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Defending, or on the defensive

Tim Wong, CFA  |  20 Apr 2020Text size  Decrease  Increase  |  
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Following on the heels of our March 18 article on the leaders and laggards in fixed interest during the COVID-19 sell off, let’s extend this to see what happened over the duration of the first quarter, with an eye on any broader findings investors can glean from this remarkable period.

Australian Bonds

Exhibit 1: Performance of Morningstar's qualitatively-rated Australian bond strategies in Q1 2020

Exhibit 1: Performance of Morningstar's Qualitatively-Rated Australian Bond Strategies in Q1 2020

Source: Morningstar Direct. Data as at 17/04/2020

Most Australian bond managers eked out a positive return over the quarter, but it was far from smooth sailing. For starters, active managers flattered to deceive—few beat the benchmark Bloomberg AusBond Composite Index. The struggles really took hold after market volatility soared from 21 February onwards, with many active Australian bond funds dipping slightly. Credit was the big loser as spreads widened dramatically. Government and government-related bonds were the best sanctuary but even this masked some eye-opening swings. Competing forces spanning fears over an economic slump, concerns that government bond yields would spike on account of a massive increase in supply to fund fiscal stimulus measures, to aggressive central bank actions to inject liquidity into the system and ease monetary policy caused bond yields to move violently in both directions.

Accordingly, CC JCB Active Bond 41406 position at the head of the pack in Australian bonds isn’t surprising. This strategy’s focus on high-grade sovereign and government-related bonds protected against wobbles in credit markets. JCB cut risk in supranational bonds to bolster cash holdings and prioritised liquidity. Meanwhile, Pendal Fixed Interest 2950 and CFS Wholesale Australian Bond 4122 also performed with distinction in surpassing the benchmark. Pendal’s long duration strategy across multiple markets in Australia, the U.S., New Zealand, and China was initially beneficial, before it quickly shifted to protect against central bank stimulus-inspired rising bond yields via curve steepeners—long positioning in shorter duration government bonds (1-3 year) and short positioning in longer maturity (10+ year) bonds. JCB, Pendal, and CFS are particularly willing to adjust their positions meaningfully on short notice, and this appears to have assisted during the quarter’s wild twists and turns.

The severity of the market movements is also visible in the fortunes of Schroder Fixed Income Wholesale 10862 and Janus Henderson Australian Fixed Interest 5666. Although both lagged the index over the quarter, Schroder and Janus Henderson were at opposite ends of the leaderboard when we checked in on 18 March. However, the changing interest rate dynamic took the gloss off early crisis gains for Schroder while Janus Henderson’s swift pivot from a short to long duration stance amid the RBA’s announcement it would initiate quantitative easing helped it play catch-up towards the end of March. Janus Henderson Tactical Income 17406 was the lone strategy in this field to decline over the quarter, primarily due to its structurally lower interest-rate risk and credit leaning.

Disappointingly, the highly-rated PIMCO Australian Bond 10881 struggled during the quarter. The strategy declined the most from mid-February. Active overweights to corporate credit and mortgage-backed securities at the expense government issuances, along with spread positioning did not fare well. Exposure to Australian inflation-linked bonds, and modest currency positioning, particularly a short to the U.S. dollar and overweight emerging markets, also detracted slightly.

Passive strategies correspondingly filled several rungs towards the top of the ladder. Government bonds are a significant component of the broader Composite benchmark, much larger than the weight in credit. Vanguard Australian Government Bond Index 16868, which invests wholly in treasury and government-related securities, returned 3.30% for the first quarter. Not far behind was the Vanguard Australian Fixed Interest Index 4487 and iShares Australian Bond Index 9093, which both track the Bloomberg AusBond Composite.

 

Global Bonds

Exhibit 2: Performance of Morningstar's qualitatively-rated global bond strategies in Q1 2020

Exhibit 2: Performance of Morningstar's Qualitatively-Rated Global Bond Strategies in Q1 2020

Source: Morningstar Direct. Data as at 17/04/2020

We’re struck by two outcomes for the global bond category: incredibly varied results post 21 February, and the struggles of active managers. The range of outcomes here far outstripped what we saw in Australian bonds, a function of much broader investment remits in the global cohort. Meanwhile, passive strategies topped the charts over the quarter, whereas few active rivals even generated positive returns. The passively managed Vanguard International Fixed Interest Hedged ETF ASX: VIF led the way, with this government-bond portfolio avoiding the damage inflicted on credit securities. Vanguard's and iShares' suite of Barclays Global Aggregate Index trackers managed to hold their ground courtesy of the dominance of developed market government and government-related securities in the index. Even so, these passive vehicles still fell in value (albeit modestly) during the post 21 February period, which may raise eyebrows from a broader portfolio diversification standpoint.

On the active front, T. Rowe Price Dynamic Global Bond 40282 stood out. Their protracted cautious view over credit risk, applied through derivative hedges on investment-grade and high-yield credit, as well as equity market hedges, paid off handsomely as these assets sold off. Tactical duration management of U.S. duration helped deliver a positive return for the month of March. A prior move to near zero duration was snapped back to a long duration stance in a matter of weeks in response to central bank quantitative easing programs.

