Quantitative Easing

The income equation: why does the bond + stock solution still add up?

Income-oriented investors have struggled in the post-Global Financial Crisis (GFC) era.

Tuesday, June 21, 2022, 10:56 a.m.

by Mint Asset Management

By Marek Krzeczkowski

Forced by the global financial crisis to cut interest rates and take unconventional measures such as “quantitative easing”, central banks set the stage for the era of the lower for longer that lasted longer. of a decade.

With inflation seemingly benign despite the extreme volume of free money flowing through the system, monetary authorities eased further – even into negative rate territory – as an antidote to any economic disruption from Covid-19.

Whatever the political justification for keeping rates ultra-low, conservative investors looking for a stable and reasonable return from “safe” products such as bank term deposits have been faced with an uncomfortable truth: either accept lower and lower returns, or take more risks.

The Mint Diversified Income Fund was launched in 2014 as an option to help these investors solve the dilemma. In a conservative approach aimed at preserving capital and generating a regular return, we have established a strategic allocation of 65% in bonds, 30% in equities and 5% in cash.

After 2014, stocks and bonds generally generated positive returns as falling interest rates pushed up valuations of all assets.

As the current yield on bonds fell alongside falling rates, the market capital value of fixed income portfolios rose in counterbalance.

In short, the strategy provided investors with the required income from a portfolio dominated by high quality bonds.

Minus signs

Even as recently as the end of 2021, central banks remained confident in keeping interest rates low for some time as a cushion for economies emerging from Covid shocks.

After years of ultra-loose monetary policy combined with global supply chain disruption and fiscal largesse, inflation is on the way in 2021. In a classic case of beware what you wish for, the genie had come out of the bottle.

Initially considering the emerging signs of inflation as “transient”, monetary authorities were slow to recognize the danger. They belatedly changed course late last year, stepping up efforts to control inflation in the first half of 2022 via a series of aggressive interest rate hikes.

What changed the situation abruptly was an unexpected large-scale invasion of Ukraine by Russia. Not long ago, markets were hoping that inflationary pressures would soon ease and US interest rates would peak in the 2-2.25% range by mid-2023. While bond yields initially fell, the inflation narrative took hold soon after. Energy and food prices reacted extremely to the conflict. The price of oil and wheat contracts jumped by more than 30 and 60 percent respectively in the first two weeks of the conflict. This created a strong inflationary impulse.

The markets reacted accordingly. The all-important benchmark US 10-year bond rate, for example, has more than tripled from a low of around 1.1% in August 2021 to the most recent high of 3.45%. Last week, the US Federal Reserve raised rates by 0.75% – the biggest increase since 1994 – and other global central banks are also raising rates again as of this writing.

Rising interest rates of course have an inverse effect on the valuation of existing fixed income portfolios. And given the extreme rate moves of 2022, bond values ​​have fallen in kind.

Fixed-income funds that track the global bond benchmark posted double-digit mark-to-market losses for the five months to the end of May – the index was down about 12% for the period.

Actively managing bond portfolios can protect investors from the worst of the market rout, but inevitably all mark-to-market bond portfolios will be in the red.

As a result, conservative funds (which are typically bond-heavy) have underperformed more growth-oriented strategies in 2022: the unusual set of circumstances has sparked a flurry of media coverage about the impact for fund members KiwiSaver preservatives.

The debate revealed understandable confusion over the meaning of “conservative” investments among some KiwiSaver members: it seems many have confused the label with the same meaning as cash.

Let’s hope the media storm didn’t encourage a massive KiwiSaver move into cash, as that would crystallize fixed income capital losses that would eventually disappear as the underlying bonds matured.

A plus for yield investors

As disconcerting as the sharp decline in bond valuations may be, the change in market regime is a silver lining for bond investors.

In recent years, interest rates have fallen, reducing opportunities for income generation but increasing the value of capital. The new market regime has the opposite effect: capital values ​​have fallen, but returns rise to investors in the opposite direction.

For example, the Mint Diversified Income Fund currently has a 5.3% annual return on its bond holdings over an average duration of around 3.5 years: at the start of 2021, the same return was around 1.3% .

We took advantage of the rise in rates to buy more bonds for our portfolios. Overall, our fund now holds around 65% of the portfolio in bonds (compared to 50% this time last year) and 30% in equities (split more or less equally between New Zealand equities, property listed and global markets).

Investors are understandably concerned about the immediate challenges of rising rates as central banks attempt to rein in inflation. The short-term focus on market volatility, however, clouds the view of likely outcomes over the coming months and beyond.

Our base case scenario sees inflation falling in the latter part of 2022, allowing central banks to slow rate hikes in a move that supports equities and stabilizes bonds.

Early signs of slowing economic activity in New Zealand and the rest of the world suggest that rates may not have room to rise too much anyway. And if a recession hits, rates might even have to drop again, pushing the capital value of fixed-income portfolios back up.

If the outlook changes, we adjust the parameters of the Diversified Income Fund accordingly. Despite much uncertainty ahead, however, the right diversified mix of bonds and equities should pave the way for income-oriented investors.

Disclaimer: Marek Krzeczkowski is a portfolio manager at Mint Asset Management Limited. The above article is intended to provide information and does not purport to give investment advice. Past performance is not a reliable indicator of future performance.

Mint Asset Management is an independent investment management company based in Auckland, New Zealand. Mint Asset Management is the issuer of the Mint Asset Management funds. Download a copy of the Product Disclosure Statement here https://mintasset.co.nz/assets/PDS-SIPO/Mint-Product-Disclosure-Statement-2020.pdf

Tags: Mint Asset Management

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