As interest rates nosedive and Europe goes back into lockdown, markets continue to accentuate the fiscal and monetary positives. Yet creating a genuinely diversified portfolio remains as challenging as ever. With cash and bond rates close to or below zero, finding defensive income requires active management across a broad investment universe.
The first week of November has been interesting, to the say the least. First, the RBA announced it would cut the cash rate to 0.10% and extend its quantitative easing scope to target bonds further out on the yield curve. While this move was largely anticipated by the markets, it once again highlights the challenge for savers when interest on cash and term deposits is abysmally low. At this stage the RBA has indicated it is not intending to take rates negative; however, in the current environment, our view is “never say never”. If the rest of the world continues to cut rates and use negative rates as a monetary policy tool, the RBA may also feel the push to take cash rates lower. Watch this space.
On the COVID front we have again been reminded that in the absence of a vaccine (still some way off, despite the recent optimistic announcement from Pfizer), the new normal appears to be a scenario where outbreaks continue to occur and authorities are in many cases forced to make the hard decision to limit transmission though various forms of lockdown, despite the resulting economic impact. Parts of Europe have gone back into lockdown, which will again impact the economy. US cases have been rising, but authorities are largely resisting a hard lockdown at this stage. Thankfully, COVID is well contained in Australia, with new cases low, and the easing of lockdowns in Victoria should see the economic and social impacts of COVID reduced.
In addition, the US election was held on 3 November. After a long, drawn-out counting process, Joe Biden has secured enough Electoral College votes to declare victory. President Trump has not conceded and has launched legal proceedings in an attempt to cast doubt on the validity of the election process. What is clear is that the “blue wave” in the House and Senate did not eventuate and it would appear that we will have a gridlocked government, with the Republicans maintaining their Senate majority. At this point the market appears comfortable with that outcome. That said, the final result of the Senate election outcome is still unknown – so once again, watch this space.
Markets see the fiscal upside
Despite ongoing uncertainty, the markets appear to be looking through the economic effect of the virus and focusing on the fiscal response. All in all, markets are pricing a continuation of extremely accommodative monetary policy and large amounts of fiscal stimulus for the foreseeable future, irrespective of the election results and the absence of a vaccine. The apparent underwriting of risk assets may continue, but several events could see a shift – for example, the threat of higher inflation or the reduction or further delay of fiscal packages.
Given this, diversification continues to be key. Yet this is becoming increasingly challenging in the current environment. With cash and bond rates close to or below zero, the defensive portion of a client portfolio is not what it once was. Bonds and cash still have a role to play, particularly in terms of liquidity and diversification; however, the fact that these assets are yielding below the rate of inflation means that the real cost of carry arguably diminishes the attractiveness of the holdings and encourages investors to venture further afield into an array of risk-based assets.
Those wishing to stay in the more defensive part of markets (that is, not simply allocating their capital to equities) are increasingly using credit-based assets. Credit can be seen as sitting between bonds or cash and equities. While similar in form to sovereign bonds, it carries, among other things, default and liquidity risk. Credit is also further up the capital structure than equities, and hence receives a set coupon, along with first right of refusal over the assets of a business should it go into bankruptcy. It is the credit portion of the portfolio that we have been increasing, broadening our exposure.
Our portfolio position
We continue to focus on working the cash portion of the portfolio harder while maintaining the liquid and defensive characteristics of our overall portfolio positioning. To this end, over the past few months we have continued to invest part of the cash holdings that we had built up earlier in the year. This has been implemented both in the total holdings of credit-based assets, but also in the mix across different assets and geographies as we seek opportunities to acquire assets that currently offer a more compelling risk versus reward dynamic.
We marginally increased our Asian credit exposure to access the additional yield and diversification available in this segment. We added to our SISF Global Credit Income Short Duration Fund allocation, which predominantly holds European credit. This provides diversification and supplements our US holdings, but importantly is shorter in duration and hence expected to be less variable should we get a spike in volatility. We also increased our US securitised credit exposures. These exposures continue to be defensive in nature and are highly rated and typically senior in the capital structure. As such, they have the advantage of subordination to help protect capital while also delivering income.
Our tactical tilt to global high yield remains at 2.5% of the portfolio, which provides a yield boost, particularly compared to cash, but is not of sufficient size to overwhelm total portfolio volatility. The global high yield market is US domestically focused and continues to benefit from fiscal support from the US government, but also remains supported by a potential crowding out from the investment grade market, where central banks can directly buy corporate bonds.
We retain our Australian investment grade credit holdings and also our hybrid exposures. Our Australian investment grade credit holdings continue to be a defensive and relatively short tenor exposure. We have rotated out of banks and into industrials and infrastructure. Liquidity in this space is also reasonable at the moment.
The hybrid exposures, which are essentially bank exposures, are where we see the best value currently in the capital structure of the Australian banks. This market continues to be an important source for bank regulatory capital and in a low rate environment the credit spread for going down the capital structure is relatively attractive.
Residential mortgage-backed securities continue to provide low risk exposure to the Australian home loan sector. They are high quality assets, providing some additional yield over shorter-term bank securities, due to being marginally less liquid. These assets pay down both principal and interest at regular intervals, so our exposures will decline over time.
We have adjusted our currency positioning, pivoting to a higher holding of JPY as our key expression of downside risk protection. We believe that the JPY will still provide diversification and a risk hedge in the portfolio without some of the complications that are influencing the USD. Our USD position remains small, given the concerns around a weaker USD. Since our credit exposures have increased, we have moved closer to the 10% limit in total currency exposure.
In terms of interest rate exposures, we retain a long duration position of close to two years. This duration position remains split between Australia and the US. In the US we are short in the long end of the curve, which benefits from a sell-off. In Australia, the positioning is more in the shorter end, which has continued to rally. We do believe duration still has a role to play in portfolios, although we believe the effectiveness of duration is challenged. We continue to assess our overall exposure and where it is expressed on the yield curve. We expect duration to provide some downside risk in more extreme scenarios in a risk-off phase.
In summary, we have reduced cash in favour of credit but retain our defensive bias with exposure to predominantly investment-grade credit. We continue to seek diversification through European credit, Asian credit exposures, US securitised exposures, and our emerging market debt absolute return focused portfolio. This supports the allocation in Australia, which we continue to see as a low risk market. The global high yield exposures, while moderate, serve to enhance the yield of the portfolio. This quality focus along with our currency and duration positions rounds out our active, defensive and liquid posture.
Published by Mihkel Kase, Fund Manager – Fixed Income and Multi-Asset, Schroders