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Jorden Brown: Hello, I'm Jorden Brown and this is Capital Ideas, your connection with the minds and insights helping shape the world of investments. Today we'll be discussing the opportunities in fixed income markets and the role that bonds should have in a portfolio, particularly in the current economic environment. I'm joined today by our fixed income investment director, Haran Karunakaran. Welcome Haran, good to speak to you again.

Haran Karunakaran: Thanks Jorden, good to be here.

Jorden Brown: Okay, so Haran, why don't we start high level and look at what happened in the bond markets last year.

Haran Karunakaran: Sure, so happy and a bit relieved, in fact, to say that it ended up being a pretty good year for fixed income. If you look at the defensive end of the fixed income spectrum, Aussie bonds returned about 5% over the year. Global bonds, heads to Aussie dollar terms, are removing the FX risk. Global bonds returned a bit more than that, 5.3%. And global investment grade credit, one of the areas we were quite positive on over the year, did even better, about 7%. So, yeah, very strong year, much stronger than is typical for those sorts of defensive assets.

Jorden Brown: Well, it sounds like a good total outcome, but thinking back through the year, it felt like a little bit of a bumpy ride. What do you think drove that?

Haran Karunakaran: Yeah, it definitely was a bit of a bumpy ride. And I think what drove that is primarily the rates component of the fixed income returns. You can break down a bond's return into the rates element and the credit component. So, over the year, I think, broadly speaking, the credit component delivered pretty stable and positive returns. Where we saw the volatility was in rate movements. So as an example, if you look at the US 10 -year yield, had a low of 3.3% in March of last year, and that was around the time of the US regional banking crisis, hit a high of around 5% when the economy started to really take off and people were worried about inflation, and then rallied pretty hard into the end of the year, ending at 3.8% as central banks pivoted toward a more dovish view. So that sort of rate volatility is what drove the overall volatility in bond markets. But as I said, happily ended the year overall with pretty strong positive returns.

Jorden Brown: So, with those strong returns for 2023, what do you expect for 2024? And while you're thinking about that, I guess importantly, is the opportunity still there for fixed income?

Haran Karunakaran: Yeah, I think the opportunity is definitely still there. You know, over a one-to-three-year time horizon, I'm very positive on the high-quality parts of the fixed income market. And this is driven by a couple of things. I think most importantly, where I start off is looking at current yield levels. So, investment grade credit today, globally, global investment grade credit yields between 5% to 5.5%, depending on which day you're looking at it. That's really high by historical standards. It's higher than it has been 85% of the time over the last decade. So, what does this mean for investors? It means that they can by investing today, lock in those attractive yields and translate those into strong returns over the coming years.

The other way to look at it is yield and bond prices move inversely. So, a high yield means a low price, which means an attractive entry point. So, what we have today is sort of the equivalent of being able to buy into an asset at nearly the cheapest point it's been in the last decade. So, I think, Yes, the opportunity is still there. As we experience this year, there's probably going to be some more volatility in the near term. That's natural at this phase of the economic cycle. But over a one-to-three-year time horizon, if you can take that longer term view, I think fixed income will be a really good place to be.

Jorden Brown: So, when I listen to the market commentary, I see a big change in the last few months has been a perceived dovish pivot by central banks in the US and Europe. I guess thinking with potential rate cuts now on the cards this year, what does that shift mean for fixed income markets?

Haran Karunakaran: Yeah, that dovish pivot has been probably the biggest factor in financial markets over the last few months, not just for fixed income markets, but also had a big impact on equities as well.

Yeah, for bonds, I think that dovish pivot is definitely a positive. You look at fixed rate bonds in particular, as rates come down, prices go up. So, an investor will get a capital gain out of that investment. We've actually looked historically at what happens through these inflection points in the monetary policy side, also, when central banks shift from a period of hiking rates to a period of cutting rates, which seems to be where we are at the moment. We looked at about 50 years of data, so four or five rate hiking cutting cycles. And what we found on average is that high quality corporate bonds, so investment grade credit, in the three years after the last hike in a given cycle, returned a cumulative 32%, or about 10% per annum, which is extraordinarily high returns for a very defensive asset class. It's almost equity style returns, equity -level returns, for a very defensive asset. And if you superimpose that onto today's environment, the last hike in the US was in July last year, so about six months ago. Since then, investment grade corporate bonds have returned about 5%. So, pretty much bang on what history is suggesting we should be expecting going forward. So, I think for me, that dovish pivot is one of the big reasons to invest in high quality bonds today. And it is a particularly important reason to not waste too much time and thinking about it and make the move sooner rather than later.

