Going active with fixed income - Independent Thought Roundtable

By Jayson Forrest

In a macro environment of rising risk and uncertainty, Amy Xie Patrick - Pendal Group believes that by being defensive, patient, but active, advisers can provide investors with the type of protection and growth they are seeking in their portfolios.

There’s no denying that we are living in very uncertain times, as a range of geopolitical issues and a structurally higher inflationary world continue to affect the macro environment, creating greater economic volatility.

Speaking at an IMAP Independent Thought Roundtable, Amy Xie Patrick — Head of Income Strategies at Pendal Group — believes the current environment makes it ideal for advisers to consider taking up a more active approach with their fixed income allocation within their portfolios.

Against this backdrop of market uncertainty and heightened volatility, Pendal has taken a defensive, patient, but very active approach with the positioning of its portfolios. This includes how it allocates to bonds, credit, equities, and FX, as part of its portfolio management process.

Bonds

According to Amy, investors are now facing many risks that compared to 2022, are more aligned this year, as inflation peaks and growth slows.

“When you’re facing into all these risks, bonds are a good risk reward. You should at least be thinking about being neutral in your portfolios,” she says. “We like bonds now and we’re getting ready to really love them later in the year.”

Credit

Investment grade credit is often touted as being the safer side of credit. However, with the likelihood of a recession over the next 12 months — at least for the U.S., and possibly even Australia — then in a recessionary environment, Amy suggests credit spreads aren’t defensive. Credit is positively correlated to equities and in this scenario, both won’t do very well.

“Don’t count on investment grade to behave like government bonds in a recession,” she says. “That’s why we stay highly defensive with our credit portfolios. We prioritise quality and we also value liquidity in our portfolios.”

Amy explains that as fixed income instruments go, even high grade credit becomes incredibly illiquid. “Therefore, if you value your liquidity, you’ll stay away as much as possible from that illiquidity risk. If you have chosen to go into less liquid assets, at least know the illiquidity (and volatility) that you are likely to suffer, which should be adequately compensated for.”

Equities

Amy concedes that being patient in credit can sometimes be painful for investors, which means, when taking liquidity into account, Pendal also positions its portfolios into equities.   

“We have portfolios where we use an allocation into equities very tactfully and opportunistically. That’s because unlike high yield bonds, if you allocate equities to beta in your portfolio, they’re actually very liquid, and equity markets don’t tend to price in a recession until it’s too obvious,” she says. “This approach allows us to be more patient in our credit portfolios.”

Foreign Exchange

In a recession, the U.S. dollar is generally counter-cyclical and does well, so Amy advises investors to buy the U.S. dollar. However, she adds that within pockets of emerging markets there are usually opportunities where investors may still get value.

In its approach to asset allocation, Pendal is factoring in the likelihood of a recession — at least in the U.S. — within the next 12 months.

With the unemployment rate in the United States sitting at about 3.4 per cent (April 2023), Amy draws upon industry research to reject any suggestion that a recession in the U.S. won’t be severe because the labour market is so strong.

“Many people will look at the slew of data coming out of the U.S. and say the American economy isn’t struggling. They look at the data and say the economy is strong, consumers are still spending, and the unemployment rate is too low for there to be a recession.

“But recessions don’t happen in a linear way. They happen very suddenly. If the established view is that the unemployment rate is too low in the U.S. to cause a recession, I would argue that the unemployment rate is so low that it’s predictive of a recession,” says Amy. “And by our estimates, that will happen within the next 12 months.”

Unlike the previous 30-40 years, as markets move to a structurally higher inflationary world, Amy is adamant advisers need to prioritise and get active with their fixed income allocation.

“It means when you locate an active bond manager, you need to ensure the manager is not just active by one or two years around the benchmark, but they’re able to neutralise all the duration in the benchmark or even double it. That’s the type of active you should be looking for when it comes to your portfolios,” Amy says.

“At a time when investors are facing recession, disinflation, and rising financial fragility — as we’ve seen with recent bank failures in the U.S. — you need to get active with your fixed income allocation. This means having the right amount and type of liquidity in your portfolio. By doing so, instead of being punished by volatility, investors can take advantage of the more volatile environment we’re heading into.”

Amy Xie Patrick is Head of Income Strategies at Pendal Group.

Speaking at an IMAP Independent Thought Roundtable, Amy spoke on the use of fixed income when positioning portfolios in an environment of rising risk and uncertainty.