November marked a turning point in the last nearly 2 years of fighting inflation with rising interest rates.
The market began firmly pricing in the end of hikes and the start of cuts. This is mainly because historically central banks have held rates steady at their peak for no more than about 7 months on average before cutting them again, as economies run into
a wall of higher borrowing costs.
Inflation is coming down from its highs, but it is by no means defeated, and the lesson of the 1970s is that if conditions are loosened too quickly then it can come roaring back. I am pretty sure no one wants that, least of all central bankers, and so
we may see cash rates remain high, but longer market driven rates are falling already.
We started adding duration, or interest rate risk, to portfolios toward the beginning of the month, particularly a new 10-year bond from Westpac which came with an amazing 7.20% coupon, but also with government bonds. If rates fall in line with history,
these will perform very strongly over the next 12-18 months.
These changes lower the headline yield to maturity, but these positions are not designed to be held until then. If all goes as planned, they will be sold in somewhere around a year’s time.
Conservative portfolio:
This portfolio is all investment grade and all AUD.
The current portfolio yields 6.00% and consists of ten bonds of roughly equal weight by value to total an approximate $525k spend.
We made a measured but fairly significant switch in the portfolio this month. We removed the two longer dated, lower coupon corporate bonds from Pacific National and Lendlease, both with BBB- ratings and 2031 maturities and added Australian Government
and Queensland Government 2033 bonds rated AAA and AA+ respectively.
This extended the duration of the portfolio by about 10% to over 3.1 years (which is still relatively short), but we anticipate these government bonds performing strongly over the next year or so.
The new bonds also have better incomes than the old ones, so the portfolio now earns over 6.25% in income per annum, as well as being better set up for a falling long dated interest rate environment.
If short term rates begin to fall as the RBA cuts rates, we will further extend duration by switching out of floating rate bonds, but we believe we are not there yet.
If we are wrong and rates do not fall as we expect, the stronger income will protect the downside all the more.
The new WBC issue at 7.20% was exceedingly attractive but has already rallied to well over $105 and as such we don’t include it just due to timing reasons.
Balanced portfolio:
The Balanced portfolio adds higher yielding bonds to the base Conservative portfolio to achieve a higher yield, while maintaining a balance between risk and return, skewed towards preserving capital rather than chasing yield.
It aims to have between 15-20 positions, with the high yielding bonds in smaller parcel sizes (comprising 38% of the total portfolio) to reflect their riskier nature.
The current portfolio has 16 bonds, yields 7.39% and is an approximate $615k spend.
This portfolio, by virtue of the high yielding allocation, has a much shorter duration than the Conservative.
Even after switching out the Lendlease 2031 for the ACG 2033, the duration was only just 2, so we decided to make one of the floating for fixed switches in the investment grade portion and changed the BNP +1.55% 2026c for the QTC 2033 bond.
This lengthened the portfolio to a duration of 2.7, which in absolute terms is still short, but is a lot more sensitive to rates than the prior 1.8 figure.
The income improved as well to 6.84%, so this portfolio is really well set up for all eventualities.
There was no significant RMBS issuance this month so we left that allocation unchanged.
High Yield portfolio:
The High Yield portfolio looks to generate a higher yield while still looking to have a bias towards as low risk positions as possible.
This is achieved by good diversification and attempting to identify fundamentally mispriced bonds.
The current portfolio has 16 bonds, yields 9.85% and is an approximate $500k spend, demonstrating the concept of greater diversity in higher risk positions.
As mentioned last month, most client portfolios are Balanced in nature, and it is unusual to find exclusively high yield portfolios.
As the AUDUSD fx rate got to around 0.63, we began selectively taking profits on USD bonds and repatriating the funds into AUD longer duration bonds such as the government bonds added to the above portfolios.
As this is an exclusively high yield portfolio, the mandate does not allow this. The yields on the USD bonds are attractive, particularly the ING 2027c and NCIG 2027c, which for these two seem to make them worth holding.
We will continue to monitor the fx situation but would be ordinarily recommending a reduction in USD exposure at these currency levels.
Unfortunately, there has been no new AUD high yield exposure with which to replace the USD bonds, but if any arrives, we will be sure to evaluate it for inclusion.
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