Global Perspectives: Bonds are back

Matthew Bullock: Hello, and welcome to the latest recording in the Global Perspectives podcast series. This is the first podcast that we’ve done in Australia and the first time, Jay, you and I have worked together doing a podcast. So I’ve been really looking forward to doing this one. But just by way of a quick introduction to everybody, before we get started, my name is Matthew Bullock, the Head of Portfolio Construction and Strategy at Janus Henderson for EMEA and APAC. I’m very lucky to be joined by Jay Sivapalan, Head of Australian Fixed Interest here at Janus Henderson. Welcome, Jay.

Jay Sivapalan: Thanks, Matt. I’m very excited to be talking about all things bonds.

Bullock: That takes us straight into the first question, if we look at the Australian fixed income market, one of the quotes that comes up quite a lot is bonds are back, and to give you another quote, and I must admit, this is not mine “we’re putting the income back into fixed income.” So if I think about the current environment today, and I think about the changes we’ve seen in the fixed income market, where do you see the next 6 to 12 months evolving? What’s the current market environment?

Sivapalan: Certainly bonds and fixed interest as an asset class has always been a core building block of investor portfolios, even going back to the pension funds that have been writing for north of 200 years. They typically have the core three equities, bonds, and cash, and, of course, the period during the pandemic, fixed interest as an asset class was heavily compromised. And we all know the journey that we’ve been on. And the very low returns, low yields, and indeed, negative returns coming out of, you know, extreme monetary policy experimentation, negative interest rates, zero interest rates, and so on. But today, bonds are back, they are back to very normal levels in terms of yields, and also prospective returns. So we would certainly describe the environment for fixed interest rates and asset classes as much more normal, as opposed to the last three or four years, and perhaps even the last decade as being atypical. So from an investor’s perspective, certainly, it’s a fruitful environment for active investors to be able to utilise the volatility that’s around at the moment for the benefit of clients.

Bullock: You talked about negative interest rates. We’ve seen lots of focus on the direction of interest rates. If I look at the direction of travel for the RBA, whether the RBA keeps rates on hold, raises or lowers them, it’s going to have an impact on the total return experience for an investor. So where do you think the RBA is going to move? What are they focused on? What’s already priced in?

Sivapalan: The first thing that we need to really get a handle on is where are we in the economic cycle. So we all know that this particular cycle was unusual, because we came across that supply chain issue and all the high inflation coming out of the pandemic, to what the central banks globally have done is to really arrest that inflation by raising rates. Now, there is a related aspect of all of this. There’s fiscal policy, because whilst monetary policy has been tightening fiscal policy, depending on which country has either continued to be loosened easy, and in some countries has been tighter, like in, in Australia, so from a Reserve Bank of Australia perspective, you know, focus has really been on inflation to date. Now, as we move through the course of 2024, they’ll continue to watch and observe the impact of all that tight monetary policy on the broader economy, and in particular, discretionary consumers and those segments that are rate sensitive, and we are starting to see good evidence that policy is working, and so the focus will shift from inflation to employment and labour markets. In Australia, the unemployment rate has risen from its lows, albeit is still at relatively healthy levels. Our forecast is that the unemployment rate starts to head towards 5%. And that’s when the RBA will switch focus from inflation to labour markets. So what does that mean in terms of the RBA and cash rates? We‘ll have an easing cycle commencing late this year, and the market is price setting, but it certainly hasn’t got a full cycle priced in at the moment.

Bullock: I want to change tack a little bit, and I just want to sort of almost from an educational perspective, want to focus in on the term duration, because it will come up I’m sure in some of the other questions we’re going to discuss, but just to sort of set the scene here before we go into the impact of duration on returns, could you give us a super simple definition of what is duration?

