Managing fixed income portfolios in a changing regime environment
Global Investment Insights
with Magdalena Kinal, Fixed Income Portfolio Manager
Magdalena is a Fixed Income Portfolio Manager with 14 years of experience in a wide range of fixed income products. Most recently, she managed assets of up to AU$4+ billion in inflation-linked bonds for state government entities, such as insurance and pension funds, during her tenure at NSW Treasury Corp (TCorp). While at TCorp, Magdalena was also in the role of Senior Manager for multi-asset portfolio solutions.
Previously, Magdalena was a Fixed Income Portfolio Manager at First Sentier Investors where she was responsible for managing a diverse range of fixed income products such as Australian domestic bonds, inflation linked and liability driven portfolios as well as global diversified fixed income.
After sixteen years of living and working in Sydney, Magdalena has relocated to Zurich, Switzerland and is looking for her next challenge in fixed income and/or multi-asset portfolio management. With increased levels of volatility and uncertainty in markets, amid high inflation and tightening monetary policy, Magdalena has taken time to share her perspectives. She highlights key implications for institutional investors’ portfolios and the approaches they can take to navigate this environment, in this exclusive interview with Global Investment Institute (GII).
Q. How are rising interest rates and inflation impacting bond and fixed income allocations within institutional portfolios?
The world’s first major inflation challenge in 40 years has indeed led to significant changes in cross-asset correlations, which has not rewarded asset ownership in 2022. This implies that we could well be in a regime change environment.
Typically, Capital Market Assumption (CMA) models are slow to adjust for regime changes, impacting the risk and return expectations, as an input into the strategic asset allocation. It is difficult to predict whether a regime change is going to be short or long-term in nature, but the impact on asset class interaction can be profound.
Evidentially, in a low inflation environment (< 2%), there is a tendency for bond and equity returns to be uncorrelated (or even slightly negatively correlated). However, in the high inflation environment (> 4%), there is a tendency for bond and equity returns to be positively correlated. It is unlikely the majority of models would have incorporated this, as a negative correlation has only existed between equities and bonds since around the turn of the century. Prior to this, between 1970 to 1997, there was positive correlation, with only temporary periods of negative correlation.
Furthermore, in 2022, a traditional asset owner with a CPI+ or Cash+ target has faced a twofold effect, an unrealistic investment objective and significant reduction in asset values, where an allocation to fixed income has not provided a defensive anchor. Moreover, the idea that an allocation into inflation-linked bonds managed against traditional benchmarks offers inflation protection, while ignoring the embedded duration risk, has proved to be naïve.
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In 2022 a traditional asset owner with a CPI+ target has experienced both an unrealistic investment objective and significant reduction in asset value, where an allocation into fixed income has not provided a defensive anchor.
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Managers who diversified their defensive sleeve via an allocation to defensive alternative strategy products or through tail-risk hedging strategies, such as option strategies, have generally benefited in 2022, albeit at the expense of the income which would have been earned via bonds.
According to the BofA latest survey[1], as of late 2021 we have seen the most pessimistic outlook for bonds in the history of the Fund Manager Survey. This has been reflected in institutional portfolios and is expected to reverse.
Q. What role do you see for Government bonds in an institutional portfolio under current macroeconomic conditions with rising rates and inflation?
In the short term, rising interest rates may negatively affect the value of a bond portfolio. However, over the long term, rising interest rates can actually increase a bond portfolio’s overall return, merely due to the fact that maturing bonds can be reinvested into new, higher-yielding bonds.
Rising cash rates have already caused a slowdown in the economy, which should dampen demand driven inflation. Supply driven components of the CPI basket can still be at risk of intensifying and are very difficult to predict, given its sensitivity to geopolitics. However, fixed income should be the Swiss Army knife of your investment portfolio right now, configurable in a variety of different ways, diversifying your portfolio while earning attractive income again. Whether investing in government bonds as a reliable source of income, or as a defensive diversification sleeve or liquidity tool, this should be favourable to the overall portfolio strategy. The key will be to correctly evaluate the drivers of the current breakdown in equity/bond correlations and be conscious that this regime change may be stickier than initially thought, as seen pre-1997.
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Fixed income should be the Swiss Army knife of your investment portfolio right now, configurable in a variety of different ways, diversifying your portfolio while earning attractive income again.
