Trading risk and reward to earn a premium from a $130 trillion market

But if the low single-digit returns, daily liquidity and diversification benefits of core bonds aren’t on your radar, then looking further out along the risk and return spectrum can highlight the breadth of opportunity available for income generation. 

The chart below, provided by PIMCO, provides a helpful guide for thinking about where investors can venture to achieve higher returns.

James Marlay

Hello, and welcome to the Livewire Income Series feature panel with my special guests from PIMCO, Robert Mead and Adam Bowe.

We're coming to you straight from the trading floor here in Sydney. It's fabulous to have the cameras out. It's great to be here in person.

This is a discussion into all things fixed income. We're going to be talking about the universe of bonds, where the opportunities are, what are some of the new trends.

We'll even ask Rob and Adam to talk about how they'd be putting together a portfolio for a family member.

Gentlemen, great to be here in person with you, and thanks for having me.

Let's lay the foundation and have a chat about the bond market — the universe that is available for people to invest in. How big is the bond market today and what sits within that universe?

Robert Mead

It's fantastic timing to be talking about bonds and income generation. There's so many things to cover.

I guess many of the viewers wouldn't even realise just how large the bond market is. It's literally $130 trillion — it's larger than the global equity market.

What we'll discuss today is that it's not just about understanding where the cash rate is or where the 10 year Treasury yield is, or even where the 10 year Australian Commonwealth Government bond yield is. There's so much more. And we'll delve into a whole bunch of those opportunities today.

Marlay

You reference the cash rate and I'd say, when people talk about bonds, they gravitate towards that really low benchmark that is the starting point, particularly in the really high-rated government bonds.

Brushing that aside or taking that into consideration, what is the case for owning bonds right now? What's the compelling reason to do so?

Adam Bowe

When we're having discussions about income generation, it's the bread and butter of the global bond market. And as Rob said, it's a massive place that dwarfs the size of the global equity market.

So when we're having discussions around constructing portfolios to generate income, I really think bonds should be the starting point, not an afterthought because people are looking at the cash rate and thinking it's low.

Whenever we think of creating portfolios to generate income, I think an important starting point for investors to acknowledge is that riskless real returns are dead, this cycle.

So at the moment there's a huge opportunity cost of sitting in cash and term deposits. Cash, close to zero; term deposits, not much better; inflation up at 3% or higher in some parts of the world.

There's deeply negative real returns and a big opportunity cost for sitting there in risk-less assets.

You have to think about what risk do I need to take to start generating better levels of income? And as I said, the global bond market is a big place, and that first conversation should be bonds. And recently we've had quite a meaningful repricing in central bank expectations and interest rates.

You don't actually have to take that much term risk or maturity risk to start generating attractive levels of income.

There have been some persistent levels of inflation and expectations for central banks to start hiking have been brought forward.

And policy rates and neutral cash rates are around 2% in most of the developed world, and that's largely priced. So you don't have to take that much risk any more.

And we will look at simple things in the current market, like core bond funds, providing daily liquidity, great diversification for the risky parts of a portfolio with starting yields up over two and a half percent now.

There are really good reasons for looking at the bond market right now as a source of income generation. As Rob said, it's a really big place. We've got portfolios that target yields of low single digits to low double digits.

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Marlay

Adam, just on the attributes that bonds have in people's portfolios, you've talked about income generation. On correlation, people have asked if they still hold that defensive attribute. What's your view on that?

Bowe

Certainly I think that's a common question. But as I said, we've seen a repricing in interest rates around the world. At cash rates of zero and long-term bond rates of under 1%, I think that's a genuine question people can start to ask, but that's not the world we're in any more.

The world is looking at emerging from this pandemic as we progress through the next 12 months and interest rates have already priced that.

So I think at the moment, in core bond markets from the starting level of yields, core bonds do offer that diversification benefit, particularly for equity portfolios.

Marlay

So a $130 trillion market — I guess the question is, where do I start? To help investors think about this universe and what the different opportunity sets might be, you've put together a chart that looks at the risk and reward, or risk and return, profiles of asset classes that fall into that universe.

For our viewers, we're going to be bringing up this chart periodically through our conversation.

Rob and Adam are going to talk about where they think some of the opportunities lie and some of the trade-offs that you're making around returns and some of the increased risks and the types of risks that you're taking to do that.

So Rob, we've got the chart in front of us. Where would you like to start?

