Why bonds are back and bond basics

The funds mentioned in this podcast are only available to Australian investors.

Louise Watson: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers Australia, where we bring you insights from our global collective of experts to help you make better investment decisions.

I'm Louise Watson, Head of Country for Natixis Investment Managers in Australia and New Zealand. And today, I'm joined by Kevin Creeden, Investment Director for Loomis Sayles’ Global Bond Team.

Loomis Sayles was founded nearly one hundred years ago in 1926, and it is truly one of the global giants of fixed income, with about $375 billion dollars, Australian dollars, invested in fixed income. The Loomis team have been looking after Australian investors for more than 25 years now. For the first time, Australian wholesale investors will also be able to access its global bond fund.

Kevin, welcome to the podcast.

Kevin Creeden: Good morning. Appreciate the invite to the podcast. It's a pleasure to be in Sydney as always.

Louise: Let's start with some of the sentiments that we've seen in the market recently in fixed income investing and including one of our own surveys, a Natixis Investment Managers survey from last year. Australian institutional investors said that fixed income was one of only two asset classes they were feeling bullish on, and the other was private debt.

While talking about performance in the March quarter, the CEO of Natixis Investment Managers, Philippe Setbon, also said that we're observing strong appetite for fixed income investments and in line with trends that we've seen last year in 2023.

And then further to that, at the recent Lonsec Symposium, 53% of attendees indicated their intention to increase allocations to fixed income and bonds. So it seems like bonds are back in a big way. But it's possibly after the worst year ever for bonds in 2022. So Kevin, why are more investors allocating to bonds at the moment?

Kevin: Yeah, that's a great question, Louise. And it partly has to do with 2022 and that repricing of global bond yields. So as many remember, yields moved significantly higher, priced higher. It actually took the yields in our asset class from relatively uninteresting to quite interesting. So why are people also allocating to bonds? It’s more than just the all-in yields. Also, we've seen stocks run  up impressively globally, so people are worried about valuations in equities.

There's also quite a few geopolitical situations going on around the world. Investors are starting to get concerned with growth, because central bank monetary policies have been extremely tight and continue to be tight. So, with all that backdrop, you look at something like the global aggregate fixed income asset class with the yields of 4, 5, 6%, depending on where you invest across it. Investors are saying, "Why take all that equity market risk when I can maybe lock in 5 or 6% yield?"

So lastly, investors tend to look at fixed income as the ballast of their portfolio, the lower volatility component of their asset allocation. So just given again, the run-up in stocks, fixed income, 5, 6% remain in investment grade, it seems like an attractive trade-off.

Louise: Yeah, that seems to be resonating quite strongly with our market here. And your team has a long history in Australia, 27 years in fact, and to give you an idea of what was happening 27 years ago, the Titanic movie was just released. And a yardstick that we use in Australia is The Triple J’s Hottest 100, the number one song at that time was “No Aphrodisiac”, by The Whitlams.

And we are now launching a global bond fund in Australia to the wholesale market. And for the first time, investors will have access to that. So why now? Why offer this investment aphrodisiac to the market now?

Kevin: Louise, I'm pleased to say I am old enough to remember not Titanic the ship but the movie. And yes, we have indeed been managing global investment grade assets for Australians for well over two decades. And we're seeing that demand globally, in global investment grade fixed income, we're winning mandates really all over the world. We've acquired new mandates in places like Singapore, Thailand, New Zealand, United States, the United Kingdom, Middle East. We've seen a tremendous amount of geographic diversity in the demand. But it's all for the same reason, the ability to stay in investment grade and get 5 or 6% yields with an active approach.

But it's also made us think about where else should we be expanding into other markets. So then of course, through the nice visibility and insights of your team into the Australian market here through Natixis, we've been seeing a lot of demand in this asset class from financial advisors and others in the wholesale space.

So we think with our long track record that we've managed global aggregate AUD-hedged investment strategies in this region, we think we've got a great investment approach that will appeal to this market. A proven track record that we can show investors, investing in global aggregate in Australian dollar-hedged terms.

Also, our investment team travels regularly into Australia from the States; we’ll come in a couple times a year. And given the importance of the global ag benchmark in Australia, we think that we should offer this capability to the wholesale market. So we think we can bring a pretty compelling offering.

Louise: Yeah, Loomis are one of the key pillars to our business here at Natixis in Australia. And we're delighted to be launching this strategy here in Australia for Loomis Sayles. And prior to your arrival, we were talking to clients. And while many have an excellent knowledge of fixed income, we've also come across a few areas of confusion too.

So, I wanted to tackle some of those and some of the most common areas that we're seeing this confusion. Let's start with equities versus fixed income. Equities have public markets where they trade via stock exchanges around the world, and private markets which operate through private deals or off-market transactions. And the bond markets also operate via exchanges as well, over-the-counter or OTC. How do you trade and what are the benefits of each type of trade?

Kevin: Yeah, so bonds are still a little bit old-fashioned in that they trade over-the-counter, as we say. Some is still done over the phones. There's electric systems to do that, but it is very much a point-to-point relationship. So it requires a large trading operation with strong ties to the largest global banks that provide liquidity from the street. So especially for global bond portfolios, you might want to have a manager like ourselves that has trading capabilities, not just in one jurisdiction, Boston, where we're headquartered, but also having trading capabilities in Singapore and London. So you can trade around the globe as the sun moves.

So having A$375 billion in fixed income assets, this makes us big enough to garner the respect and access that you need to get great execution on the street. But we're also ... we're not too big where it impacts liquidity or our ability to generate alpha. So I think we sit in a nice sweet spot as an asset manager given our size.

