Stuart Dear

Fixed income is set to be a standout asset class in 2023, both in absolute terms and relative to other assets, according to Schroders Australia head of fixed income, Stuart Dear.

However Mr Dear says the market environment is likely to stay volatile as the battle between slowing growth and still-too-high inflation plays out.

“Although the surge of inflation in 2022 rose to levels not seen since the early 1980s, with the resulting negative impact on the bond market, there is now reason to be optimistic about the outlook for the fixed income asset class,” he says.

“As well as the material possibility of high quality fixed income delivering strong returns this year, partly erasing last year’s losses, it should also be a good diversifier as we enter the down phase of the cycle. Riskier assets appear to be still priced for relatively benign macro outcomes.

“The fact that yields have repriced sharply higher means that forward-looking returns from bonds are now significantly better. For now, the income is back in fixed income.”

Mr Dear says determining value in government bonds is a fine art, as value depends on many moving parts including future economic growth, inflation, central bank policy, investor risk appetite, and market liquidity.

“Two of the most common bond valuation methods are estimating the ‘fair value’ level of bond yields given medium-term macroeconomic inputs, and comparing bonds to equities and making a relative assessment.

“Using both of these methods, bonds are ‘cheap’ at their current levels.”

“There is no question that high quality bonds now offer attractive absolute and relative value, and a compelling medium-term risk-adjusted return,” Mr Dear says.

Schroders Australia portfolio manager for fixed income and multi-asset, Mihkel Kase, agrees the next few months could potentially be a sweet spot for fixed income as yields in investment grade debt have already risen, prior to any economic slowdown.

“We still expect a period of volatility ahead in fixed income markets but we believe the rebuilding of yields across most investments means that these markets will be able to deliver income and expected improved returns to investors.”

“Bonds tend to do best when growth is falling, inflation is softening, and central banks are easing policy. While we may not see all three in 2023, Schroders believes at least two out of three are likely.”

Mr Kase says investors may be enticed to use the next few months to accumulate high quality assets at good levels and wait for better opportunities in risker assets.

“Although eventually the downside risks to growth are likely to dominate market pricing, these may not eventuate for some time,” he explains.

“Investors should consider taking advantage of attractively priced fixed income markets over the next few months as opportunities present.”

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Stuart joined Schroders in October 2012 as fund manager, Australian fixed income, and was subsequently promoted to deputy head of fixed income (Australia) in April 2016. He has 20 years’ fixed income investment experience.

Simon Doyle said: “As deputy head of fixed income, Stuart has successfully led the rates and credit teams, adapting the investment process to a challenging interest rate and credit environment. Appointing Stuart as head of Australian fixed income is recognition of his skills as a fixed income investor, his commitment and of the team’s achievements in delivering strong results for clients.”

Schroders Australia CEO Sam Hallinan said: “Fixed income continues to play an important role in client portfolios, and it is pleasing to be able to promote internally from what is already a very well-respected team in the market. Talent development and promotion from within is a great sign of success.

“It’s clear that our industry is at a pivotal juncture. It is facing some tough and unique challenges with multi decade low rates, asset-owner consolidation, regulatory reform and net zero sustainability trends. While it is a given that a business as strong and successful as Schroders invests in its teams and capabilities to help our clients respond to these challenges, this is a people game, and I am really happy to see Stuart take the reins of such an important investment capability.”

The Schroder Fixed Income Fund has delivered strong performance over the past year, while also outperforming its benchmark over three and five years^[1], achieving top quartile performance over all these periods.

This aggregate performance experience has resulted in research rating upgrades in 2021 from both Zenith, which upgraded the Fund to ‘Recommended’, and the Morningstar Analyst Rating, which upgraded the Fund’s Wholesale Class to ‘Silver’ as of 18 February 2021^[2]. The Fund is already ‘Recommended’ by Lonsec.

Schroders’ Fixed Income team currently manages $6bn of AUM.

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[1] Performance relates to the Schroder Fixed Income Fund (Wholesale class) as at 30/6/2021 after fees.
[2] The Morningstar Analyst Rating for Schroder Fixed Income Fund – Wholesale is ‘Silver’ as of 18 February 2021.

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“Many retirees rely on their allocation to cash to meet their day-to-day expenses, but falling interest rates have made it difficult to generate income without taking excessive amounts of risk.

“With official interest rates remaining at a record low of 0.75 percent following the latest RBA board meeting, it is now a serious challenge for investors to generate income using traditional approaches. This problem is compounded further on platforms where the rate paid to investors for cash accounts is nearing zero after fees.

“A commonly used investing technique by advisers is the “bucket strategy”, where they allocate investments for their clients to three asset buckets: equities, diversified but defensive, and cash.  As the income and capital from the cash bucket is used for day-to-day expenses, the income generated by the riskier buckets flows down to top up the cash bucket.

“With significantly lower return on cash, there is clearly a problem with this model.

“Furthermore, while one percent has commonly been seen as an effective floor for the cash rate in Australia, we think rates can go lower still – even to zero, given the global experience.  And it’s likely that cash rates will be kept at low levels for a considerable period of time, exacerbating the challenges facing retirees, and indeed any investors, seeking the benefits of cash.”

Mr Dear says that in light of the prospect of low cash rates for the foreseeable future, it makes sense for advisers to consider making a change to the way they manage their clients’ cash buckets in order to generate more return.

“With very little return on cash, it makes sense to consider other alternatives.

“For example, a diversified, defensively oriented fixed income strategy that offers periodic income and daily liquidity could be a good substitute for part of the cash bucket.

“Of course, any alternative option must be considered in light of the trade-offs involved.  By investing in alternative options to cash, investors are likely to be taking on more risk.  As such, advisers should choose options that can generate higher returns while preserving the liquidity and relative certainty of return their clients require – both key features of cash.

“A fixed income strategy predominantly made up of high quality, liquid, publicly traded securities, can help with this,” Mr Dear says.

He adds that advisers could also consider dividing cash buckets into three further segments, based on timeframes, which vary according to their clients’ requirements for liquidity and certainty:

Figure 1: Segmenting the cash bucket

Source: Schroders

• Next 12 months – over this period, investors want the greatest certainty and liquidity, therefore may be best maintained as cash investments.
•  1 – 2 years – in this segment, investors can take a little more risk to invest for slightly higher returns. However, this allocation away from cash should only be into defensively oriented strategies with high liquidity, and cash should still be a large part of this segment.
• 2 – 3 years – this segment can take more risk again, and this is where it may make sense to blend some of the higher risk options, alongside cash and more defensive options.

“Based on this strategy, investors would still hold a little over half of their “cash bucket” in cash, but also utilise fixed income to lift their income generation without unnecessarily compromising the certainty of capital and liquidity requirements,” Mr Dear says.

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