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Putting the Income Back into Fixed Income

Despite the state of flux that has defined fixed income markets since 2022, investors are now getting more income from fixed income assets than they have in some time. While higher volatility persists and yields continue to vary with changes to growth and inflation outlooks, investors may be able to find attractive entry points for buying fixed income in 2023.

5.40 min read

Twenty Twenty-two was a challenging year for fixed income investors, with yields rising dramatically, and rate volatility at elevated levels not seen since the global financial crisis1. The yield on the 10-year Australian government bond rose from 1.67% on 31 December 2021 to 4.05% as of 30 December 2022.2 Meanwhile, the credit spread on investment grade corporates in Australia has risen from 1.13% to 1.91% over the same period. Both rates and spreads have since retraced somewhat this year2.

The broad uplift in yields has had a negative impact on 2022 returns for Australian and global fixed income assets. Going forward, investors should be able to benefit from higher levels of income within their fixed income investments than has been available in over a decade.

Fixed Income Index Performance and Yields

Fixed Income Index Performance and Yields

Role of Fixed Income in a Multi-Asset Portfolio Context

An improvement in income is likely to be welcomed by most investors. However, income is just one consideration for an investor when deciding to allocate to fixed income in their broader investment portfolio. Fixed income assets can play a role as a diversifier, when blended with equities and other ‘risky’ assets, potentially resulting in a smoother ride in sometimes volatile markets.

In 2022, the unique combination of factors, such as ultra-low prevailing rates and aggressive central bank rate hikes in an attempt to address increasing inflationary pressures, meant that equity and fixed income returns became more correlated. Both asset classes produced negative returns over the year. To many investors, fixed income assets may appear to have – at least temporarily, and likely until inflation falls back to levels closer to central bank targets – lost some of its ability to offset the losses in equities within a multi-asset portfolio. However, this is a short term view, as longer term analysis shows this relationship still holds.

Over a time horizon that encompasses a variety of market environments, one could have invested solely in growth assets such as Australian equities, and been quite well compensated for taking the risk. However, by introducing Australian fixed income to the portfolio, and then global assets, we demonstrate that it would have been possible to achieve increasing levels of diversification, or in other words portfolio efficiency (as measured by the historical Sharpe Ratio). The robustness of the portfolio is tested by its performance in downmarket scenarios, such as during the global financial crisis, the Covid-19 crisis and most recently the inflation/rate shock of 2022. Compared against Portfolio 1, Portfolio 2 and 3 have higher Sharpe Ratios, and experience smaller drawdowns in stress scenarios.

Portfolio Comparisons

  Portfolio 1
Australian Equities
Portfolio 2
+ Australian Bonds
Portfolio 3
+ Global Diversification
Description 100% Australian Equities 60% Australian EQ / 40% Australian FI 30% Australian EQ / 30% Global EQ / 20% Australian FI / 20% Global FI
20 Year Return (annualised) 8.9% 7.9% 7.2%
Realised Volatility (annualised) 16.5% 9.8% 7.2%
Sharpe Ratio 0.33 0.45 0.52
GFC (Nov 2007 - Mar 2009) -50.58% -29.11% -25.60%
Covid Crisis (Feb 2020 - Mar 2020) -35.93% -22.22% -18.66%
2022 Inflation/Rate Shock (Apr 2022 - Jun 2022) -14.90% -11.27% -9.09%

Source: State Street Global Advisors, Bloomberg Financial L.P., as of 31 January 2023. Global Financial Crisis refers to the period from the portfolio 1 performance peak to trough, November 2007 to March 2009. Covid-19 Crisis refers to the period from portfolio 1 peak to trough, February 2020 to March 2020. 2022 Inflation Rate Shock refers to the period from portfolio 1 peak to trough, April 2022 to June 2022. Past performance is not a reliable indicator of future results. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Australian Equities = S&P/ASX 200 Index | Australian Fixed Income = S&P/ASX Australian Bond Index | Global Equities = MSCI AC World Index (unhedged) | Global Fixed Income = Bloomberg Global Aggregate Index (AUD hedged). Sample portfolio returns shown above are hypothetical and were achieved by mathematically combining the returns of the underlying market indices in the proportions shown above, and rebalanced monthly. Market indices are unmanaged and not subject to fees and expenses which would lower returns. Neither index performance nor sample portfolio performance is intended to represent the performance of any particular mutual fund, exchange-traded fund or product offered by State Street Global Advisors (SSGA). SSGA has not managed any accounts or assets in the strategies represented by the sample portfolios above. Actual performance may differ substantially from the hypothetical performance presented.

Are we Seeing an Opportunity in Fixed Income?

As investors review their asset allocation, and weigh up future opportunities against the risks, how does Australian core fixed income stack up? On the one hand, we are keenly focused on inflation, when it might peak, and whether it might remain sticky. On the other hand, long-term investors see an opportunity to lock in the higher yields available.

Australian core fixed income has historically performed well even if the investor enters the market at the very beginning of the rate hike cycle. The chart below assumes an investor bought diversified Australian fixed income at the beginning of each of the previous rate hike cycles (the equivalent of buying in May 2022 in this current cycle). It shows that despite a negative return in the first year, Australian core fixed income delivered not insignificant positive returns on a two- and three-year horizon.

Sources: Bloomberg Finance, L.P., Federal Reserve, Reserve Bank of Australia, and State Street Global Advisors analysis, as of 31 January 2023. Past performance is not a reliable indicator of future performance. US Fixed Income = Bloomberg US Aggregate Index (USD) | Australian Fixed Income = Bloomberg AusBond Composite 0+ Yr Index (AUD).

Investment Horizon and Objectives Matter

Long-term investors may consider Australian core fixed income allocations from an overall portfolio diversification and risk-adjusted returns perspective. Meanwhile, income-oriented investors are now able to benefit from higher yields. More tactical investors with shorter time horizons, may want to stay close to the economic data and market indicators to identify favourable entry points.

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