"Selective opportunities": How Schroders is navigating a chaotic fixed income environment

"There's a lot to feel uneasy about in Australia at the moment."

That's how Schroders Australia's Head of Credit Helen Mason is seeing things, and it's hard to disagree. 

An "unpleasant" budget, persistent inflation and interest rate volatility are all confounding factors for fixed income investors who may be presented with attractive yields and opportunities, but who are having to face up to lots of uncertainty to find it.

And markets are increasingly adamant we're entering an aggressive rate hiking cycle, which could complicate the picture further. 

Against all that, Mason says the chickens are also coming home to roost on Australian private credit. 

The end result is an ongoing sense of whiplash for income investors that should "reinforce the importance of defensive income strategies, liquidity and disciplined risk management."

Schroders' recent moves

In the face of a complex economic picture, Mason says Schroders' biggest recent move has been a "reduction in Tier 2 bank paper, using the spread widening as an opportunity to get set at better levels in the sectors which we maintain high levels of confidence, regulated utilities and infrastructure."

"Tier 2 paper continues to underperform broader markets although there is a very odd kink in the Tier 2 curve, as long-dated bullet major bank Tier 2 outperforms the mid-curve, where spreads remain relatively elevated."

"We have therefore reduced long-end exposure, recycling capital into higher spread opportunities."

For Schroders Head of Multi-Asset and Fixed Income Sebastian Mullins, a widening credit spreads has also meant a move to high yield in US and European credit. 

"We shifted our 2% European credit position from investment grade to high yield and also added another 2% to US high yield, both through selling protection on credit default swaps. This resulted in a net increase in credit of around 2% and an increase in high yield of 4%." 

"While we are not out of the woods and there is plenty of room for further widening if the economy slows, we believe we can take carry in credit and that we should see credit default spreads tighten back once bond volatility subsides."

It was also a "very active" month in terms of duration, especially in Australian bonds given the fast-moving rates market.

"We added to duration in Aus at the front-end as we don’t believe the RBA will be able to hike that aggressively, given the slowing economy, increase in taxation and falling house prices, which will hinder consumption."

"We sold our front-end US inflation linked bonds and bought Australian 10-year inflation linked bonds, which at the time of purchase had a real yield of 2.9%. We stayed away from US duration mostly throughout this period. At this time, only Aus, EU and UK markets were pricing in more hikes than our views." 

On currency, it was a 2% move away from emerging market currencies to the US dollar, and remaining short the British pound. 

"We continue to expect US growth to outpace other developed markets, and now with more rate hikes being priced in the US treasury market, we expect these rate differentials to support the USD, especially given our view of less rate hikes than expected in the EU, UK and Australia."

The impact on corporate bonds

The complicated backdrop for the Australian economy has clear knock-on effects for the credit market, specifically in terms of corporate bonds.

"With macro events keeping rates markets on a perpetual rollercoaster, for credit investors we are naturally thinking about the impact on the consumer and the flow through to consumption and company earnings margins," wrote Mason.

But the local bond market is fairly insulated to a weak consumer market, and Schroders has limited its exposure there to two names.

"Fortunately, very few of the available corporate bonds in Australia have earnings predicated on discretionary spending. Our only exposure to this space is limited to two names - The Lottery Corporation and Tabcorp."

On private credit worries

"The private credit landscape looks somewhat dire in Australia," wrote Mason.

And that landscape means its unsuitable for investors looking for defensive stability in their income portfolio.

"20 years of low regulation and lack of scrutiny has introduced a plethora of bad practices," she wrote. "I want to reiterate that this is an entirely different market to Public Credit and why I have argued for some time that Private Debt is not, and will never be, defensive fixed income."