Making sure defensive portfolios are truly defensive

A Money Management roundtable found planners need to ensure that the defensive parts of their client's portfolios are truly defensive in the face of uncertainty in the global bond market. 

Mike Taylor (MT) 

Managing editor, Money Management 

Christopher Joye (CJ) 

Founder, Coolabah Capital 

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Libby Newman (LN) 

General manager, income and multi asset, Lonsec 

Damien Wood (DW) 

Principal, Spectrum Asset Management 

Brad Bugg (BB) 

Head of multi asset income, Morningstar 

Andrew McKee (AM) 

Financial planner, Australian Unity 

AM: I think how markets behave will depend a little bit how the bond prices, yields, move and how quickly they move and whether it's in a managed sort of process over an extended period of time or whether it happens in an uncontrolled way over a short period of time which I think would reverberate through all of those markets and have a more significant impact on equities and property, property trusts, residential property as well. So, yeah, I'm cautious about how it unfolds is probably the best way of putting it. 

In terms of the portfolios, it's a fairly similar theme.  You want your defensive part of your portfolio to be defensive so if you think there's a risk that global bond prices are going to come off then [it is] best to avoid that which means you focus the defensive side of the portfolio on term deposits and short-duration and high-credit quality funds.  

None of that's very sexy but it's defensive.  And then you try and construct portfolios that have a risk profile that suits the client. 

CJ: On the asymmetric point, I mean, one of the other things I've heard from – we deal with a lot of financial advisors and increasingly you hear folks talking about equities for income and bonds for growth, right – 

LN: Yeah. 

CJ: – which is, I just think, the most sort of crazy logic.  To Libby's point, you could get double-digit mark-to-market returns on sovereign - year-on-year sovereign bonds with negative yields and so people look to Aussie government bonds, so AAA-rated government bonds, and they think that's, yeah, your defensive and a liquid part of your portfolio.  But they fell 40-basis points last month and then they're probably down another 50 basis points already this month, or thereabouts, and so, yeah, I agree with you.  I think there's massive asymmetry in the risk return pay-off for fixed income and I think the key message I have for investors is you've got to de-couple credit and duration risk because duration's not defensive right now.  Duration's never been more expensive in human history. 

MT: Brad? 

BB: Yeah, no, we agree.  It means it's – 

DW: That's a good quote, by the way. 

MT: Yeah, I know. 

AM: Well, it's also when something looks out-of-whack it probably is and negative yields just are very hard to get your head around. 

DW: Fair enough. 

CJ: And actually the other point I was going to make as in Aussie credit, one of the interesting things is superannuation. 

I agree, and I think we all agree, Aussie credit looks either close to fair value or slightly cheap.  Our point in our portfolios has been it was extremely cheap in 2015 and particularly cheap in January, February '16, which is why we were long credit.  But I think there's a structural problem on the demand side for Aussie credit, which is super asset allocations. 

We all know that super funds have bugger all allocations to cash in fixed income in Australia because there was a massive equities chase during the 1990s and 2000s.  Paul Keating established super in 1992 on the premise that it would give blue collar workers access to shares and I think that's really pervaded consultant thinking and there's huge inertia, I think, in consultant land in super asset allocation around cash and fixed income, notwithstanding that it's been such a, frankly, wickedly – as in positively – performing asset class for the last decade, particularly duration. 

But if you look at super – like, we deal with a lot of super funds, as all you guys do as well, and if you look at asset allocation within fixed income, there tends to be next to no Aussie credit allocation.  So they have a global credit allocation but no Aussie credit allocation. Now, the irony of that is if you take the sizeable Aussie fixed income, it's $1.4 trillion in total, and obviously there's a lot of sovereign risk in that but that $1.4 trillion of asset class size – it's basically the same size as Aussie risk. 

AM: Stock market, yeah. 