Also, we can operate in both high or low liquidity segments of the different sub-markets of fixed income, whether it's global treasuries, high yield bonds, or securitized credit, or wherever we want to try to put into the portfolio. So the scale of the operation allows us to navigate the sometimes complex fixed income markets.

Louise: Yeah, that's great. So interesting. Bringing this conversation back to Australia now, and if I'm an Australian investor wanting a broadly diversified exposure to the global bond market, what would you recommend I look for? And I know you use the global agg index as your benchmark. Why did you choose it and what is in that index?

Kevin: Yeah, so I've mentioned the global agg index quite a few times. It's many investors preferred index for running a global bond portfolio. Why is that? It's because it really is a combination of many bond types. It's the combination of really all the investment-grade treasury bonds of the world, and then many other bond types that trade at spreads or higher yields over government bond yields.

So with this one index, you get global access to really all of the investment-grade government and corporate bond issuers of the world in one portfolio. And then we go one step further and try to actively outperform this index with our experienced portfolio managers and our large global research team.

Louise: And bonds can be both fixed rate and floating rate. What's the difference between the two?

Kevin: Well, most bonds are fixed in nature. But even some investment grade issuers offer floating rate bonds that often convert to fixed rate bonds over a period of time.

So the key difference is a floating rate bond floats. As global bond yields rise or fall, their coupon effectively resets higher or lower with the market. So this reduces duration sensitivity.Louise: Let's get back to that term, duration, because it's a term we hear a lot about when we're talking about bonds. Can you explain duration and why it's important?

Kevin: Yeah, so duration is an important concept. In 2022, really underscored its impact. So if you think of the nature of bonds, it's that inverse relationship. When yields go up, bond prices go down. When yields go down, bond prices go up.

So every bond has a certain interest rate sensitivity and that's what the duration is. And it's typically measured in what we call years. So, what this really means is if we think of the entire global aggregate index as a single bond, it has a duration of about seven years. So again, interest rates across the entire yield curve moving 1%. That seven-year duration sensitivity means that the bond prices could go down 7%. And we saw that handily in 2022 as yields priced 2-3% higher. So that was a very painful year.

Now, with yields much higher though, there is a lot more yield in investment grade, so it does help soften the blow of duration sensitivity. So now, if you saw another 1% move higher in duration and yields in global investment grade fixed income, you might see another -7% total return. But you're now collecting 5% coupon income to help offset that.

Duration works the other way too though. If yields move lower as if we think global growth's moving lower, central banks may start to ease and lower interest rates and they can benefit. So that's the key input of duration, sensitivity to interest rate moves.

Louise: And the Loomis Sayles Global Bond Fund is hedged to the Australian dollar. Why is your fund hedged and what are the risks and benefits of hedging?

Kevin: So 99% of the bonds in the global aggregate index are not Australian dollar denominated bonds. So, Australians who want to get the yield of that asset class, that benchmark in its income, but they might want to get it without all the currency volatility that can come from an unhedged benchmark like this; which if you think about our benchmark, it's 40% US dollars, 20% euro, 15% emerging market currencies. So, it would be a shame to get a 5-6% yield in a year, but perhaps it's a year where say the US dollar is weak versus the Australian dollar, and that currency weakness of all the US dollar denominated bonds in the portfolio underperform simply because of the US dollar price movement.

So that's why Australian investors tend to prefer hedged approaches to fixed income, help reduce that currency volatility. And it's something we're happy to do in the portfolio and offer that.

Louise: You mentioned some of the different types of bonds earlier. And the portfolio is made up of securities that are predominantly investment grade, around 90%. Can you explain why the strategy is positioned this way?

Kevin: Yeah, so well currently, we're pretty equal to the quality of the index and that's because we're defensive in nature. If we wanted to be riskier than the benchmark, we would lower the average credit quality of the portfolio to take advantage of what we think are cheaply priced, maybe corporate bonds in the overall portfolio and in the index.

So we'll do this in a way to hopefully outperform the index over time and provide active returns. So that's where we leverage this really large research effort at Loomis Sayles, both from our corporate and government research teams. And really, what we're looking to do all day is find these mispriced bonds, tilt portfolio weightings in a way that we think will outperform the index.

So we'll also do things like own high-yield bonds, just a small portion of the portfolio. We recognize this as a global investment grade opportunity set and that's what investors are hiring us to do. But there is a segment of the high-yield market where double B issuers are on their way to being investment grade and BBB. So, we will seek to take advantage of those opportunities and put them in the portfolio because they can bring nice alpha generation opportunities for the mandate.

Louise: Yeah, so let's dig a little bit deeper into beating the index and ways in which Loomis Sayles can do that. The RBA is due to hypothetically cut its interest rates. So how would you position the portfolio in that scenario?

Kevin: So, if the RBA was due to cut interest rates, Australia is in the index and we can be actively positioned. So if we were going to anticipate a cut in rates, it might be advantageous to go overweight, the duration, the yields, the government bonds of Australia. Because as we mentioned in the duration part of the discussion, as those yields move lower, the bond price is moving up, so it's an opportunity to help outperform and own that portion from an active standpoint in the portfolio.

That's one way we would try to outperform. The other way is to, for instance, be in industries, corporate issuers that we think are well positioned to outperform ... or within just that industry, find the one or two bond issuers that we think will outperform even all those issuers in that industry. So that's what it's all about, is constantly turning over relative value, leveraging the research skill of the firm.

Louise: Well, as we launch this global bond fund into Australian markets, we look forward to learning more about the strategy and how it performs in the future.

But thank you so much Kevin for joining us and helping all of us improve our bond knowledge. And thank you as well to everyone listening in. 

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