In an environment of extremely accommodative monetary policy with policy rates at a record-low 0.1% and term deposit rates not much higher, investors are increasingly concerned about how they can invest and meet their investment objectives. Many investors are holding too much cash, reducing their ability to meet those objectives. The opportunity cost of sitting on large pools of cash is high, particularly when credit markets still present some significant opportunities and the Australian bond curve has been steepening.
Below are three ideas for bond investors in 2021, catering to different liquidity requirements and levels of risk tolerance.
Lower risk tolerance: Pursue a higher return than cash in short-term bond strategies
While returns on cash may be historically low, many investors are anxious about losing money, particularly given recent market volatility. For investors with a lower risk tolerance and/or higher liquidity needs, an actively managed short-term bond strategy can help enhance returns and preserve capital, while maintaining daily liquidity.
These strategies can take advantage of opportunities in shorter-term bonds and credit markets to generate returns above the cash rate. They offer defensive characteristics by maintaining a high average credit quality rating, along with a structural level of duration (sensitivity to interest rates) at a relatively attractive entry point versus recent history, which should allow them to deliver returns if we experience volatility in risk markets. In addition, they typically run a structurally lower level of duration than core Australian bond allocations, so if interest rates were to rise in the future, investors should not be overly exposed.
Medium risk tolerance: Seek out the opportunities in public bond markets
For investors with a slightly higher risk tolerance, we see opportunities to earn more from domestic bond investments while taking on manageable risk. At the higher quality end of the spectrum, we favour assets rated AAA and senior tranches of residential mortgage-backed securities (RMBS), which are backed by robust cash flows. There are still pockets of the investment grade credit universe with attractive valuations and scope to recover from the pandemic shock. We see opportunities in sectors such as leisure, hospitality and gaming. However, careful credit selection is required to differentiate the winners from the losers.
While central bank support remains strong, we also favour Australian semi-government debt, particularly 5-year to 7-year maturities, which offer better value than shorter-duration bonds. These bonds are expected to “roll down” the yield curve towards the Reserve Bank of Australia’s three-year yield curve control target of 10 basis points (bps). Although spreads for most semi-government bonds have narrowed to historically tight levels, we believe the sector still offers value amid this environment of ultra-low cash rates.
Higher risk tolerance: Selectively take advantage of the illiquidity premium
For those investors with longer time horizons who can tolerate some risk, we think there are significant opportunities in the more illiquid areas of the credit market – private credit, special situations, and some areas of the distressed credit market.
Most available risk premiums may be fair, currently, but they are not cheap. When looking to generate a return above the “risk-free” rate, investors should consider the illiquidity risk premium, which is typically underrepresented in portfolios. The illiquidity premium is essentially the additional compensation to investors for limiting their ability to take advantage of future market dislocations, should they arise, as their capital is locked up for a specified period. As a result, illiquid investments should offer a premium in the form of higher yield expectations. These comparably higher yields can be a helpful income-generating component of a portfolio.
In our view, alternative credit now looks extremely attractive on a relative basis. Central banks have been supporting the most liquid, traditional areas of capital markets. A lot of that liquidity hasn't found its way into the less liquid, alternative areas of credit markets such as private corporate debt or real estate opportunities. For investors prepared to have some of their portfolio allocated to less liquid assets, there is the potential to earn high single-digit returns in exchange for locking-up some assets for a period of time.
Building an efficient portfolio: Consider all available risk premiums
With short-term interest rates at 0.1%, investors are being penalised for holding cash and not putting their money to work. Now more than ever, investors need to consider all of the available risk premiums when building an efficient portfolio. This may mean a number of things, including boosting diversification and taking advantage of unique opportunities caused by the current dislocations in areas like alternative credit.