CJ: Yeah. So it just kind of – and you can swap out all that sovereign duration risk. So if you wanted to, you could actually have an Aussie fixed income allocation that had no duration risk. If you're worried about duration, you just swap it out. So, for me, there's a massive imbalance in the asset allocation within savings, which is, in part, the explanation why Aussie credit's cheap, vis-a-vis credit overseas. So it's not obvious therefore that that cheapness will necessarily disappear. 

DW: What I've looked at in the super funds is there seems to be a bar bell approach and they have equity or bank deposits and the bank deposit is somewhat a substitute for fixed income although that's starting to change a bit now with their new FSR rules they're bringing out in 2018 which are making deposits from self-managed super funds less attractive for the banks so they were going to start ratcheting down [and] the yields are going to be getting the deposits. 

So there's a chance we can get some of that money to move into credit because the yields and deposits are getting less and less and less.  On a relative basis, they're getting even more attractive than credit. So there's scope there for marketing but it's hard to get that habit to change and that's what we were probably trying to do here. 

CJ: And I actually think that on the deposit books, we've had this anomaly since the GFC where the banks were all underweight deposits, so they've paid up for deposits. 

Cash deposits have been such incredible, risk adjusted and returning instruments that you've been able to have a massive cash allocation that's been a proxy for credit.  But the truth is that the ROEs in the major banks are just dropping like stones, as we've forecast for three or four years.  You see what's happening in Parliament today - yesterday.  They're talking about bank portability, they're talking about cutting credit card rates. I mean, ROE's going to get crushed back to their cost of equity, around 10 per cent to 11 per cent for the major banks.  And there's no way on earth - they've basically sorted out their deposit weights in their portfolios, so they're all about 60 per cent deposit funded which is where APRA wants them to be. They're fixing the issue through the NSFR but once they get sorted, I reckon you're going to see margins on deposits for investors get crushed as well because the banks can't afford to pay up for deposits.  So I actually don't think deposit are going to be a long-term solution for the credit problem for investors. 

DW: Yeah, I agree. 

CJ: And I'm agreeing with you. 

LN: It's obviously dominated by the banks which obviously people already have heavy weightings to in their share portfolio and their cash book allocation an everything else in their life.  So I think there has to be some development of the corporate bond market for it to lure people otherwise they're going, 'well, I've already got banks, how many parts of the capital structure can I be exposed to, the same sort of risk?' 

BB: It was part of that evolution.  I think a great development would be the loan market because that is a massive market which is currently dominated by the big four banks. And you know why they don't want to give it away, because it is massively profitable to them. 

We've had a bit of a look at the loan market and it's much more diverse, a lot more industries, a lot more sectors, a lot more widespread across credit ratings as well so I think if that market were to be opened up and made more accessible to the broader market, then that would be a fantastic development for our market. 

We're not going to have a loan market like we have in the US overnight, it will take time but I think if we can make strides to moving towards that, that would be a great development, not only for the retail investor but for the broader superannuation market here. 

CJ: That's the end point because if you include unrated loans sitting on bank balance sheets obviously fixed income would be multiples the size of Aussie equities, right, because that $1.4 trillion is just the investment grade market.  But the only issue I have with the loan market is just the illiquidity. 

LN: Yeah. 

CJ: How do you value this stuff, there's no secondary market?  I think there's a lot of pressure for people to pay up for the direct loans in terms of chasing yield and direct loans but I think people are just going to understand, it's not a retail product, there's zero liquidity, there's no secondary market, it's extremely hard to value, it's a hold-to-maturity asset which is why, actually, it sits on bank balance sheets. 

BB: I think that's why it's good for the super market as well –  

LN: Or super funds, yes. 

AM: And in insurance companies. 

BB: Long-term investors and that can't access it. 

CJ: Yeah, correct. 

BB: Illiquidity.

Click here to read part one of this roundtable: Positioning the key amid continuing fixed income uncertainty
Click here to read part three of this roundtable: The reality of lower return expectations