Sivapalan: In its simplest term, the definition is a change in the market value of bonds for a change in yields. So essentially, if I can use this very simple analogy, if bond yields rise by 1%, and the duration of a portfolio is five years, then the portfolio falls in value by 5%. In other words, a negative 5% return and vice versa. Now, how is duration used by investors in particular, in the construct of a broader balanced fund or diversified portfolio, it is really that ballast against growth assets. So, when you introduce and have fixed interest that has duration, often in a crisis or economic downturn, the central bank will be cutting rates. And if those even if the central bank hasn’t started cutting rates, the mark will assume that the central banks likely to cut rates and therefore, bond yields fall, prices rise and provides that balance against growth assets like equities and property.

Bullock: When we talked about the environment, we talked about the interest rates and what potentially has been priced in by the market or what hasn’t been priced in the market. We talked about the impact of duration. Now I want to sort of pull all that together, and to say, where are the opportunities right now? What are the two or three areas that you find really quite attractive that the rest of the market hasn’t picked up on yet?

Sivapalan: Let me perhaps start with interest rates and duration. Because that’s often overlooked, sometimes when we’re talking about opportunities, because investors have flocked straight to credit. So in rates and duration, at the moment, as I suggested, the market hasn’t fully priced in a complete cycle. And so that’s a great opportunity for investors to really think about fixed interest allocation and really locking in those high yields that we have available today, in our portfolios. So that if and when the RBA does cut rates, and indeed, even before that, when the market assumes that the RBA is going to cut rates, or the central banks are going to cut rates that will drive higher performance than outright yields. It’s important to keep in mind that today we have defensive yields from asset classes, like fixed interest that are higher than yields available in growth assets.

Bullock: What do you mean by defensive yields?

Sivapalan: So yields on government bonds, state government bonds, and even investment grade credit. Now, that’s a setup we haven’t had for over 15 years. So it’s a great setup for the asset class. And it allows it to really maintain and display that defensive attribute.

Bullock: Are there any particular areas in credit that you’re focused on?

Sivapalan: Credit is a broad church, but if we help break it down into the mainstream segments, so investment grade, high yield loans, and so on. I’m talking both here in terms of public and private markets. But in the investment grade segment, we think that’s really the sweet spot for investors today. Why? Because investors can enjoy comfortably a 6% plus yield in that segment, and lock that in today. The second is many of the investment grade companies at the large end of town really did refinance and extend out the maturities well into late this decade, so refinancing risk isn’t a near term challenge. And for the most part, they have remained very profitable, and quite resilient, even in a slowing economy.

Bullock: I think infrastructure comes up from time to time as well. Do you have any particular views on where that sits?

Sivapalan: I guess, when we start drilling down into the sub sectors and industries, and we like today, infrastructure is one of those key areas. So both the conventional infrastructure like senior debt of airports, seaports, toll roads, but also more contemporary infrastructure, like National Broadband Network, and the senior debt of that, and data centres and so on.

Bullock: We’ve talked about some of the opportunities, and I sort of want to flip that around now and focus on some of the areas to avoid. Are there any particular areas that are jumping out at you and you’re thinking I just want to stay well away from that?

Sivapalan: So there are probably two things we’re talking about. One is a perceived area to avoid, but one we really like and quite a controversial sector, and that is the senior debt of Australian REITs. They are quite different to our global counterparts in terms of the level of gearing that they have these days, as well as their resilience in terms of the cash flow collection that they’ve been having.

Bullock: So that’s not an area you’re wanting to avoid or an area that others are avoiding?

Sivapalan: That’s an area that others are avoiding. It’s got a dark cloud over their head at the moment, but something that we see as a great opportunity. So that’s a perceived area of avoiding that we really like.

Bullock: Just to go a bit further into that, because I know REITs and the property market gets a lot of people’s attention, and as you said definitely there is a dark mark or shadow over it, any areas in particular, there are opportunities there to be had?

Sivapalan: Yeah, so I guess just to go through some of the examples that we’ve been really focused on, we essentially lined up every single rate in the country side by side, and did the underlying due diligence on the properties, the owners, the tenants, how long the leases were, when the debt was maturing, and the sweet spot is that premium and the highest quality available and of office, for obvious reasons, office has been really challenged. But also we like our, you know, highly restricted town planning, law driven shopping centre, malls, and there’s a lot of examples in Australia that’s worthwhile investing in industrials, probably the area that we’re least enamoured with in that area.