Elsewhere, currency was a source of angst. The perceived safe haven of more liquid currencies like the U.S. dollar, as well as the Japanese yen and Swiss franc, meant all appreciated versus most currencies across the globe. Legg Mason Brandywine Global Opportunistic Fixed Income A 16192 felt the full effects of this trend, crashing 10.58% over the quarter. The damage was largely attributed to currency, principally its bearish view on the US dollar. Their favour of lower-quality sovereign bonds in emerging markets, as well as commodity currencies, hurt significantly, including exposure to both Mexican sovereign debt and the peso and to a lesser extent Brazil.

Diversified Credit and Multi-Strategy Income

Exhibit 3: Performance of Morningstar's qualitatively-rated diversified credit strategies in Q1 2020

Exhibit 3: Performance of Morningstar's Qualitatively-Rated Diversified Credit Strategies in Q1 2020

Source: Morningstar Direct. Data as at 17/04/2020

Exhibit 4: Performance of Morningstar's qualitatively-rated multi-strategy income strategies in Q1 2020

Exhibit 4: Performance of Morningstar's Qualitatively-Rated Multi-Strategy Income Strategies in Q1 2020

Source: Morningstar Direct. Data as at 17/04/2020

Almost all the strategies we cover in the Diversified Credit and Multi-Strategy Income fell in value over the March quarter. Falls were typically less than 5%, though we'll talk more about outliers such as Bentham Global Income 10751, Payden Global Income Opportunities 19589, and PIMCO Income 41334 later in this article. As per the global bond group, the range of outcomes exploded after 21 February to the quarter’s end, reflecting the broad mandates these managers operate within. An inability to protect against capital declines is disappointing when many of these strategies tout their extra flexibility in handling bond market gyrations as a key advantage over more traditional index-relative offerings. In fairness, this is undoubtedly a black swan event, and the speed and ferocity of the market’s movements hamstrung bond managers in trying to alter their physical positions meaningfully. Still, it does reinforce our long-time view that more flexible bond managers have generally favoured credit risk over interest rate risk. While duration was not a perfect equity risk hedge over this period, sovereign bonds still proved to be a more effective diversifier overall.

Vanguard Australian Corporate Fixed Interest ETF ASX: VACF stood alone in delivering a positive result over the quarter. Interestingly, this strategy outdid the Vanguard International Credit Securities (Hedged) ETF ASX: VCF by almost 4% throughout the quarter, suggesting that domestic credit markets held up better than global. Relatedly, AMP Capital Corporate Bond A 17388, the top active player in the diversified credit group chiefly comprises investment-grade domestic credit. Kapstream Absolute Return Income 17256, another Australian credit-leaning manager, also stood out in protecting against the worst of the market’s decline. Its prolonged conservative inclinations concentrated solely on investment-grade, biased to shorter-dated issues (fewer than five years), and avoidance of more volatile or troublesome regions and sectors told the story. Purchasing credit default swaps also helped to protect the portfolio.

However, Australian credit wasn’t a goldilocks safe haven. Circumstances in Australian credit were far from benign. Similar to what happened globally, liquidity for Australian credit evaporated as fear and uncertainty took hold in February, prompting several managers to raise the charge for investors to exit funds—including Vanguard Australian Corporate Fixed Interest Fund 40548 (not to be confused with the aforementioned ETF) lifting its sell spread to 1.72%, one of the highest marks in the cohort. Substantial and unprecedented monetary easing was needed to restore liquidity and confidence into credit markets (and to a lesser extent, government bond markets), and this has in turn prompted some bond managers to reduce their exit charges. While things have since settled, the fact that such actions occurred at all should not be underestimated.

Meanwhile, Payden Global Income Opportunities 19589 slumped 12.31%. This fall eclipsed some global equity managers. Despite Payden and Rygel retaining broadly matched allocations to their "stability" and "opportunity" buckets, high-yield, loans, and emerging-markets debt in the opportunity camp caused significant headaches. Emerging market paper, credit risk transfer securities and other loan instruments, collateralised loan obligations, for example, turned disastrous with double-digit falls not uncommon. Tail-risk hedges employed as protection against extreme market conditions consequently proved fruitless.

PIMCO Income Wholesale 41334 bore the brunt of its sub-investment grade exposure, a preference for emerging market currencies at the expense of U.S. Dollar, and to a lesser extent short duration positioning. Exposure to sub-investment-grade and emerging market currency markets were in the firing line and subtracted substantially from returns. Another high-profile manager, Bentham Global Income 10751, also felt the pain of the loan market. Significant exposure to global syndicated loans and collateralised loan obligations, as well as asset quality at lower echelons, roughly 40% below investment-grade, depreciated sustainably with widening credit spreads.

Concluding thoughts

The first quarter of 2020 will not be fondly remembered by most investors in actively managed bond strategies. The inability of many strategies to provide a buffer against equity market volatility, particularly in globally-oriented and more flexible offerings, was disappointing. The consensus position for several years has been to favour credit risk, to varying degrees, and this came unstuck. Even so, while government bonds broadly outperformed, there were periods when market fear even materialised into discomfort with high-grade duration. A repeat would make constructing a diversified portfolio particularly tricky, especially as Australian interest rates approach zero alongside unconventional monetary policy being enacted. Such concerns should not be dismissed, though it’s worth remembering the basic tenet of favouring higher-quality fixed interest instruments as your first line of defence held firm. And keep in mind what role you expect these strategies to play. Notably, almost all of the strategies that suffered the largest declines during the first quarter of 2020 were marked as Supporting Players, which is indicative of the greater risks we think they possess.

is director, fixed income strategies, at Morningstar Australia.

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