Katrina King

Fixed income investors should be factoring a rise in the term premium into their planning, according to QIC, one of Australia’s largest institutional investment managers. The QIC Global Liquid Strategies (GLS) team is conservatively anticipating normalisation of around 50 basis points.

The ‘term premium’ defines the compensation required by investors for holding long-term debt, as opposed to continually rolling over short term debt.

“For some years now, the term premium has all but evaporated or even been in the negative. In essence this means there’s been no excess compensation for investors holding long term debt,” explained Susan Buckley, MD of QIC’s GLS team. “But we have identified a range of global factors that signal a return to higher levels – and believe investors should be acting upon this return sooner rather than later.”

These factors include a “normalisation” of monetary policy following the US’s withdrawal of quantitative easing, investors’ demand for higher compensation to counter increased illiquidity caused by increased regulation in the finance sector and the general expectation of higher interest rates and inflation.

The nearing of peak foreign ownership of US Treasuries and sovereign investors’ consequent move to new asset classes is another driver. That includes increased interest in the Chinese renminbi as a currency, coinciding with the debate about its inclusion in the IMF’s standard drawing right basket and its new, more freely traded basis.

“Investors should understand that the return of the term premium does not signal a return to ‘normal’,” said Katrina King, GLS’ Director of Research and Strategy.

‘This time is different’ are said to be the four most dangerous words in economics and markets. Well, this era really is different. For a start, the term premium has spiked three times since the global financial crisis, showing that that term premium can move quickly and undercut unprepared portfolios. Then there is the emergence of a new risk, illiquidity, which investors are only now starting to give thought to. There is a rising tide of commentary on the new threat, but few ideas on how to counter it.”

Against this backdrop, QIC’s view is that fast, targeted responses to market adjustments will be critical for success. Inflation protection and inflation-related assets warrant renewed attention as will favouring short rates positions when valuations show mis-pricing.

“Rising inflation should not be a source of alarm – we are looking at moderate levels that we believe offer return opportunities for investors that look beyond the present and signal a welcome step-change in the post-GFC era,” explained Ms King.

“The upshot is that the extended holiday from risk premium is coming to an end – and that is a good thing. The return of the term premium represents a significant step up from the current broadly zero figure. For best results, investors must adjust to its return – but doing so may well test some nerves,” concluded Ms Buckley.

Read more in QIC’s latest Red Paper: The term premium is down but not out: prepare for its return.

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Speaking on the release of QIC’s Red Paper Au revoir credit beta: meet credit alpha, QIC’s Director of Fixed Income Research & Strategy, Katrina King, yesterday warned that institutional investors accustomed to strong returns from credit markets in recent years will need to re-think their current strategies or risk seeing the capital value of their portfolios eroded.

Ms. King said that while it is true that credit markets have been a strong source of capital returns in recent years and corporate bond yields are currently at their lowest level since the GFC, the economic environment is starting to change.

“It’s true that the situation today is still quite constructive overall, but as economic growth picks up and central banks move to normalise monetary policy, yields will gradually rise. Portfolios which simply rode the spread tightening of the past few years will be threatened,” she explained.

In Ms. King’s view, for institutional investors to benefit from corporate bonds’ yield advantage, they will need to take a truly active investment approach and look at removing both interest rate and inflation risk from their credit allocations.

“Inflation may be muted now, but it remains a worrying undercurrent,” she said. “Credit spreads have tended to rise when inflation uncertainty has risen. Investors have just lived through a lengthy period of ultra-low official interest rates which, while not our base case, carries the risk of causing an inflation outbreak.”

Ms. King said that at the same time, global economic conditions are improving, and businesses are responding positively. Shareholders are beginning to expect higher returns, which in turn puts pressure on management to take less risk-averse positions.

“I certainly don’t mean to suggest that companies are about to play fast and loose with their finances, but there is a definite sense that company-level risk is on the rise,” she said.

Long-only credit strategies, which have worked well over the past few years as global investors fled risk in all forms, are now less likely to perform. The next phase of the credit cycle will require much deeper analysis industry by industry and company by company to identify vulnerable companies as well as those with reassuring credit metrics.

Ms. King concluded that with the right approach to credit, investors have nothing to fear from the changing world order, and that truly active investors will find plenty of opportunity to exploit price gaps between industries as well as individual companies.

“At QIC our focus on outcomes has meant that we are happy to decouple from the benchmark and manage the three levers of inflation, interest rate and credit risk separately, in order to harness multiple alpha sources.”

“Current market conditions are calling out for this kind of unconstrained approach, including macro positions and long short trades between different indices in order to make the most of corporate bonds’ yield advantage,” she said.

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