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.
1 Source: Bloomberg Finance L.P., as of 23 June 2022. 2 +1 is in lockstep, -1 is moving completely in opposite direction. In times of market stress, historical correlation patterns tend to break down, and markets move either up or down in lockstep.
Issued by State Street Global Advisors, Australia, Limited (ABN 42 003 914 225) is the holder of an Australian Financial Services Licence (AFSL Number 238276). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia T: +612 9240-7600. F: +612 9240-7611.
The views expressed in this material are the views of the SSGA Fixed Income Strategy Team through the period ended 23 June 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
This material is general information only and does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. There is no representation or warranty as to the current accuracy of this material, and SSGA Australia shall have no liability for decisions based on such information.
Investing involves risk including the risk of loss of principal.
Floating rate securities are often lower-quality debt securities and may involve greater risk of price changes and greater risk of default on interest and principal payments. The market for floating rate securities is largely unregulated and these assets usually do not trade on an organized exchange. As a result, floating rate bank loans can be relatively illiquid and hard to value. Diversification does not ensure a profit or guarantee against loss.
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates rise bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks but provide lower potential long-term returns.
BLOOMBERG and BLOOMBERG INDEXES are trademarks or service marks of Bloomberg Finance L.P. Bloomberg Finance L.P. and its affiliates (“collectively, “Bloomberg”) or Bloomberg’s licensors own all proprietary right in the BLOOMBERG INDEXES. Bloomberg does not approve or endorse this material and disclaim all liability for any loss or damage of any kind arising out of the use of all or any part of this material.
This document may contain certain statements deemed to be forward-looking statements. All statements, other than historical facts, contained within this document that address activities, events or developments that SSGA expects, believes or anticipates will or may occur in the future are forward-looking statements. These statements are based on certain assumptions and analyses made by SSGA in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein. Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond SSGA's control. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA Australia's express written consent.
This website is intended for persons resident in Australia. State Street Global Advisors, Australia Services Limited ABN 16 108 671 441, AFSL Number 274900 ("SSGA, ASL") is the product issuer. State Street Global Advisors, Australia, Limited (AFSL Number 238276, ABN 42 003 914 225) (“SSGA Australia”) is the Investment Manager. The material on this website is general information only and does not take into account your individual objectives, financial situation or needs.
You should seek professional advice and consider the Product Disclosure Statement (PDS) and target market determination, available at www.ssga.com, before deciding whether to acquire or continue to hold units in the Funds.
You can access our PDS online or by calling us. The offer made in our PDS is available to persons receiving the PDS within Australia and applications from outside Australia will not be accepted. Past performance is not a reliable indicator of future performance. Investing entails risks and there can be no assurance that State Street Global Advisors will achieve profits or avoid incurring losses.
Investing involves risk including the risk of loss of principal. This material should not be considered a solicitation to apply for interests in the Funds and investors should obtain independent financial and other professional advice before making investment decisions. There is no representation or warranty as to the currency or accuracy of, nor liability for, decisions based on such information. Performance quoted represents past performance, which is not a reliable indicator of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.