When Federal Treasurer Jim Chalmers hands down the budget on 14 May, the pressing need for fiscal responsibility is likely to trump spending programs.
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‘Putting the income back into fixed income’
Fixed interest manager Colchester Global presented ‘Putting the income back into fixed income’ to investors focusing on the current state of traditional fixed income markets.
PM and Head of Risk and Analytics at Colchester, Alberto Martin, explains why fixed income is topical highlighting that ‘over the last decade, income has become a bit like the scarlet pimpernel. It’s quite an elusive character to find.’
To demonstrate that he used the RBA base rate and displayed the level of income it would have generated.
- Retiring on $1m back in March 2007 rates, will have earnt you $62,500 pa.
- Retiring on $1m back in March 2014 rates, you will have only received $25,000 pa.
- And finally, retiring on $1m this year will have generated a paltry $1k.
So, there is a real need to do something about this. The key is ‘Don’t forget the Fixed’. Protecting the portfolio is an essential part of portfolio creation. Traditionally holding a fixed interest asset has many uses such as – acting as a defensive anchor, liquidity during market stress, low correlation to risk assets, and it generates a steady income albeit rates must be of substance. And it’s all highlighted in the table below.
During the GFC, global equities halved in value whereas global bonds gave a return of about 15 per cent. It’s non-correlation with risk assets is its attractiveness. And this is exactly how it played out last year, during the pandemic albeit magnitudes are a little different. Global bonds returned positively whereas equities fell over 30 per cent.
Today, Martin asks the question ‘wow are we going to generate income?’. Some ways could be Investment grade credit, high yield, asset backed securities or local currency emerging sovereign debt. Why is it, that many investors haven’t considered EMD?
Back in the 90’s, high yield bonds returned close to fifteen per cent and Investment grade corporates around 7-10 per cent. Quite attractive rates. Martin says ‘fast forward to today and high yield is less than 5 per cent at an all time low and investment grade credit isn’t as appealing as it once was.’ Looking at the chart below, securities are plotted at the current coupon versus 10-year volatility.
Government bonds at 2 per cent, investment grade at 3 per cent which surprisingly returns the same as Aussie equities but a lot less risk. Martin says ‘it doesn’t make sense to use Australian equities as an income generator’. High yield and local market emerging market debt are the way to go. Both generating the same coupon, but EMD has lower volatility.
Why emerging markets?
There has been an improvement in credit quality in some of the emerging market economies says Martin. With a high coupon rate the ability to repay is a lot better than it used to be. This asset class also offers relatively low correlation with credit and other risk assets, acting as the perfect cushion for a black swan event.
To conclude Martin says ‘Government bonds. Don’t throw them out. They still play an important defensive role. The income they generate is still reasonable. They should act as the bedrock of your portfolio.’
When you get to the ‘how can I add more income, that’s where the EM local currency securities come into play’.
Although these types of securities aren’t well known in Australia, Martin thinks they can really add great diversification benefits and generate relatively high income for your investor’s portfolios.
