May 2016
Fixed Income
Focusing on absolute returns
Stuart Dear, Fund Manager, Fixed Income
Our flagship fixed income portfolio is designed to be a key defensive allocation within broader portfolios. While
diversification of equity risk is a key defensive feature, other defensive aspects that we emphasise are income
generation, capital stability and liquidity. In managing the portfolio we attempt to balance these defensive
features, so that the portfolio plays both the diversifying role and is defensive in its own right.
Focusing on absolute returns and risk is the best way to achieve this balance. Our process is built around a
long-term valuation driven approach to estimating returns and risk and therefore strongly supports an absolute
focus (as the more expensive an asset is, the lower its expected return, and the higher its risk). This focus on
absolute returns and risk – hence absolute portfolio outcomes – puts us in contrast with most of our peers who
focus on benchmark-relative metrics, and certainly the benchmark itself (which, being cap-weighted, wants to
allocate more to an asset the more expensive it gets). This strong stance against the benchmark as a wellconstructed portfolio sees us position our portfolio materially differently to the benchmark.
Valuations of government bonds remain stretched, and this remains the key driver of our main relative-tobenchmark positioning – i.e. our shorter duration positioning and concurrent underweighting of government
issuer exposure. We are currently 1.15 years shorter duration than the benchmark, for which the reward (yield)
to risk (duration) regarding interest rate risk has moved to its lowest point ever.
Despite our views on valuations, duration / government exposure remains important to ensure the portfolio
plays its diversifying role. The last half of 2015 and early 2016 were reminders of the value of holding duration
through government bond exposure as these assets strongly outperformed others, in spite of low / negative
starting yields. Mindful of this, the approximately 3.5 years of absolute duration the portfolio holds is actually
slightly more than the historic average. Where you hold your duration is also important – we are short in
Europe (where valuations are worst) and the US (where the case for monetary tightening is strongest) but hold
4.3 years of absolute duration in Australia, where there is still room for yields to fall should the environment
worsen.
This recent period of market volatility also serves as a reminder about the different roles cash (being short
term return certainty and portfolio rebalancing flexibility) and fixed income (being portfolio diversification in
adverse scenarios) play in a broader portfolio. Cash can’t provide the higher short term returns that bonds can
to insulate the portfolio from losses elsewhere. Hence it’s not advisable, in spite of the rough equality of yields
on term deposits and government bonds, to give up on defensive fixed income in favour of cash. Nor should a
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Australian Equities: May 2016
shift to higher alpha fixed income strategies (which are by definition return seeking and likely to underperform
cash during adverse market moves) be seen as a substitute for defensive fixed income.
Rather, portfolio construction in defensive fixed income portfolios remains vital. Diversification, capital stability
and liquidity are key elements to construction and are important reasons why we hold a more than double
benchmark exposure to credit assets (including mortgages, subordinated issues and other non-benchmark
exposures) and about 25% in cash. Active management across a forward-looking opportunity set is also
essential - credit improved to cheap value in Q1 and we added; we have subsequently removed this additional
exposure as spreads compressed and value deteriorated – in order to deliver a more flexible diversified
approach to defensive fixed income.
It seems the market noise around central banks continues to obscure some of these bigger picture issues
about the role, objectives and management of fixed income portfolios on which we remain focused.
Important Information:
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect
the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the
Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification,
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