The first half of 2020 was certainly a period of extremes, with risk sentiment fluctuating wildly as investors digested the latest COVID-19 developments. Policy responses to the pandemic from both governments and central banks have been almost unprecedented. These initiatives have helped liquidity return to markets following March’s dislocation and have buoyed risk sentiment despite continued softness in economic data, and labour markets in particular.
Throughout this period of market volatility, our flagship CFS Wholesale Australian Bond Fund has delivered healthy positive excess returns in both rising and falling yield and risk environments. At least to the end of May, the Fund was sitting comfortably in the upper performance quartile for the past six and 12 months1.
The Fund was launched nearly 25 years ago, but bond markets have changed during that time. Investors expect their fixed income managers to modify their investment approach as conditions evolve, to ensure continued value-add. For this reason, we reshaped our investment philosophy and process in mid-2016. The recent favourable performance relative to both the benchmark and peers2 demonstrates the success of these changes and, in our view, set the Fund up to become a market leader in the years ahead.
Tenets of our investment philosophy:
– Consistent with the role of fixed income as a diversifier, we seek to generate alpha that is uncorrelated with equity/ credit market performance.
– Our ‘balanced risk’ approach ensures that individual risk sources do not dominate performance, providing for more stable risk-adjusted return outcomes over time.
With the investment philosophy in mind, it was pleasing to see a number of different alpha sources making significant positive contributions to overall Fund performance over the past six months. Ultimately, we believe an ability to add uncorrelated alpha in all market environments is critical for core fixed income managers. In this note, we provide a brief recap on key market events in 2020 to date and explain how our investment philosophy and process have enabled the CFS Wholesale Australian Bond Fund to perform as well as it has.
1 Mercer Fixed Income Performance Survey - May 2020
2 Mercer Fixed Income Performance Survey - May 2020
Despite the volatile market conditions and swings in risk sentiment, the Fund outperformed the Bloomberg AusBond Composite 0+ Year Index benchmark in all of the first six months of the calendar year.
Perhaps even more pleasingly, active management helped preserve capital during March and April when benchmark returns were negative. Minimising drawdowns during periods of market weakness should support the Fund in achieving its longer-term performance objectives. This is also of particular importance when considering the role of fixed income as a defensive asset in a broader portfolio context.
In the six months as a whole, returns were 125 bps ahead of the benchmark – ahead of the annual performance target.
Consistent with our investment philosophy, we have been able to exploit trends in various domestic and offshore fixed income markets, many of which are uncorrelated with one another. By ensuring that portfolios are built in a balanced and diversified manner – where no individual risk position or view has the ability to dominate the return profile – we increase the likelihood of delivering on our stated portfolio objectives, thereby providing investors with the potential of better risk adjusted returns over time.
We attempt to maintain a high level of diversification in the portfolio at all times, which includes diversifying research responsibilities across a broad team of analysts/decision makers. By decentralising decision-making and using experts across the globe to help adopt and manage risk, the portfolio is not overly influenced by the biases of a single portfolio manager. Moreover, excess return streams are expected to be ‘all-weather’ and the Fund is expected to generate alpha in all market environments. This has certainly been the case in 2020 to date.
As highlighted below, value was added across a wide range of alpha sources; both within Australia and overseas. The Fund predominantly invests in domestic fixed income markets, but can make smaller allocations to exploit opportunities offshore. By design, more than two-thirds of the risk budget stems from domestic opportunities. Unsurprisingly then, outperformance in the year to date has been largely sourced domestically.
The domestic rates market was actively traded, taking advantage of movements in 10-year yields, in particular. In fact, more than a dozen active positions were in place in Australian rates during the period. Almost all of these strategies performed as anticipated and collectively added more than 30 bps of relative performance to the portfolio. The market was primarily traded with a long duration bias to benefit from the downtrend in yields, though tactical short positions were also implemented when yields had declined close to the lower bound of prevailing trading ranges.
The improvement in performance outcomes from the domestic rates signal was a particularly pleasing aspect of overall performance during the period. We have utilised our proprietary performance analysis systems to dissect previous performance outcomes and modified elements of the investment process as a result. While we cannot expect to always get calls right, we have an obligation to our investors to analyse and understand our investment decisions and behaviour; in short, we strive to become better investors tomorrow than we are today. In the case of Australian rates, in recent years we have increased the emphasis on technical analysis in the research process and have also tightened risk control parameters.
A further ~15 bps of relative performance was added from active duration positioning offshore. Around half of this total was generated in the US Treasury market, where we were generally biased to short positions. This strategy added particular value during the market panic in March and remains in place in anticipation of an upward drift in yields. Active positioning in the UK, Germany and New Zealand also added relative value, underlining the value of maintaining a broad opportunity set.
Various country spread positions that were implemented further supported performance. A long position in US Treasuries was held relative to Australian Commonwealth Government Securities for a short period, for example, which was beneficial as the US outperformed quite significantly whilst the position was in place. Long positions in UK gilts and French OATs relative to German Bunds were also beneficial. Importantly, virus-related developments are not evolving uniformly across different regions, suggesting yield differentials between major bond markets could remain quite volatile. Central bank policy settings are also not consistent globally. Further, in some cases explicit intervention from authorities to defend currencies has the potential to result in some quite substantial movements in bond yields regionally.
The breadth of these performance drivers across domestic and offshore rates markets highlights the merits of an investment process that utilises a diverse pool of uncorrelated ‘alpha sources’. First Sentier Investors is fortunate to have fixed income experts located globally, with the expertise to make determinations on drivers of bond yields at the local level. These insights help inform active portfolio positioning in Australianbased portfolios.
