Cash and diversified fixed income update

With cash and term deposit rates still at historic lows, there are a variety of other fixed income options available to investors at different levels of risk.

So, what has happened in the markets recently?

Trade dominated headlines again as the U.S. met with China, resulting in ‘phase one’ of the trade deal being announced. It is nothing new; China will buy U.S. agricultural products in exchange for a freeze in tariff hikes. Sound familiar? In reality, the primary issues of intellectual property and technology have yet to be sorted and even ‘phase one’ has not been signed yet.

Economic data globally remains weak. Australian consumer and business confidence are worsening, though employment remains resilient with the unemployment rate dropping to 5.2%. However, this may not continue as job advertisements continue to fall. In the face of increased risks to the economy from the global slowdown, the Reserve Bank of Australia (RBA) cut rates once again to 0.75%.

The U.S. does not look so great either. After showing strong resilience to global ails, the U.S. consumer looks to be weakening over the past months, with activity indicators below expectations and employment growth slowing despite the unemployment rate falling to 3.5% as participation fell. Retail sales and consumer confidence have also been falling. These are significant concerns given the consumer accounts for nearly 70% of the U.S. economy.

Europe remains weak as Germany continues to flirt with recession and manufacturing and exports continue to fall. Calls for fiscal stimulus continue to get louder, but quick action on this end is unlikely.

Like the U.S., China’s service sector has also shown signs of slowing, and trade continues to falter as exports and imports fell more than expected in September. There is a ray of light through the shadows though, as China’s manufacturing indicators came in better than expected and are showing some signs of a potential rebound.

Moving forward, the quarterly earnings season is upon us. Locally, the banks will be reporting, and many other companies will be holding their Annual General Meetings during this period. Expectations are low and early reports have been quite positive, so we may see a rally in the short term, but unless global economic growth turns around, future earnings will be at risk.

So, what does this all mean in the context of cash and fixed interest?

Global central banks are back to an easing cycle due to a slowing global economy. We don’t expect much further easing from the major central banks unless a global recession is on the horizon which is currently difficult to predict due to elevated levels of geopolitical risks. Our base case is that yields and rates are likely to be bottoming out and will likely be higher in the long term but do not expect a strong rebound in the near term. However, we acknowledge that the tail risks of a sharp move in either direction is much higher in the short to medium term.

So, what do we like in this space given this backdrop?

We prefer alternative exposures where returns are relatively predictable and not dependent on changes to yields. This includes relative value strategies, high quality floating rate credit, and domestic senior loans and asset backed securities.

The fund or strategy manager for relative value is crucial to returns. Relative value strategies involve making pair trades where the idea behind it is that one security is undervalued and one is overvalued so you buy the undervalued one and short sell the overvalued one whilst keeping your market risk exposure neutral and your returns come from asset specific moves rather than market moves. Investment in this space can be complex and generally involves leveraged positions but we prefer a conservative approach that look for reasonable returns rather than those shooting for the stars.

Given the slowing economic backdrop and higher risk of a recession, we prefer to move up in quality when looking at floating rate credit. Floating rate credit generally has a yield of the cash rate plus an additional fixed percentage. The additional fixed percentage is lower for companies with better balance sheets and lower default risk. The primary capital risks for these securities are default and a change in interest rate spreads.

When markets expect balance sheets to deteriorate, they demand higher interest rate spreads which means higher yields from credit and therefore lower capital value.

Therefore, with a slowing economic backdrop and higher recession risk, we prefer to stick to investment grade and better quality floating rate credit so the portfolio is not too exposed to a potential widening of the interest rate spreads.

One of our most preferred positions at this stage is domestic senior loans and asset backed securities. We think that the Australian economy is on good footing and potentially bottoming out so we continue to like domestic companies and their balance sheets. Senior loans are similar to credit but they are higher up the corporate structure and illiquid though there are investment vehicles that make these investments more accessible. Asset backed securities are loans that have been securitised by an asset so in the event of a default, you can repossess the asset and sell it to recoup money. Mortgages are a form of asset backed security. Like senior loans, they can be illiquid but there are investment vehicles that make these accessible. Like relative value strategies, choosing the right manager is important for investing in this area because returns are highly dependent on the capability of the manager to avoid or reduce the chance of default through credit assessment – much like the banks assessing your mortgage application.

What don’t we like?

We are underweight duration and high yield. Though it may seem counter-intuitive as duration tends to be negatively correlated to high yield performance, the current index duration is high relative to history thanks to lower rates. We do not believe that the risk-reward is attractive to own a large exposure to duration at this stage. The duration of the current bond index implies a 7% capital loss for a 1% rise in yield.

As for high yield, as stated in the previous section, we think the slowing economic backdrop and higher risk of recession means a higher risk of credit spreads widening and a higher risk of defaults. Therefore, we would prefer to look at higher quality exposures in the investment grade space.

Our fixed income offering

We have access to our own in-house Investment Committee and our approach is to prioritise capital preservation and manage risk primarily through diversification. As an alternative to cash, and in keeping with our core investment approach, we are proud to offer our own Diversified Fixed Income Portfolio.

This Diversified Fixed Income Portfolio provides exposure to an actively managed portfolio of international and domestic fixed interest securities. The portfolio invests in both direct listed fixed income securities such as capital notes, and investment vehicles such as Managed Funds.

Our Investment Committee undergoes a rigorous process of evaluating investments, using both proprietary internal research and external research to identify suitable investments. Suitable investments are then evaluated relative to the portfolio exposures to ensure diversification of various sectors such as investment grade, credit and geographical exposures.

If diversification is not a primary concern for you, we are happy to individually recommend one of our holdings based on your desired exposure.

In addition to our Fixed Income Portfolio, we also offer some exciting options in the single asset mezzanine funding space. With over $1.4b of funds under management, we are often able to get exclusive access to opportunities which we source specifically for sophisticated clients. Please note that due to the complexity of these offerings, access to these is restricted to those who meet the legal definition of a Wholesale Investor.

Do you have any concerns or questions?

There is a lot of noise in the media and our message to our clients is to try and cut through as much of this as possible.

We are here to help by offering support and guidance to navigate the complex landscape of superannuation, investments and retirement planning and we would love to hear from you if the above has raised any questions or concerns.


For more information on the above please contact Bentleys Wealth Advisors directly or on +61 2 9220 0700.

This information is general in nature and is provided by Bentleys Wealth Advisors. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information.

(PRPIA Pty Ltd (ABN 61 144 888 433) trading as Bentleys Wealth Advisors, authorised representatives of Charter Financial Planning, Australian Financial Services Licensee).