Why the fundamentals continue to support credit

Vivek Prabhu

Vivek Prabhu

Head of Fixed Income
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The Perpetual Diversified Income Fund is an active floating rate credit fund, invested in a diversified portfolio of quality debt securities. But as Vivek Prabhu, Head of Fixed Income at Perpetual Asset Management, explains, it’s not all about defensive positioning.

Fund Objectives

Perpetual's Diversified Income Fund is designed to provide investors with liquidity, capital stability, and income and it's suitable for the defensive part of investors' portfolios. Particularly for those investors looking to get a return above cash and who are prepared to take a little bit of high quality, predominantly investment grade credit risk in order to capture that credit yield premium. So when we think about the Diversified Income Fund and how it compares to other traditional defensives such as cash, term deposits, and fixed rate bonds, it has a lot of advantages against some of those other defensives. One of those is that it is built around investor outcomes.

The impact of COVID

The fund is designed to deliver bank bills plus 2% per annum before fees. It provides investors with an opportunity to earn a real return above inflation by capturing that credit yield premium unlike term deposits. And it provides a hedge against inflation. So, in terms of how the fund was positioned prior to COVID, I actually began de-risking the portfolio almost 18 months prior to COVID, back in September 2018. And at that point we had the AAA exposure in the portfolio, being the highest credit rating, at below 20%. At the end of the de-risking, which was completed before COVID hit, that AAA exposure was increased to above 50% or more than half the portfolio. The portfolio was therefore well protected on the downside when COVID hit and in fact it was actually more defensively positioned than the Fund was during the depths of the GFC, when the AAA exposure hit about 40%.


But that was only half the battle, protecting investors on the downside, the other half of the battle was taking advantage of that fire power and deploying it on the other side of COVID. And during the June quarter, we turned over 90% of the portfolio in repositioning the fund. And the reason I point out 90% is because that's about twice as much as we would typically turn over in a typical quarter. And I cut that AAA exposure in half, down to 25%, and reallocated it to the longer dated BBB securities, or the bottom end of investment grade, buying longer-dated banks, financials and corporates. So that BBB exposure, which was 20% pre-COVID, was then increased to 40%.

Global Strategy

Credit is a global market, which means we can buy corporate bonds in Australian dollars or in foreign currencies. Now importantly, the fund doesn't permit us to take currency risks. So we're hedging all the foreign-denominated bond holdings back into Australian currency risk and Australian floating rate interest risk. Now from time to time, we do see opportunities in the foreign-denominated markets. And typically during periods of market volatility we find that the baby gets thrown out with the bath water when it comes to credit yield premiums. During COVID, we were able to buy some CBA AA minus-rated US dollar bonds. And even after all our hedging costs, we were able to get a credit spread almost double the equivalent credit risk on the Australian dollar bonds.

So, we were able to purchase that security and within two or three months, those credit spreads equalised closer to the Australian credit spreads on the Australian CBA bonds and we were able to take profit on those. We're going to invest where we get the best bang for our buck. And so for a given level of risk, where we can earn a higher credit premium in the US dollar bonds compared to the Australian bonds, that looked pretty attractive. And it shows you that even a boring senior major bank highly rated AA minus bond, if you're looking at credit markets domestically and globally, you can capture those options.

Improving Outlook

Looking forward, credit spreads have now got back to pre-COVID levels and in some cases are actually tighter than pre-GFC levels. And that's really been a result of some of the policy responses by regulators, central banks and governments. They've been successful in calming markets down. And so now we got to the point where credit spreads are quite low, but we still see the fundamentals being supportive of credit. So, we've got accommodative monetary policy from central banks, we've got quantitative easing, we've got fiscal stimulus from governments and of course the economic outlook's improving as a result of the global COVID vaccine rollout.

At this point, it makes sense to remain fully invested but to do it in a more defensive fashion. And for that reason, I've increased the AAA exposure back up to above 45%, and I've trimmed the BBB exposure from 40% post-COVID down to below 30% today.


Find out more about the Perpetual Diversified Income Fund.


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