Jorden Brown: Well, that does sound pretty interesting. I guess the one question I've got is with a strong rally with that dovish pivot, have we missed the entry point?

Haran Karunakaran: Yeah, that's a fair question. I think if you looked at just the headlines in the financial press, you could really understandably draw that conclusion. There's so much focus on the rate cuts, the yield falls we've seen since November of last year. Treasury yields have come down by about 100 basis points since then. But if you zoom out just a little bit and take, say, a 12-month view, it's a very different picture. As we talked about earlier, there was a lot of volatility over the year. But over a 12-month view, yields have barely budged at all. If you look at the 2-year US Treasury bond today, it yields 4.47%. Twelve months ago, it yielded 4.5%. So, it's changed by three basis points, barely moved at all over the year. So, what that says to me is there is still a lot of room for the impact of the dovish pivot from central banks to flow through, the yields to fall down and for bonds to have this capital appreciation boost that we're hoping to see.

Jorden Brown: And is this easing cycle happening everywhere in the world? Is Australia on the same path?

Haran Karunakaran: In most developed markets it's happening, but I think it's happening to different cycles or at different stages. The US is pretty clearly leading the way in this disinflationary cycle. Inflation has come down quite convincingly. In particular, at the end of last year, what we saw was the more sticky components of US inflation started to come down. And that's really what gave Jerome Powell and the Fed governors, the confidence to come out and start talking about the end of rate hikes, potential rate cuts in 2024. If we look at the Eurozone, I think we're seeing a similar trend. Inflation has come down quite convincingly, which is positive news. The ECB, I think, is a bit more cautious in shifting from hiking to cutting. For example, just this week, the chief economist of the ECB was speaking, and he basically said that he said the trends are positive, but you want to see them continue, see this low inflation trend continue for a few more months before they start seriously talking about cutting rates. The UK, very similar to the eurozone, maybe a bit further behind. And then Australia, I think, is even further behind those markets. Inflation in Australia is coming down, but not as quickly as it is in the US and still has quite a way to go. So, it's likely that in Australia rates will stay elevated the longer. There may even be one or two more rate hikes before we actually start seeing cuts. And if you look at what futures markets are pricing in, that sort of reflects that. In the US, futures markets are expecting five to six rate cuts over 2024. In Australia, it's more like one to two rate cuts over the year. So that's important for investors to know that there are different cycles happening because if you want to benefit from the falling yields that we've been speaking about, you really have to invest in the markets that are going to be cutting rates. So, investing in US, Europe, UK, the really the global markets, domestic bonds, probably won't see the same tailwind as those markets, at least in the near term.

Jorden Brown: Okay, so we might change tack a little. I'm still hearing from clients that cash and TD allocations are still really high. I guess in the new fixed income world that you're describing, with higher yields, potential rate cuts in the US and Europe. It sounds like the time to make the shift out of cash into fixed income. But I guess where in the fixed income markets would you be investing?

Haran Karunakaran: Yeah, it's a good question. I think on TDs, definitely I hear the same thing as you when I speak to clients. TDs and cash are an interesting allocation. I sort of think they have a very useful role in a portfolio, but it tends to be a more tactical role. There are times when it makes sense to go overweight cash. I think right now is an environment where that's not the case with yields high in fixed income markets and rates potentially coming down. The case to be in fixed income over cash is pretty strong today. And within those fixed income sectors, I think what I favour the most is investment grade credit. I think that's the real sweet spot today between providing a defensiveness that will add to your portfolio, as well as the return potential. So, if we take each of those in turn, what do we mean by defensive? Well, there are two elements. There's the high-quality element. So, investment grade by definition is only high-quality bonds. And that means the risk of default, risk of you losing capital on those investments is very low, less than 1% historically when you adjust for recoveries. The other element is duration. Duration or the interest rate sensitivity that comes with buying fixed rate bonds, is really important because that's what gives a negative correlation to equities historically. So, if you buy a floating rate bond, you may get the high-quality element, but you won't get the duration element. You really need to buy fixed rate bonds to get both those elements of defensiveness. Then on the return potential side, it's what we just spoke about. There is a high starting yield, 5%, 5.5% in dollar terms on investment grade credit today. And then the tailwind that you'll get from rate cuts if they're closer or so, following history, 10% per annum over the next two to three years. So, investment grade definitely provides, I think, a good balance between those defensive and the return potential characteristics.

Jorden Brown: That is interesting, but a number of clients I speak to which have similar thinking around duration, they're thinking rather than investment grade credit, they're allocating to sovereign. What are your thoughts on that?