Mead

It's a great graphical representation of what's available to investors. Starting in the very bottom left-hand corner, very risk averse, low risk investments — low risk, low return — and all the way out to the top right in private equity.

And the reality is, for most Australian investors, they're sort of barbelled between some cash, some listed equities.

They also have some residential investment property and potentially some hybrids, but all of those things are somewhat correlated to the listed equity. All the gaps in the middle are where you get that diversification.

One of the things we love saying is that the only free lunch in investing is diversification — there's no other free lunch.

When it comes to filling in those buckets, as Adam said, the cash rate is still low, but further out, the yield curve has started to steepen as markets start to price in a normalisation of the interest rate cycle.

As investors move out of very low risk, cash rate oriented investments — that would even include some of the floating rate credit investments that are now extremely low yielding versus some other opportunities — there's a whole bunch of different ways that additional return can be generated.

Think about the risk premiums associated with interest rate risk, or duration in bond speak; credit risk, taking a little bit more credit.

The things that are really interesting at the moment are things like illiquidity premium and complexity premium. Some of those can be harvested by investors, fill in that diversification across the portfolio allocation and actually improve risk-adjusted returns.

Marlay

What is complexity premium and what is illiquidity premium and where are they found? Whereabouts are they sitting in some of these different investments that you've listed?

Mead

As you move out — and Adam will talk about the private credit space that we're very active in, not only globally, but also domestically — is things like, essentially an investor should be paid a premium for giving up their liquidity.

So the opportunity cost of being able to make another decision tomorrow because they decided to invest today. They deserve a premium.

And if you look at the historical risk premiums, illiquidity premium — whether it's private equity or private debt — is about fair, whereas other risk premiums have been extremely expensive, including equity risk premium, with equity markets — most of them — at all-time highs.

So that's the way you take advantage of some of those premiums.

Bowe

That's right. I don't think complexity premiums are too much different. It's just looking at asset classes that are not as common as others, and the amount of time and resources it takes to dedicate to analysing the risk and return of these types of instruments means you earn a premium for that.

Whether it's securitised structured product or private credit, they're a lot more complicated, and require a lot more resources and time to analyse them, and investors expect a premium for that.

Marlay

Let's talk about where you're finding some attractive opportunities. Adam, do you want to pick up on private credit and talk about some of the returns that you're able to identify and some of the opportunities and where you're finding them?

Bowe

I'll come back to the start, when you were thinking about a family member and what attractive areas of the bond market are there for them to construct income portfolios at the moment.

I'll come back to what Rob mentioned before in terms of the initial conditions of most investors in Australia, because that allows us to assess alternatives and what might be better.

Rob said a typical income portfolio in Australia is a mix of cash, term deposits, a few hybrids, and blue chip equities, which are heavily weighted to banks. Maybe a property investment on the side.

At first blush, you look at that and think that's pretty well diversified. You've got fixed-income-like instruments, you've got equities, you've got a bit of property, but when you look at it closely, it's a very concentrated bet on the Aussie housing market, either directly or through the banks that fund them.

There are more optimal ways to construct similar levels of income without such a concentrated bet on the domestic housing market.

The recent repricing and interest rate expectations brings core bonds back into the mix as alternatives to those types of assets.

A core bond fund yielding between 2% and 3% compares quite favourably to residential real estate that has rental yields not much better than that. We even had a premium office building in Sydney trade at a cap rate of close to 4% just recently.

So a core bond fund that provides daily liquidity, correlation benefits and diversity, versus risky assets, is really starting to become quite compelling.

So that's an asset class I'd certainly recommend as an alternative to those types of initial conditions from people's portfolios.

The other one Rob mentioned was private credit. It's a space in Australia that's evolved and grown over the last several years, and a place we're getting more active in as a firm.

One of the big differences between the private credit space and the public credit markets is that liquidity difference. You can earn attractive levels of income, but you give up liquidity.

I think most Australian investors can get their heads around that. I mean, we own property — we own things that aren't particularly liquid. But as investment managers, it's important for us to structure the funds to allow for that.

We can do that by offering private credit vehicles that have lock-up periods, so that we have to match the liquidity of the fund with the liquidity of the underlying investments.

The other way is offering products that have liquidity at the unit level. So listing it on an exchange, for example, so investors have liquidity in units that doesn't affect the liquidity of the underlying portfolio.

We have to be careful how we construct those portfolios and offer them to our clients, but it's certainly another very attractive space to start generating healthy levels of income.

Marlay

Can you talk in more detail about the levels of income you can achieve in private credit and the types of investments that would be made?

