Credit Update – December

Credit

Greg Stock

Head of Credit Research

We’re nearing the end of the calendar year – a good time to look at market developments in fixed income and credit. 

In June I discussed the strong credit outlook - investors were hunting yield in a low rate environment and the fact that there were positive credit dynamics amongst some industries and issuers. The market has confirmed our view - performance has been strong. The iTraxx rallied from 130bps to just over 100bps, when 10 year government bond yields were at historic lows around 2%.There has also been significant change in the past 6 months and during this period credit has continued to perform well. Investors have benefited from high running yields and capital gains with the index spread now just over 100bps, and the 10 year bond yield has increased to 2.87%. Whilst those changes may not appear large in an absolute sense, they are large proportionally and depending on how investors have been positioned have resulted in very different outcomes. 

What has driven these changes, how did we fare and what is the outlook now?

Whilst there are still good running yields available for investors, the outlook for capital appreciation has reduced given the large rally we have had. Generally credit quality remains sound, despite a few headwinds - including the negative outlook on Australia’s triple A credit rating and the negative outlook on the banks credit ratings. In our view, the banks, by and large, have positioned themselves well for the challenges; however the outlook for relative value in this sector has diminished.

What has been the impact from the US election?

Post the US election, markets were extremely volatile around the unexpected result.  There was an initial risk-off rally in rates, and then they sold off substantially.  We maintained our short position throughout, the rationale being there was no new information to alter our view:  valuations were still expensive, economic data here and especially in the US has been strong, and in addition to this, a substantial rally in oil and resource/commodity prices had helped push inflation expectations upwards. 

The current interest rates in Australia are:

RBA Cash 

1.5%

3yr

2.01%

10yr

2.87%

 

Current credit 

iTraxx

104.5

(As at 16 December 2016)

The Perpetual Dynamic Fixed Income Fund  

The Perpetual Dynamic Fixed Income Fund (Fund) is our absolute return fixed interest fund, designed to manage interest rate risk and credit risk to give investors 1.5% to 2% above the RBA cash over a rolling two years before fees and taxes. It is also designed so that any negative month (or ‘drawdown’ in industry jargon) should be minor and recovery quick. 

In November, we celebrated the Fund's 6th year anniversary. In my view what is most pleasing is how the Fund has managed during volatile periods - the Greek Euro crisis, the crisis in European banking, the US taper tantrum, the collapse of oil and commodity prices, and the recent US election result.  

To recap on how we manage the Fund’s interest rate duration, we keep it strategically at two years until our view is either very positive or very negative. Next, we tactically take sizeable positions with the aim of boosting the positive return focus of the Fund. Our view on duration has been negative all year, valuations are expensive, and economic activity continues to be picking up, although these negative indicators have been offset partly by some technical price momentum. 

However, in September this technical indicator sharply turned around and the large rally in rates this year unwound.  As this technical indicator turned and our view was unambiguously negative for rates, we tactically positioned interest rate duration very short, and remained short during the large sell off in rates.  This means we have produced positive returns when most bond funds have had negative returns - a great result for investors, and another prime example of how our long-term perspective of managing duration tactically at extremes has produced strong risk adjusted returns for investors. After this large sell off, towards the end of November, value started to return and we modestly increased duration in the Fund. 

As we sign off on November performance, I’m really pleased with how the Fund has delivered for our investors over this challenging period. Returns for the Fund are up over 2% for the financial year to date whereas the traditional bond index (Composite Bond) has fallen by around 1.8%. In a lower return world this 4% differential in the last five months alone can have big impacts on clients’ investment outcomes.

Like to know more about the Perpetual Dynamic Fixed Income Fund?

This information has been prepared by Perpetual Investment Management Limited ABN 18 000 866 535, AFSL 234426 (PIML). It is general information only and is not intended to provide you with financial advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.

The product disclosure statement (PDS) for the Perpetual Dynamic Fixed Income Fund issued by PIML should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling 1800 022 033 or visiting our website www.perpetual.com.au.

No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital.  Total returns shown for the Perpetual Dynamic Fixed Income Fund have been calculated using exit prices after taking into account all of Perpetual’s ongoing fees and assuming reinvestment of distributions. No allowance has been made for taxation. Past performance is not indicative of future performance.