bonds sitting at 1.88% as at 23 November 2021, surpassing the recent highs seen in February’s bond market selloff. Until recently, rising yields had been a phenomenon observed only at the long end of the curve, as the short end of the curve had been held down due to the Reserve Bank of Australia’s (RBA) yield curve control policy. However, over the two days of 28 and 29 October the 2-year yield rose by more than 55bps, as the RBA failed to defend its target of 0.1%. This sudden move foreshadowed the RBA’s decision to end yield curve control in the following week. Central Banks globally face the issue that if inflation was to become ‘sticky’, then they may find market driven movements in yield curves force rate hikes to be brought forward. This will be the challenging environment fixed income fund managers will be dealing with coming into 2022.

Credit

2021 has seen the continued trend of a buoyant covid recovery across major markets around the globe, spurred by an abundance of monetary and fiscal stimulus and the re-opening of economies through vaccine rollouts. Whilst these developments have led to broadly favourable credit conditions, they do so whilst warranting caution as credit spreads across the corporate debt spectrum have tightened to near historic lows. As the largest corporate bond market in the world, the US market can provide a good indication of current spread levels and how they compare within a historical context. Using the ICE BofA US Corporate Index Option-Adjusted Spread as a proxy for US investment grade corporate debt, the spread as of 30 September 2021 was 89 basis points (bps) versus a 20-year average of 162 bps. Within the US high yield market and using the ICE BofA US High Yield Index Option-Adjusted Spread as a proxy, the spread as of 30 September 2021 was 315 bps versus 20-year average of 557 bps. Whilst tighter spreads mean that overall corporate yields provide less of a risk premium than before, one important observation has been the high level of dispersion across credit spreads. This has come as a result of a highly uneven covid recovery across regions and in particular across sectors, presenting return opportunities across structural covid winners and recovering cyclicals. Potential risks that the corporate bond market will have to contend with include the threat of new covid strains, Evergrande crisis-like contagion, as well as supply chain disruptions which have caused shortages of products worldwide and increases to raw material costs. Furthermore, the threat of rising inflation looms large as the response by central banks to such pressures threatens the state of existing credit conditions. In recent years, investors have grown accustomed to looking at credit in providing a return boost in an otherwise yield starved fixed income environment. With the overall tightening of credit spreads along with persistent risks as we look to a post-covid world, the importance of robust and careful bottom-up credit selection becomes as critical as ever in scoping out opportunities, maximising returns and avoiding unwarranted risks.

Emerging Markets

The most significant recent development in Emerging Markets Fixed Income is the ongoing crisis surrounding Chinese real estate firm Evergrande. The firm has had significant difficulty servicing its total debt of over $300bn USD, and while the price of its bonds has already collapsed, there are fears that a default could cause significant damage to China’s property market, and its economy at large. Currently, Evergrande are already one month behind on their repayments, and falling further behind could result in a default. However, the firm has managed to find the liquidity to make its most recent payments as at 22nd October, implying that the firm may continue to limp on for some time yet. There are also questions as to what the government response would be in the event Evergrande defaults on its debts, with concerns of the economic impacts of the default being weighed up against the potential implications of de facto condoning Evergrande’s actions if they were to be bailed out. As the situation continues to develop, the government may be forced to make a decision, and markets could take that decision as a precedent as to how similar situations may be handled in the future. As such, the stakes remain high as the probability of default continues to be elevated.

Outside of Evergrande developments in Emerging Markets have largely mirrored those in developed markets, with the Delta variant of COVID having introduced a significant disruption in recent months. September’s bond market selloff also flowed on to Emerging Markets, although there was significant variation in magnitude between countries. Mexico and Brazil both observed the yields in their 10-year Government Bonds jump sharply upwards, by approximately 40 and 50 bps respectively, whereas China experienced only a 6bp increase over the course of September for its 10-year Government Bond yield. The differences largely come down to variation in inflationary expectations, as well as differences in monetary policy among the different countries.

 

To find fixed income funds that are either Highly Recommended or Recommended, go to the Managed Funds tab in the Members Research Portal, and filter for “fixed interest” in Asset Class , and the rating of your choice in “rating”. The same thing can be done for ETFs if you prefer that ASX listed vehicle. Note Viewpoint reports are not provided for funds or ETFs that are just following an index, however Product Profile reports are available.

 

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2021 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited.