FEATURE: Fixed income | Adjusting the lens

Closer to home, Rainmaker Information reveals that Australian-sourced fund inflows into domestic and international fixed income have been steadily increasing, rising from $450 million in early 2022, when Russia's invasion of Ukraine shook global markets, to $645 million in December last year.

Although fixed income is likely to benefit as investors seek safer asset classes in volatile markets, some industry experts are surprised by how non-reactionary risk markets in general have been to the current geopolitical disturbance. Arguably, many fund managers were already positioning portfolios for Trump-induced volatility and have had geopolitical risks on their radar for some time.

There has been a slight widening in credit spreads as the conflict has gone on, but this has still been modest, especially in comparison to what happened following the introduction of the Liberation Day tariffs last year.

Neuberger senior fixed income manager Adam Grotzinger⁰¹ says, however, that before the most recent shock, there was already a question mark over some elevated tail risks in the system.

"Even at the start the year, credit was relatively tight in valuation terms, and in our view, not overly compensating you for some of these risks," he says.

"We're kind of cautious on credit. 'Patient, cautious and selective' would define our thinking on credit. We didn't bite the bait on this recent widening in spread."

Where he has been noticing a bigger dislocation that is better on a risk-adjusted basis has been in the government bond markets around the question of how central banks would adjust monetary policy in reaction to higher oil prices.

At the start of the year, the US market was pricing for two or three cuts from the Fed but has since moved to pricing in a slight chance of a hike. In terms of basis points, that's a radical 50 to 75 basis point adjustment.

"We've decided to put more risk capital into investing in that, while watching credit and not chasing the credit widening," Grotzinger says.

While there will be headline inflation from oil, markets are in a very different place to where they were in 2022 which means different reactions from central banks are likely.

For example, in 2022, monthly US job gains were between 200,000 to 600,000 compared to around 60,000 today. Core US inflation was also running at 6% in 2022, whereas currently it is closer to 3%. Wage inflation has also slowed to 3.4%, the slowest rate of growth since 2021. Fed rates were closer to negative three years ago compared to the mid-threes they are in now.

It is not a 2022 playbook, according to Grotzinger.

"Hence, we see value in the move higher in yields and in the market's pricing for further central bank hikes, particularly in the US. We've also seen similar moves in Europe," he says.

The market's pricing of inflation, as measured by the US 10-year breakeven rate, has barely changed. Similarly, Grotzinger says markets are not pricing in an aggressive stagflationary scenario either.

"I think the market still believes in central bank credibility and in their commitment to fight inflation, but we see the disconnect between the market pricing in some chance of a hike and our expectation for the Fed to cut in 2026. Higher oil prices have more of a disinflationary pulse than inflationary," he says.

Shock and awe

The bigger question about the disruption to the supply of oil from the Middle East, which is impacting most global economies, is whether an inflationary shock turns into a growth shock.

Currently, the fixed income market is hyper focused on interest rates and what central banks are going to do in response.

Bentham Asset Management chief investment officer and principal Richard Quin⁰² says the market has priced out the two or three rate cuts it had priced in at the beginning of the year.

"In Australia it is different, we've had two rate hikes and priced in another two- and a-bit rate hikes. It's a slightly different scenario though, that we find ourselves in, and that supply side shock is quite a big deal," he says.

How economies react to a shortage of oil may be the decider in whether the shock turns into a global brake on growth. If countries introduce rationing, for example, that destroys demand.

"That destruction of demand is where this supply shock could go from being inflationary to having a negative effect on overall economic growth, and I think we're close to that, but it depends how long the disruption occurs,"
Quin says.

Of the many different outcomes or scenarios that the current war or conflict in the Middle East could have resulted in, some - such as a quick resolution - have already passed. Others, such as resolution drawn out for three or four months, may still be a possibility and could have limited impact on global demand. But there is also still the real threat of a prolonged conflict which could significantly damage global
demand.

"Should the conflict come to an end, but with significant demand destruction, fixed income may provide some upside. We are also conscious that we've seen some pretty poor confidence numbers come out recently," Quin says.

