Recent market events have helped prove out the value-add of sophisticated fixed-income strategies, IAM’s James Shillington said.

Global markets are facing their first significant bout of volatility since February this week, stemming from contagion fears around embattled Chinese property developer Evergrande.

The Evergrande concerns centre around its capacity (or lack thereof) to pay the next round of interest on its corporate debt.

Notably, the equity wobble in February also started in the bond market – when yields jumped unexpectedly as markets reassessed the outlook for inflation.

It’s a timely reminder on the importance of the bond market, which is much bigger than the stock market and often acts as a leading indicator for key trends.

It also marks a good time to talk to a bond expert. And Stockhead caught up this week with professional fixed income investor James Shillington, from the ASX-listed Income Asset Management Group (ASX:INY), for a chat about the current outlook.

 

Australian bond market

As executive director of Fixed Income, Shillington works with a client base of sophisticated investors who invest directly in fixed- income products.

He said the volatility in global stocks this week reinforces the fact that fixed-income products are still a “missing piece” in many Australian investment portfolios.

Local investors “tend to be well allocated to equities on one end (higher risk), or they prefer cash and term deposits – which obviously aren’t as attractive right now with rates so low”, Shillington said.

“So it’s the bond allocation, which I’d describe as that middle component of risk/return — that tends to be missing from portfolios.”

Citing the example of Evergrande, Shillington said the merits of well-managed fixed-income exposure are highlighted when stock volatility increases.

For starters, when a company in Australia issues debt coupons they are guaranteed by the issuer, and rank higher in the capital structure compared to equities.

In addition, while there might be wild swings in equity prices, fixed-income assets remain stable (relative to equities).

As an example, Shillington cited recent activity on corporate debt markets by ASX heavyweight Wesfarmers (ASX:WES).

“There’s been plenty of client demand, and we’ve been very active in giving investors exposure to some of their longer debt – 10-year notes (to June 2031) yielding 2.5%,” Shillington said.

“So that’s an example of a high-grade Australian issuer that gives you fixed returns at a higher rate than benchmark government bond yields.”

 

Portfolio construction

Working off the Wesfarmers example, Shillington also explained how INY’s client base structure their fixed-income portfolios to generate optimal balanced returns.

In that context, Shillington’s team facilitates exposure to various fixed-income products such as investment-grade corporate debt, to higher-yield debt and hybrid securities.

“I’d say for standard individual investors, they’d have around 60% of their portfolio allocated to investment grade (IG) corporate debt. That’s your blue-chip Australian issuers – household names such as Wesfarmers, Downer EDI and LendLease,” Shillington said.

“Then they’d fill the remaining 40% with a mix of higher-yield debt products and some hybrid notes.”

Balancing it out, “you’re looking for a blended return of around 5-7%”, he said.

“Typically, you’d be looking to achieve a 3% return on the IG component, and anywhere from 6-9% on the higher-yield notes — then trying to blend that return.

“What it means is you’re achieving 5%-plus return and you’re not taking too much risk. So if you take a sophisticated investor who has 10 $100,000 bond investments across a $1m portfolio, you’d achieve a nice risk-adjusted income return of $50-$70,000 p.a. across those different securities,” Shillington said.

 

Managing risk

Returning to the current macro backdrop, Shillington said the value-add from disciplined fixed-income strategies could become more pertinent in an era of rising volatility.

He added that Australia’s investment-grade credit market is one of “the most stable asset classes of its kind” globally, in terms of the credit profile of the primary issuers.

In addition, Australia’s corporate debt market gives exposure to big global firms that issue debt in Australian dollars.

$US220bn telco major Verizon is a frequent issuer in the Australian market, as is tech giant Apple, Shillington said.

“Those are names you can’t get access to via the ASX, which are active in the Australian bond market,” he said

More broadly, weighing the outlook it’s “hard not to be a bit cautious”, Shillington said.

But while the post-COVID balancing act for global central banks is growing increasingly complex, he still expects longer-dated 10-year government bond yields to remain relatively stable through to year-end (unlike in February).

“Obviously the markets had a good run, and there’s plenty of talk around asset bubbles in property and equities,” Shillington said.

In that context, “fixed income can work as an asset you don’t have to worry about as much as you do with equities.”

“The investor needs to be comfortable with the credit risk in their portfolio and not lock in too much of the portfolio into bonds with a long maturity. The key is diversification (as always) and make sure you truly understand the credit risk.

“Those investments can act as the anchor of your portfolio, with access to quality names in the Australian market and a higher  ranking in the capital structure,” he said.

“It means you can generate a steady return above the risk-free rate, and you don’t have to lay awake at night.”

Income Asset Management (ASX:INY) delivers unparalleled access to a complete income investment service. We aim to provide investors and portfolio managers with the most trustworthy and capable platform to research, execute, and manage their income investments. Our businesses across deposits, bonds, treasury management and asset management are all there to enable investors to compare, choose, and execute, in the most efficient, transparent, and cost-effective way.

This article was developed in collaboration with Income Asset Management, a Stockhead advertiser at the time of publishing.

This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.

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