Haran Karunakaran: Yeah, I think an allocation to sovereigns can make sense at certain points in time. So, if you're expecting a severe recession, sovereigns over investment grade credit does make sense. And actually, if I reflect back over the last year, I think in the first half of last year, there were definitely points where it would have made more sense to invest in sovereigns, where the recession risks seemed quite high. Today, I think what the data is showing us is that risk of recession has faded away a bit. It's not gone completely. We're still cautious. It's something we're monitoring. But it's receded quite a bit. And I think why we like investment grade today, is it provides much more versatility. It will do okay if we do see the recession unexpectedly because of its high-quality nature, because of the duration element. It will do okay. But if we don't see a recession, if we see a continuation of what we've seen last year, the sort soft landing scenario that people are speaking about, investment grades should outperform sovereigns. You earn an extra one, one and half percent yield on that. And then you have potential spread compression and red cuts, which can lead to price appreciation. If you look long term, actually, investment grade pretty clearly outperforms sovereign bonds. Going back to 2000, so roughly 25 years of data, investment grade bonds have outperformed sovereigns two-thirds of the time. And every year that sovereigns have outperformed, it's been because of a recession or a severe market stress event like the euro crisis or the GFC. So today, if you're not expecting a recession or a severe market stress environment as your base case, I think investment grade is a much better option for an investor.

Jorden Brown: So, I'm hearing the opportunity for investment grade credit is quite strong, but looking at the universe, it's quite big. So where within the IG universe are you seeing opportunities today?

Haran Karunakaran: Yeah, it is a huge investment universe, particularly when you look globally. Today, there are about 16,000 investment grade bonds outstanding. So that's a really big universe from which to find opportunities. Today, one of the interesting things that we're seeing is that the level of dispersion in bond prices and valuations across regions, across sectors at the individual bond level is much higher than it has been over the last couple of years. So, this is an environment that's really suited to an active manager, a bottom -up focus manager, someone who has the resources and capabilities to go out and find individual companies, speak to their management, really keep the ties on their business models and uncover these value opportunities. If we look across geographies, what we see today is US corporate bonds are fairly expensive. The average index level spread is about 95 basis points versus a historical average of 125. So quite expensive. That doesn't mean that there are no opportunities there are opportunities at the individual bond level, but it means we at the margin of skewing away from the US a bit and skewing a bit more to Europe and Asia where valuations are actually more attractive than historical averages. So, Europe, for example, average spread level is 131 basis points, so much higher than the US, which means a higher running yield and lower entry, lower price for an entry point into the market. So, in terms of where we're buying now, it's more in Europe and Asia than in the US.

If we look at sectors, one of the big, the interesting divergences is between financials and non -financials. Historically, they've traded at a similar price. What we have seen since the US regional banking crisis early last year, is financials are trading at a discount to the broader market. So, a discount of 20 basis points in the US, a discount of 40 basis points in Europe. So, financials are one of our highest conviction positions in our investment grade portfolio. And we continue to see opportunities. Last year we were heavily focused on the large US money center banks, the JP Morgan's of the world and large global banks like HSBC. Yeah, they're still in our portfolio, but this year I think we're seeing more opportunities in Europe. The European banks are offering cheaper entry points, attractive yield levels. They tend to be less well researched and less well covered, so more value opportunities to emerge.

I think one of the important things to highlight here though is when there's a universe of 16,000 bonds, it takes a lot of resources to go out and find the right opportunities. You need a team of analysts that are located around the world who can be on the ground with companies. You need traders who can make sure you get the allocations to the bonds that you want to buy. And you need portfolio managers to put all those ideas together in a portfolio that makes sense. So, it does take a lot of effort to invest successfully in global corporates. But if you do have those resources, I think that's a great place to be today. So that's sort of broadly my thinking around IG at the moment.

Jorden Brown: Well, thanks, Haran. I guess what I've heard today is that 2023 was a good year overall for fixed income markets. However, the experience month to month was maybe a little bumpy. But as you mentioned, maybe due to changes in rates rather than substantial credit movement. I guess in 2024, potentially has some exciting tailwinds with the shift in view from central banks in the US and Europe. And when thinking about how to position portfolios in that environment, you feel that investment grade credit investments offer potentially attractive opportunities for investors.

Haran Karunakaran: Yeah, that's spot on.

Jorden Brown: Well, thank you, Haran. Great to speak with you again.

Haran Karunakaran: Thanks, Jorden.

Jorden Brown: We're always trying to get better, so if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@capgroup.com. And if you like what you heard today, please follow us on your favourite podcast platform for Capital Ideas. This is Jorden Brown reminding you that the most valuable asset is a long-term perspective.

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