Bowe

When you look at the chart we've been referring to in constructing income levels, I can throw high numbers out there to look attractive, but a good rule of thumb for people to keep in mind is (depending on your time horizon, which is often dictated by age): start at the top right and work your way down to the bottom left.

The yields available in private credit range from mid single digits to low double digits, depending on the attachment point, how much leverage is in there.

And, obviously, the funds that target high yields come with associated risks and volatility as well. But certainly that would be the spectrum of the different products that we can offer.

Marlay

In terms of where those investments are made, are we talking primarily Australian private credit? PIMCO has a global footprint — what's the market?

Bowe

Most of the opportunities we're seeing are in the global space, but as I said, the Australian market is evolving quite rapidly. The size of the transactions is now more meaningful and allows players like ourselves with a lot of scale to participate.

Most of the opportunities we're seeing in the Australian space are finding their way into our global portfolios that we offer to clients in the local market. But, increasingly, as that space evolves, I'm sure there'll be opportunities to have more concentrated Australian-focused products as well.

Marlay

Rob, Adam has put core bonds with a bit of private credit for his mum or his dad in their portfolio. Is there anything you would add to that, or do you find those sorts of assets attractive as well?

Mead

Of course I'm going to agree with Adam, but I would just add one more thing. It's a theme that's now resonating with everyone across their investment life cycle: ESG and sustainable investing. It's something that's obviously very topical, given what's happening in Glasgow.

The most important thing is it's almost incumbent upon every fund manager to represent their clients, their end investors, in terms of ensuring that we're on the right path.

It has evolved from a very simplistic approach where you just have a bunch of names, a bunch of bond issuers that you wouldn't invest in, into a completely different regime where we engage with corporate management and political leaders to ensure they're willing to embrace this change.

The way we've talked about it in PIMCO is this transition from brown to green.

The reality is the world is not ready to turn off all the brown and turn on the green. We're not quite ready physically, but capital markets, as we all know, are very forward looking. So if institutions aren't embracing that new world, they may find themselves unable to complete their own transition because the equity markets or the debt markets close to them.

There needs to be an engagement; there needs to be an understanding. There needs to be a willingness, even if physically the market is not quite ready.

They can't be a laggard. You need to be on the front foot and embrace some of this.

A passive manager can't do that, because they're just buying a benchmark. Whether it's equities or debt, they need to be active.

You need to really understand the changing nature of the investment universe and position accordingly.

Bowe

You can construct ESG-aware passive indices by negatively screening out certain portfolios. But as Rob said, an important approach, and certainly the one we've embraced, goes much beyond negative screening and is embracing positive engagement.

As Rob said, the world is not ready is to switch off from brown to green. And part of the way of getting there is having that conversation and that engagement, and making sure that corporates and sovereigns, we are having those conversations, investing and aligning, and moving in that direction.

Marlay

Does the transition create pricing opportunities within the bond markets? We've seen the demand from capital wanting to back greener projects, but does it mean those really pure players get overpriced?

Bowe

There's definitely a bit of that. In bond markets, there's a different payoff profile than in equity.

There may be a lot of upside from equity, but a bond holder just wants to get the right coupon and the right credit premium, and also get your money back.

It's very important to identify those institutions that aren't embracing the change because you may not get your money back. They may not be able to refinance; the equity market may abandon them. It's very important to cut off that left tail, but it's also a philosophy, right?

We're all in this together; we want to make sure we're making sustainable investments. And we also want to make sure we're generating strong returns for our investors.

Marlay

The name of our Income Series is Solving the Income Puzzle. Rob, could you wrap up how you feel bonds can play a role?

Mead

If you think about the things Adam and I have covered, the first thing is core bonds are a much more attractive investment opportunity than they were even a few months ago, given the normalisation of interest rates.

And as we move from a policy-driven growth world in the pandemic to an organic growth world, there's going to be a lot more volatility and yields are already higher.

As Adam mentioned, in the private credit space, you get a chance to harvest some of that illiquidity premium and harvest some of that complexity premium.

But if you can do it in a listed format, then maybe you don't have to personally give up the liquidity and you still get that benefit. And finally, being very aware of ESG and sustainable investing.

All of these things are strongly income generative. I think investors should feel even more positive around how they diversify their portfolios going forward.

Marlay

That brings to a conclusion our feature panel for the Livewire Income Series in 2021. I'd like to thank Rob and Adam for your time today. And I would like to thank PIMCO for supporting the series.