As to whether the supply shock turns into a global demand shock and recession, that may depend on whether or not oil restrictions are necessary and introduced in different economies. This is unlikely to happen in the US, as it is energy self-sufficient, but oil prices will of course rise there instead.

The longer the conflict goes on, its impact on global growth will become the more important question, which may be why bond markets, especially at the longer end, have found more of an equilibrium.

If a recession eventuates, that's likely to be good for bonds, which is why bond managers are very keen to buy long bonds at a certain level.

"The US has been outperforming most of the world for a long time now, and we still think that is going to continue because there's all the stimulus coming through this year," senior client portfolio manager at Franklin Templeton Richard Rauch⁰⁴ says.

But as a tax on consumption, the higher oil prices may be enough to undo any tax refunds or other benefits consumers might receive from the Big Beautiful Bill in the US.

In Australia, the middle to lower income bracket is also fiscally constrained, especially if they need to drive a reasonable distance to work.

"Certain forecasts suggest that it is worth about a 1% increase in interest rates, just that change in fuel price," Quin says.

Although with the sell-off in the last month, yields have gone higher, and credit spreads have widened slightly, he does not believe credit is pricing in a recession just yet.

In terms of how Bentham is investing in this environment, Quin says it is staying on the more defensive side of credit and leaning a little bit into the duration side.

Meanwhile, as the conflict has persisted, the focus of QIC has also shifted from inflationary concerns and a supply shock to the potentially broader negative impacts on global growth. It also believes the more lasting impact may be on real disposable incomes, household spending and, ultimately, growth.

"Activity could be further impacted if supply chain disruptions begin to ripple through to restricted availability of refined fuels and/or other key manufacturing items critical to global production," QIC head of liquid markets Beverley Morris⁰⁴ says.

"We believe that financial markets currently are somewhat complacent about these risks."

A super lens

Superannuation funds have a slightly different approach to market disruptions. HESTA chief investment officer Sonya Sawtell-Rickson⁰⁵ says managing system risk is critical to retirement outcomes, especially during periods of heightened uncertainty. HESTA's approach to fixed income therefore is practical and grounded in long-term discipline.

"The recent geopolitical risk has resulted in supply-side disruption, fuelling commodity price rises and short-term inflation. This has resulted in rising bond yields, as the market reprices the risks of sustained conflict. This has led to both equities and bonds delivering negative returns during the recent period, and positive correlations," she points out.

But for HESTA this repricing has created one of the most attractive fixed income opportunities in years, with bonds again offering attractive yields that can help protect portfolios.

"Yields are compensating investors for risk, and by being selective about where we invest, we're well-placed to make the most of this market environment for members," Sawtell-Rickson says.

As a superannuation fund investing across the entire suite of asset classes, fixed income's role in relation to other assets in the HESTA portfolio is also important, with the bond-equity hedge an essential portfolio tool. However, the relationship between the two asset classes doesn't always perform as expected, with it more likely to provide a hedge in demand shocks rather than inflationary or fiscal repricing environments.

"Future demand shocks are always a possibility, which is why we added inflation-protection to our bond portfolio earlier in the year," Sawtell-Rickson says.

"No portfolio can be immune to all scenarios, but our approach is to be prepared across the portfolio to be resilient in the face of inflationary challenges."

Favourable outlook

QIC's Morris says the forward-looking environment for fixed income is favourable despite the heightened volatility.

"For corporate investment grade credit, fundamentals are strong with relatively high all-in yields and a positive sloping yield curve delivering strong income, alongside the potential for duration-led capital gains," she says.

Most institutional investors like QIC are accustomed to looking through geopolitical volatility, and QIC's process places greater emphasis on assessing various risk scenarios and understanding economic fundamentals and how policy might react.

From early March, when the obvious impacts on oil and inflation were starting to emerge QIC adjusted its views accordingly.

"This is consistent with the rise in bond yields seen across developed bond markets since the beginning of the conflict, as markets moved to anticipate more restrictive monetary policy by central banks to counteract the inflationary impact," Morris says.