Spread product-sourced alpha
Active positioning in domestic and offshore credit markets added substantial value to the portfolio; nearly 45 bps in total. Bought credit protection positions via synthetic credit indices added value during March, in particular, as spreads widened very sharply. This positioning was established in very early March and not only took the portfolio short overall credit exposure, in anticipation of an increase in virus-related disruptions both in Australia and worldwide, but actually moved the Fund to an outright negative credit spread position. In the weeks that followed, domestic credit securities were buffeted by the same headwinds as their global counterparts. Spreads soared as investors and price makers retreated; the spread on the active Australian iTraxx contract rose more than 100 bps in March, rewarding the short bias that was in place and enabling the Fund to appreciate in a month where benchmark returns were negative. The position was exited in April, after market sentiment turned in the face of an unprecedented amount of monetary and fiscal stimulus measures being announced.
More recently, a small long position was established in Australian physical credit, which also contributed to performance. Fundamentally we still have medium-term concerns over the economy, earnings and credit spreads, but in the short term a dynamic had appeared suggesting there was scope for some further tightening in physical spreads. State Government and SSA spreads had returned to pre-virus levels, while credit had noticeably lagged and some catch-up was anticipated. This overweight credit spread position was neutralised in June as spread levels were generally more than half way back to their pre-virus levels and as virus numbers began to pick up again in the United States and across emerging markets.
It wasn’t only credit spread views that added to performance in the spread product space – substantial alpha was also derived from active positioning in the State Government sector. A profitable overweight exposure to State Government bonds held early in the year was exited just prior to the liquidity-driven widening of spreads in late February. After the Reserve Bank of Australia announced it would be buying Commonwealth and State Government bonds directly, as well as the States concluding an initial spurt of issuance in expectations of worsening budget positions, a long position was established at the end of April. State Government bonds were yielding 54 bps above comparable Government securities at that time, but within a two week window the spread narrowed to below 30 bps; back towards precoronavirus levels. This provided an opportunity to bank profits from the move and the position was neutralised.
Passive enhanced strategies
While the Fund is actively managed and takes meaningful exposures in the strategies outlined above, we also go to great lengths to ensure the core portfolio is positioned efficiently. Instead of pure benchmark replication, our passive enhanced strategies include elements of smart beta portfolio construction, single name stock selection and relative value, as well as carry and roll optimisation. Alpha strategies are overlaid on top of this core base – both focused on delivering Australian-focused fixed income exposure.
The smart beta portfolio construction focuses on generating a higher running yield, without exposing the portfolio to a meaningful increase in tracking error. Long positions in credit are expected to add value over the full market cycle, but we want to ensure the Fund remains uncorrelated with equity market volatility. As a result, we have a strong focus on short-dated credit, which provides a running yield enhancement with minimal incremental spread duration. These positions are balanced with other exposures along the curve.
While any kind of overweight credit exposure would have detracted in March, our passive enhanced strategies added value in the six month period as a whole. By minimising spread duration from this source, we were able to re-position the portfolio with outright negative spread duration in the sell-off using active strategies.
Markets appear to have stabilised and the need for intervention in the local bond market from the Reserve Bank of Australia has declined. That said, the central bank remains ready to support market function if and when required. Further, we are comfortable that officials will be able to anchor the front end of the curve close to desired levels. Other central banks are expected to remain active too, intervening as required to help stabilise yields and provide sufficient liquidity for markets to function normally. Again, there is no indication that this support will be withdrawn any time soon.
With economic data unlikely to improve meaningfully in the foreseeable future, investors are likely to remain focused on government initiatives to help soften the blow of virus-related disruptions. The scale and duration of stimulus packages will be important, as it will influence funding requirements and the expected future issuance of government bonds globally. At the same time, official cash rates are at lower bounds in Australia and elsewhere and are unlikely to move in the near term. Consequently, monetary policy is unlikely to be a driver of bond yields for the foreseeable future and we may see less volatility further out the curve. Even if yields are little changed, however, there are almost always some fluctuations within a channel. These movements as risk sentiment ebbs and flows should continue to present opportunities to implement short-term, tactical trades in rates.
Separately, it is possible that a broader range of investors might start to consider Environmental, Social and Governance (ESG) issues in a post-COVID world. There seems almost certain to be an increased focus on social responsibilities of governments and corporates, for example. Over time, there may even be a clearer delineation of performance outcomes between issuers that manage ESG considerations effectively and those that do not. First Sentier Investors is well-placed to make these assessments in the fixed income space, having been recognised by the PRI as being best-in-class in the integration of ESG considerations in the investment process1.
More broadly, we expect to be presented with further opportunities to exploit movements in State Government bonds and SSAs as well as in domestic credit and inflation markets. A continuation of recent ‘hit rates’ in these areas would result in the Fund adding further value in the remainder of the year. Opportunistic allocations to offshore markets will continue to be made, seeking to exploit anticipated fluctuations in various bond markets globally. With US/China relations seemingly becoming strained again and with the US Presidential election just a few months away, it appears geopolitical risk could spike higher. These and other macro factors – like employment trends and the risk of a ‘second wave’ of virus infections – seem likely to affect bond and equity markets alike in the remainder of what is becoming one of the strangest years in living memory.
Irrespective of what’s in store, our expectation is that the active returns from the CFS Wholesale Australian Bond Fund will remain well diversified and, perhaps even more importantly, largely uncorrelated with movements in rates, spread products and equities.
1 Source: PRI 2019 Report
This material has been prepared and issued by First Sentier Investors (Australia) IM Ltd (ABN 89 114 194 311, AFSL 289017) (Author). The Author forms part of First Sentier Investors, a global asset management business. First Sentier Investors is ultimately owned by Mitsubishi UFJ Financial Group, Inc (MUFG), a global financial group. A copy of the Financial Services Guide for the Author is available from First Sentier Investors on its website.
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