Thinking fixed income? It's time to drop the home bias

Our conversations this year with Australian investors continue to reveal a strong home bias to Australian rates and credit assets.

When discussing the role of their fixed income holdings, these investors most commonly cite diversification and defensiveness as the targeted characteristics of their fixed income allocations, with some also aiming to generate growth.

A bias to the Australian share market is understandable. After all, few economies can match the relative economic health of 'the Lucky Country' over the past 30 years. Plus, there are franking credits - which provide investors with tax benefits by passing on company-paid tax as a credit on dividends.

However, I am not convinced that this same home bias should be applied to fixed income portfolios.

The limits of local credit exposure

The Australian credit market is heavily concentrated, with five companies making up 31% of the Bloomberg AusBond Credit Index. If any of these were to experience an adverse event, it would pose a significant risk to portfolio returns.

Additionally, there is a high correlation between the names in the domestic credit and equity index. This effectively doubles investors' exposure to the same economic risks. Any national downturn or one-off domestic crisis could negatively affect not only the businesses within the index, but the individuals whose financial wellbeing is tied to their performance.

Given the issues raised above, it's fair to suggest that relying on domestic credit holdings for diversification and defensiveness in a wider portfolio context is sub-optimal; the logical approach lies in tapping into the larger global opportunity set. For those focused on return generation, this broader opportunity set offers greater scope to improve risk-adjusted returns.

Looking at returns over the past 20 years, investment-grade credit has delivered returns of c.6%, while high yield has returned an impressive c.8% for Australian investors.

In comparison, global equities returned c.7% over the same period. Had you built a portfolio back in 2005 combining investment-grade and high-yield debt, you would have achieved comparable returns to equities - without enduring the significant drawdowns in personal wealth. This portfolio would have offered steady, predictable contractual cash flows from coupons, and its capital value would have experienced significantly lower volatility given the numerous stress events since 2005.

However, past performance is no guide to the future.

Indeed, today's credit markets differ in two key ways compared to the environment investors have grown accustomed to over the past 20 years.

1. Where have all the defaults gone?

One notable curiosity is the decline in default rates.

Typically, when interest rates rise, we expect a corresponding increase in defaults from distressed borrowers. However, the rate hikes between 2023 and 2024 did not result in the anticipated spike in defaults. While many corporates have learned from the Global Financial Crisis and now manage their debt more cautiously, others have simply moved out of public markets.

Many now source their loans from the private credit market, which has quadrupled in size over the past decade. For corporates with lower credit ratings, this market is appealing as it is easier to secure funding. However, by its nature, it offers limited transparency and is not open to market analysis.

It is possible that defaults have not disappeared, but have instead shifted from public to private markets.

Additionally, many distressed borrowers in the private credit market are having their maturities extended to help them repay. They're being given a new profile by either changing their coupon or extending their maturity - restructurings that are not classified as defaults.

2. The decline in credit volatility

Another change is the decline in credit volatility seen in 2024, to well below that of government bonds and currencies.

This is largely the result of substantial inflows into credit markets, attracted by much higher relative yields compared to the 2010 to 2022 period, when quantitative easing kept returns artificially low. So, a steady stream of investors seeking to capture yields close to 5% from credit has helped keep volatility in check.

However, we believe that interest rate volatility is unlikely to decrease, and that credit volatility must rise, as it has over the past month.

Volatility creates opportunity for active managers

For an active manager, volatility presents an opportunity. It can provide a chance to acquire fundamentally sound issuers whose securities have become undervalued. In periods of high volatility, such as now, the frequency of these buying opportunities should increase. But does this play out in practice?

Active management draws a lot of criticism, particularly in equities, but fixed income tells a different story. The median fixed income and credit manager delivers around 0.5% per annum of gross alpha, compared to only 0.1% for global equity managers. Why? Fixed income markets are more imperfect and inefficient than equities, with a much larger volume of issuance and a faster turnover of assets - a structure that better supports active management.

The merit of credit

From our perspective, with average yields at over 5% for US investment-grade credit, this is arguably the best time to invest in credit since 2009-10.

With high volatility, macroeconomic, and policy divergence, the global credit market offers a much broader playground than a domestically focused fixed income portfolio.