Franklin Templeton's Rauch is quite surprised by how well risk assets have held up overall. But he suspects that's because the market expects the conflict and energy shock to be relatively short-lived.

"Within the fixed income world, credit spreads have pretty much reached the tightest levels we've seen since maybe pre-GFC, maybe of all time. Meaning the compensation for default is very low, but defaults have also been low," he says.

Rauch also notes an insatiable demand for public market credit, whether it's high yield, investment grade, mortgages or even in the private space. Spreads might have widened slightly, but nothing like what has happened during risk-off events historically and there are still pockets of value in credit markets were all-in yields look attractive.

Inflation-linked bonds

With an Australian focus, QIC used the rise in bond yields through March to increase its interest rate duration positioning, once it was comfortable that the market was adequately pricing the Reserve Bank of Australia's (RBA) likely response to inflation.

"Our portfolios also increased their overweight to inflation-linked bonds (or real yields), as high spot inflation and weaker medium-term growth impacts are a favourable environment for real yields, and with the level of real yields around 15-year highs,"
Morris says.

QIC's spread positioning remains close to the lower end of historical ranges given the historically tight level of spreads and the potential for the market to be underestimating possible downside growth risks.

But for investors in general, Morris says some of the most compelling opportunities in bonds right now may be in inflation-linked bonds where investors can earn attractive real yields in an instrument that also offers portfolio protection in the event of higher inflation.

"Currently, 10-year inflation linked bonds have a real yield of around 2.5% and a breakeven inflation rate that is still slightly below the mid-point of the RBA's target band," she says.

"If inflation turns out to be higher than expected, the exposures have inbuilt inflation protection. However, if inflation risks subside, it should allow the RBA to be less aggressive than priced, which should lead to a fall in real yields."

Franklin Templeton's Rauch is also a fan of inflation-linked bonds, or Treasury Inflation-Protected Securities (TIPS) in the US.

US Treasury inflation protected bonds like US TIPS are currently offering a real yield of nearly 2%. That may not be a shoot-the-lights-out kind of yield but a 2% return above inflation for the next 10 years is starting to look very attractive in the current environment.

"If you buy really long dated bonds, it's a little bit higher than that," he says.

But investors need to be discerning when it comes to how they invest in bonds and Rauch has a cautionary message for those buying the big broad-based bond indexes expecting to never lose money.

"What I like to point out to investors or clients is to make sure you know what you're getting when you're buying the index. In the global bond market, what you're buying is about six to six and a half years of interest rate risk. Meaning, if bond yields go up 100 basis points, you lose about 6%. So, you can lose money with bonds, at least on a mark-to-market basis," he says.

AI disruption

Before late February and the initiation of 'Operation Epic Fury', the market's biggest worry was the AI bubble bursting and the impact that might have in the Software-as-a-Service sector with the likes of Oracle, Xero and Atlassian all laying off employees in efficiency drives. This didn't go away; it just moved to one side as geopolitical risk took centre stage.

"Before we went into this in March, we witnessed a major sell-off in the software sector on the impact of AI disruption. We believe that there will be big issues from the creative destruction of companies, so you'll see a lot of losers as well as a lot of winners from AI," Bentham's Quin says.

AI disruption is still very real, especially in light of some of the changes in how companies in the sector are raising funds. The hyperscalers like Amazon, Microsoft, Alphabet and Oracle have been moving from financing via cash and/or equity to greater reliance on the debt markets due to the scale and urgency of their computer power requirements.

"Investment grade corporates have seen a surge of bond supply from these hyperscalers in the last year or so, which is introducing a new risk to the investment grade markets," Neuberger's Grotzinger says.

Investors therefore need to recognise the potential liabilities these large companies might have when they invest in this sector.

Bond markets have plenty to deal with in the current environment, but with geopolitical outcomes still up in the air, most industry experts say the best opportunities will most likely be in long government bonds and inflation-linked bonds, as they can offer some protection in an uncertain world. fs