Understand the Risks in Your Search for Income

With the macroeconomic backdrop becoming more challenging, and the stubbornness of inflation leads to increasing risks of Central Banks crashing growth in the pursuit of price stability, investors should be more aware of the risks within their portfolios and adopt greater caution.

  • Global Central Bank policy has rapidly shifted from quantitative easing (QE) to quantitative tightening (QT), the market impact has been compounded by geopolitical forces.
  • Downunder, rising rates are happening at a faster and more aggressive pace than previously signaled by the Reserve Bank of Australia (RBA).
  • For the first time since 2002, bond and equity correlations have become positive.
  • As investors reposition portfolios to generate higher income, it’s critical to understand where the exposures lie and the liquidity profile in times of market stress.

The global investment landscape has changed rapidly over the past 6 months and has become more complex for investors to navigate. There are multiple variables to consider such as tighter monetary conditions with quantitative tightening globally, growth scares from China’s zero-COVID strategy, the prospect of natural gas rationing in Europe and surging inflation with elevated food and fuel costs as a result of the Russia-Ukraine conflict. There has been a significant increase to both implied and realized volatility in almost all markets year-to-date. More importantly, the expected diversification and downside protection from traditional bond investing have failed investors in what is now the longest stretch of positive equity-bond correlations since 2002 which can be seen in figure 1 below.

Figure 1: Weekly Australian Equity-Bond Return Correlations

Source: Bloomberg Finance L.P., SSGA, as of 23 June 2022. S&P/ASX 200 & BBG Ausbond Composite 0+Yr Index used to represent Equity and bond Markets respectively. Correlations have no unit.

Rising Rates Downunder

The environment is also becoming more challenging in Australia with the RBA surprising markets in June, by taking a higher than expected 50bp increase in the cash rate. The RBA also signaled further normalization in the months ahead. While the overall economy remains resilient, with favorable terms of trade, strong investment pipeline and strong labor markets with unemployment at 50 year low, uncertainty exists in the form of high inflation levels, higher interest rates and declining house prices on household budgets. Consensus growth expectations for 2022 have been downgraded to 4.0% year on year (yoy) (as of 23-Jun-22) from 4.4% (1 month back), and inflation expectations have increased from 4.4% (1 month back) to 5.8% (as of 23-Jun-22).1

The Overnight Index Swap (OIS) markets are now pricing in rate hikes to a policy rate of ~3.8% in one year’s time (see figure 2), which is amongst the highest in developed markets (see figure 3).

Figure 2: Current Implied Policy Curve (as of 23 June 2022)

Source: Bloomberg Finance L.P., as of 13 June 2022.

Figure 3: Significant Repricing of Policy Rates

Source: Bloomberg Finance L.P., as of 23 June 2022.

Buyer Beware - Understand the Risks in Your Search for Income

With an unsupportive global backdrop and further hiking expected from the RBA, investors have been reevaluating bond allocations to limit duration in pursuit of real income by increasing ultra-short floating rate credit, or absolute return strategies that have wide investment mandates.

With easy financial conditions reversing, now might be a good time to review those strategies, to better understand the risk exposures and simplify portfolios to provide more transparency. Investors need to ask themselves whether they truly understand where the risks lie with non-traditional and sometimes manager dependent idiosyncratic risk that might be present in the implementation of absolute return portfolios.

While there exists a wide spectrum of complexity within products within the absolute return/income space, many have exposure to lower quality subordinated debt, alternate credit, Emerging Market, high yield debt, convertibles, long/short strategies and risk exposure through derivatives.

While investing in those parts of the market do have their benefits, attention also needs to be given to the liquidity profile of these underlying exposures – particularly during times of market stress when correlations approach +1.2

Another added consideration is credit ratings. A high quality portfolio will have greater resilience in a market downturn, but investing based on average credit ratings has limitations, as this metric doesn’t provide a full picture of the risks and suitability. It’s worth remembering that changes in credit ratings by the agencies tend to significantly lag the market pricing of risk. In fact bond prices usually move down sharply, well before a rating agency downgrades its credit rating. While credit ratings have proved to be quite accurate in the measurement of default risk historically, there have been instances where investors faced significant capital losses when relying solely on ratings alone such as the mis-rating of US mortgage-backed securities during the 2000s and the failure to capture accounting frauds at Enron and WorldCom.

The Bottom Line

Investors should be more aware of the risks within their portfolios and adopt greater caution as the market cycle peaks. As risks remain to the downside and short duration, high quality, floating rate notes that provide consistent income and transparency could be considered to provide greater certainty to portfolio outcomes as the market continues to evolve.

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