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Q. How sustainable is interest rate normalisation given the high debt levels and what possibility do you see of a credit crisis being triggered?
The level of private debt has been decreasing since the GFC. It is public debt which is at record highs, given the continuous stimulus governments have had to provide, increasing the requirement for debt issuance while being indifferent to the level of interest rates. That stimulus has also been a contributor to higher inflation. If uncertainty about the future is high, then the typical behaviour would be to pay down the debt regardless of where interest rates are. There is evidence that the level of private debt does not go hand in hand with the level of interest rates. If we faced an imminent credit crisis, the most probable trigger for it would be an uncertain negative outlook for the economy, influenced by central bankers’ interpretation of future economic factors. In turn, this would likely prompt businesses to cut costs by laying off staff, reduce future investments and minimise debt in response to the uncertainty, which in itself is only a sentiment-based view, rather a certain outcome.
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It is public debt which is at record highs, given the continuous stimulus governments have had to provide. That stimulus has also been a contributor to higher inflation.
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The recent widening in credit spreads was caused by rising interest rates, rather than due to fundamental concerns. That uncertainty is somewhat a function of the central bank’s actions and is significantly subject to human error in attempting to forecast future economic factors, including inflation. Central bank board members are heavily incentivised not to fail on their mandates and only have limited monetary tools at their disposal. This intervention is heavily manifested in the market’s desire for certainty. The model of a central bank’s function in the economy is so embedded, that the market lost its ability to regulate itself. Hence, as long as stability is assured, a private credit crisis should be avoidable, if anything, the risk is skewed towards a sovereign debt crisis.
Q. From an asset allocation perspective, how would you be positioning an institutional portfolio at this point in the cycle to immunise it against risk?
Monetary policy tightening in the developed world, amidst a global downturn in economic activity, translates into an unfavourable backdrop for risk assets, driving for regime changes. A peak in real rates should provide a turning point in markets. To get there, the Federal Reserve, for instance, will need to pause its interest rate hiking cycle based on their interpretation of future inflation and employment. In essence, the central bank’s view of inflation is more important than inflation itself. Over the long term, bond yields will adjust to the economic reality of the environment. However, in the short to medium term, the primary driver of bond yields are central banks.
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The central bank’s view of inflation is more important than inflation itself.
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As this inflection point approaches and the level of volatility in bond markets declines (as measured by the Merrill Lynch Option Volatility MOVE index for instance), as an asset allocator I would gradually increase physical bond risk via government and local government bonds and, high quality global credit to lock-in the carry;
in any case overlayed with duration management on the total portfolio basis. The funding would have to be individual to the portfolio’s objective.
Lastly, look for a defensive anchor which is tested for negative correlation to growth assets during time of market stress (point in time as opposed to over time correlation).
Owning assets has paid off until 2022. Therefore, going forward, active management, diversification and downside management capabilities will be key. Fixed income managers who actively add value via relative value and carry strategies, should be rewarded going forward. Furthermore, institutional investors have been traditionally applying conventional benchmarks and are, in the process, running the risk of unintended total return outcomes. Using the absolute return target approach removes inadvertent portfolio performance consequences in the long term.
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Owning assets has paid off until 2022. Therefore, going forward, active management, diversification and downside management capabilities will be key.
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Magdalena Kinal, Fixed Income Portfolio Manager
Magdalena is a Fixed Income Portfolio Manager with 14 years of experience in a wide range of fixed income products. In her last role at NSW Treasury Corp (TCorp), Magdalena managed up to AU$4bn+ in assets under management in inflation-linked bonds for state government entities such as insurance and pension funds. At TCorp Magdalena was also in the role of Senior Manager for multi-asset portfolios solutions. Prior to that she was a Fixed Income Portfolio Manager at First Sentier Investors (formerly known as Colonial First State Global Asset Management) responsible for managing a diverse range of fixed income products such as Australian domestic bonds, Inflation Linked and liability portfolio as well as Global Diversified Fixed Income.
Magdalena holds a Master of Applied Finance from the Macquarie University, Sydney and a Bachelor of Science with major in Applied Mathematics, from Darmstadt University of Applied Science in Germany.
[1] Source: Bank of America (BofA), Fund Manager Survey 15 November 2022
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