Bullock: So when we when we talk about areas to avoid the industrials is, is the main one for you know.

Sivapalan: On the other side, where we’re really avoiding outside of the REIT sector, are those consumer cyclicals highly leveraged companies. So when you start looking at what’s occurring in the market as a result of high interest rates, and this elongate it cycle that we’re in, it is really those companies that are highly levered consumer cyclical. So for example, asset backed securities that have credit card receivables, some auto, and so on, which are now feeling the pinch of higher rates. And then, of course, some pockets, not all of it, but some pockets of the mortgage market, in particular, the mortgage belt and exposures related to that. Certainly the default cycle has commenced, and we’re starting to see that in the in the data.

Bullock: So Jay, you mentioned about the default cycle picking up but that’s something I want us to spend a little bit more time on understanding more about what you’re seeing. So what are you seeing right now with default cycles? And what’s the direction of travel?

Sivapalan: Every economy is different. When you look at the US, for example, it’s quite different to Australia. But I’ll give you a couple of examples. So as a general comment, the large end of corporate Australia and corporate America, and indeed, corporate Europe, is actually faring quite well. So that’s certainly not the area that we’re concerned about. But interest rates and the hike in interest rates certainly have hit the small to medium enterprise sector. So in Australia, for example, we have seen a real lift in defaults in that sector, driven by property construction and development, as well as now hospitality and some other areas starting to join property construction. Over in the US. It’s more on consumer credit card, auto receivables, and so on the differences between the two economies between the mortgage structure so in Australia, we have a variable rate mortgage structure. So it’s felt a lot quicker when the central bank raises rates versus the US, which has fixed rates, where it’s not felt as quickly. Or we’re starting to observe those differences as well.

Bullock: I’m based in the UK, I can tell you that we’re generally variable and I can feel the pain right now, as well with what’s happening in mortgage rates there. So you sort of touched a little bit on this, about sort of what’s happening globally. But I want to go a bit further into that because you know, as a global manager, we’re looking at things from a global perspective. Now, whilst a lot of the listeners will be Australian based, I mean, I’m interested in understanding more about the differences between what you’re seeing in the Australian market versus the global market. And then I’m just going back to my previous questions, the opportunities but the areas to avoid as well, when we think globally.

Sivapalan: Certainly when you’re considering Australian credit at an aggregate level, we’ve had our own journey which is different to the world. Germany, in particular, many of the policies that were put in place during the pandemic, including the term funding facility for our banks. And what that meant is that as that all got reversed out last year, our credit spreads. So the additional yield that investors get for lending money to companies remained higher than the rest of the world. And so from a relative value perspective, there’s a really good opportunity in Australian credit for that reason, for example, the US didn’t have that. The flip side is that we don’t have really a large high yield market in Australia and loans market that’s largely within the banking fraternity and also within the private sector. Whereas offshore, we are starting to see some weaknesses in loans in particular, and I mentioned defaults earlier, one of the areas that’s picked up is loans, which has been a favourite asset class, and now investors are starting to rotate out to other areas.

Bullock: Do I put that on the areas to avoid this?

Sivapalan: You certainly can

Bullock: To wrap us up, I want to get you to get your crystal ball out, and to look at the sort of next six to twelve months or so. So what’s the most important thing that you want to leave everybody with? What’s the biggest risk, the biggest opportunity and the final message from Jay?

Sivapalan: I think, for investors, you know, we’ve had a strong growth environment boosted by policy. That’s not forever – now’s the time to really reshape investor portfolios with the right ballast in place, and we think, fixed interest today, if you can consider it portfolio insurance. There’s good yields on offer, good income on offer and certainly provides that defensive element should interest rates and the economy perform poorly going forward.

Bullock: Well, Jay, we’re out of time. I want to thank you very much for all of your thoughts and to thank our audience for listening. And of course, if any of our listeners wish to learn more about Janus Henderson’s investment views, or if you have any other questions, then please don’t hesitate to contact your client relationship manager or visit our website. So once again, Jay, thank you so much for your time.