Strength in house prices good news for bond investors
As governments and central banks around the world try to set their economies into overdrive, inflation has quickly become the key story of 2021. Rising inflation is good news for income investors. Bonds and real estate backed securities will begin to re-earn their place in portfolios with rising yields increasing their return.
The RBA and Federal Reserve have indicated they're waiting to see real signs of inflation before pulling away any support of local economies. Massive infrastructure stimulus in the US and the upcoming Australian Federal Budget are expected to push inflation further but the real impact of these initiatives on local economies are yet to be seen.
In this trading floor update, John Valtwies and I discuss what inflation means for income investors, how recent house price growth has impacted our portfolios and why the rosy outlook for the Australian economy may not be so definite.
John: Welcome to this month’s trade floor update, my name is John Valtwies, and I’m joined today by Rob Mead.
For the last few weeks we have been talking a lot about our latest cyclical outlook – “dealing with an inflation head fake”. The key take-outs related to that latest piece of research focus on inflation.
Inflation has been a really big driver of markets year to date. Our base case is that we think inflation is likely to be bumpy over the next few months as it recovers and that is consistent with the positive news flow that we are seeing from economic data, the continuing vaccine rollout and of course the enormous support from policy makers. And when I say that I am really referring to the ongoing supportive approaches from central banks across the globe, including here in Australia, as well as the fiscal forces that are supporting this ongoing recovery.
An example includes the massive infrastructure spending being rolled out in the US. Given that backdrop we do expect bond yields to rise. Under that scenario it’s also likely that bond yields could potentially tick higher over the next few months.
Rob, bringing that in to markets today, what does that mean for bonds? And I would also like you to talk to some of the frameworks that are evolving, including the Fed. The Fed has moved to this more outcome-based approach to inflation versus a more objective-based framework for inflation. Could you comment on that?
Rob: You’ve characterised it beautifully John. When you think about what central banks want to achieve, they want to let economies run a little hot. So they do, exactly as you said, want to actually observe inflation rather than just forecast inflation. That is all well and good, but whether or not they can achieve that is a question mark. When it comes to investing, we want to take into account what that looks like but also say what are the potential risk factors that prevent that escape velocity occurring for the first time since the GFC.
So in Australia there are some concerns. Despite the fact that the RBA continues to reiterate that policy will be loose and that all of their forecasts are going up – their forecast for inflation growth and employment all rising – we still think there are a couple of warning signs. We are looking very closely at the upcoming budget, where we think, while it will be stimulatory, it won’t be anywhere near as stimulatory as say in the US, as you reflected. Also the vaccine rollout, it’s been incredibly slow. So what that means for Australia is that international borders are likely to reopen much later, which also means that some sort of defensiveness needs to be maintained in a portfolio because this rosy outlook may not materialise and as you talked about a little earlier, interest rates are starting to move up, so the defensiveness of bonds is returning.
John: So given that backdrop of higher bond yields, and year-to-date we have seen bond yields move significantly and that is reflected in some of the performance year-to-date. A lot of the discussions we are having with our clients show they’re concerned about the potential for ongoing weakness in bond portfolios and the targets to achieve their client outcomes. What is also challenging is to try and communicate the ongoing benefits of bonds. They’re continuing to be defensive, they can bring diversification through their low correlation with other assets classes, but more importantly one key message we are trying to communicate is that with bond yields moving higher that also means future income levels are higher. Simply by example, an Australian bond portfolio today is going to yield you over 2 and a half percent.
How do you respond to that challenge of trying to communicate those defensive and higher income producing characteristics of bonds in the environment you have just described?
Rob: It is a great way to portray it. I think we always try to talk about these things in as simple a fashion as possible because you need to simplify investing as much as possible. So when it comes to making investment decisions, we think across different risk factors or risk premiums. And when I look at the different risk premiums, they include equity risk premium, complexity premium, illiquidity premium and even interest rate or term premium. The way those premiums evolve over time gives you an insight into where value lies or what is expensive and cheap. And when I look across those risk premiums, only one of them has re-priced which is, exactly as you said, interest rate risk. And so rather than looking less attractive it is actually looking more attractive, providing that income and providing that defensiveness given that interest rates curves have steepened significantly. We won’t dwell on it now, but the roll down yield curves and all of those great capital generating opportunities have returned.
The other thing I’d mention on risk premiums is that illiquidity and complexity premiums are also fair to cheap, so we are seeing plenty of different bottom-up opportunities – sometimes a lot less liquid – but plenty of bottom-up opportunities are continuing to materialise.
John: You highlight a good point - that there are many different sources of return or yield generation within a bond portfolio for instance.
Jumping to the topical and popular subject that is home prices. I would certainly love to hear your thoughts on the outlook for Australian home prices. But I really want to dive a little bit deeper. With all the housing market activity locally and around the globe surely it presents a lot more investment opportunities. Quite simply, surely there is a lot more mortgage issuance from a local perspective that investors like PIMCO can tap into for really high quality sources of income, and other instruments that can preserve capital.
Could you comment on that and give us some insights into what that all means?
Rob: It’s probably not appropriate to make a short-term forecast for house prices but I think there are some really important elements in terms of the PIMCO portfolio. First thing to note is that we have positions in RMBS, so RMBS securities or residential mortgage-backed securities benefit if house prices go up. Typically what populates one of those securities are mortgages written 2-3 years ago, so the more price appreciation the more credit protection. The second thing is there is not much supply coming because the central bank and the RBA especially are providing such cheap finance to the banks. So the nice thing about RMBS is every single month as individuals pay their mortgages back, the principal amount of an RMBS security shrinks, it amortises. So every day you need to replace what is slowly amortising away in your portfolio. That means that the portfolio managers and our analysts around the world are constantly looking for both secondary market and primary market opportunities to re-fill that bucket in the portfolio.
Some of those opportunities are coming from the non-bank sectors in Australia but also we are finding great opportunities all over the world to replace what would be typically coming from the major banks in Australia into Aussie dollar-denominated securities.
John: Well thanks for sharing those insights today Rob
John: And thank you for taking the time to listen to today’s trade floor update. To learn more about our inflation head fake outlook, please visit pimco.com.au.
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Robert co-oversees the portfolio management teams in Asia. Previously, he was a portfolio manager in Munich and head of the European investment grade corporate bond team. He has 29 years of investment experience.