Regional slowdown needs better portfolio design with longer bonds

While the regional growth slowdown has sneaked up on the Australian equity market, it remains apparent that a continuation of such a slowdown will take an even larger toll on local equity pricing. In this context, portfolios need to find better portfolio construction ideas, and it can be argued that longer bonds can be of great assistance, as they cut portfolio risk, while increasing portfolio return over the medium term. Adding interest rate risk to an Australian portfolio that is typically swamped with equity risk tends to protect the portfolio from any negative growth surprise. If you think that such a growth surprise is impossible, then the recent experience, with a regional slowdown, may make you think twice, and better portfolio design will help protect your investments and preserve your financial capital.

In this article we:

1. Review the performance of equities in the light of recent downward revisions in Chinese growth.
2. Compare shorter maturity bonds with longer bonds, in terms of return and risk.
3. Review the outlook for interest rates as well as the recent trends in interest rate markets.

1. Australian equities already feeling the chill of a regional slowdown

Recent discussion of a slowing regional Asia-Pacific growth remains one of the main factors impacting equity performance, especially in the case of Australia. In Figure 1 the disappointment of the market with Chinese releases, and estimates for growth, has been reflected in a decline in the Chinese Economic Surprise Index, as compiled by Citibank. In general, the Citigroup Economic Surprise Indices are quantitative measures of economic news, and comprise the weighted historical standard deviations of data surprises, where actual releases are compared to Bloomberg survey median data.

While a positive reading of the Economic Surprise Index suggests that economic releases have on balance been beating consensus, the opposite has been the case for China. In particular, note how the Chinese Economic Surprise Index has slumped, from a positive reading, meaning that releases were better than expected in March 2013, to now, where the index is very negative.

Also, note how the relative performance of Australian equities, or the light blue line, have suffered since March 2013, where we deduct the annual local currency return from US equities, as measured by the S&P 500, from the annual local currency return of the Australian All Ordinaries Index. In other words, Australian equities have felt the chill wind from a regional slowdown already.

Now, if Chinese data continues to disappoint, then Australian equities should begin to underperform US equities substantially.

Figure 1

2. Longer bonds can add return and help to better control portfolio risk

In the event that Australia continues to feel the chill of a regional slowdown, where perceptions of growth continue to sag, then insulating the portfolio against lower equity prices is something to consider in more detail. Here, if we were to hold the allocation to bonds constant, and then vary the allocation to different bond lengths, then it would be interesting to compare and contrast the two portfolios return time series.

Since equities are so volatile relative to bonds, using longer dated bonds should be more effective, when compared to shorter bonds from a risk point of view, in terms of controlling overall portfolio risk. This is because of the way interest rates move when perceptions of economic growth fade, as they did during 2008. In general, when perceptions of economic growth fall, the equity market tends to fall in price, and the bond market begins to anticipate a response from the central bank, in terms of lowering rates. Lower rates then drive up fixed rate bond prices in the secondary market, so the longer the bond, the bigger the offset to the overall portfolio, which is typically swamped with equity risk. In contrast, floating rate notes are more capital stable, meaning that their prices do not fluctuate to the same extent as fixed rate bonds due to changes in interest rate expectations.

In Figure 2 we compare the performance of two portfolios, each with 50% bonds and 50% equities. However the bonds are of a very different length:

• one portfolio has bonds of around 3.5 year modified duration, as shown in Figure 2 as the dark blue line. These bonds are contained in the UBS Composite Bond Index. Such a modified duration means that the bonds will rise by 3.50% for every 100 basis point fall in secondary market yields, and fall by 3.50% for every 100 basis points rise in yield
• the other portfolio contains one bond of around 14.5 years modified duration, which means that the bond will rise by roughly 14.5% for every 100 basis points, and fall by roughly 14.5% for every 100 basis points up in yield. This portfolio is shown by the light blue line in Figure 2

Figure 2

Notice the performance of the portfolio in the 2008 period, and see how the longer bond portfolio, or the light blue line, stabilises overall portfolio return, even in that period, whereas the shorter bond portfolio, as shown by the dark blue line, fails to stabilise overall portfolio return. Such a performance means that the longer bond portfolio much more adequately controls investment risk, than the short bond portfolio, as the following risk and return statistics for the period 2003 to mid July 2012 demonstrates.

Source: FIIG securities, UBS, ASX

In other words, the long bond portfolio cuts overall risk by more than 20%, having an annualised risk of 6.26% compared to 8.62%, when compared to the short bond portfolio. Also, the long bond portfolio adds over 20% in return, having an annualised return of 10.13%, as opposed to 8.29%, for the shorter bond portfolio. While this sounds somewhat counter-intuitive, as one is adding more interest rate risk to the portfolio, the reality is that portfolio risk falls, as interest rate risk is generally negatively correlated with equity price risk; each price generally move in opposite directions. Return is added, as the portfolio picks up the extra return that is generated by a longer bond, which is typically of a much higher yield than the shorter bond, as the market typically rewards investors for taking on additional interest rate risk.

3. Higher rates provide a great entry point

Although timing of these trades is more an art than a science, the portfolio design idea is still significant; longer bonds do the job of insulating the portfolio from interest rate shocks better than shorter bonds. Despite the inherent imperfections involved with timing, we can make the following observations:

• regional growth has slowed as evidenced in the economic surprise index shown in Figure1, which should bias rates lower in the medium term,
• Australian short term cash rates are set to be lowered one more time, before year end, and
• US growth is apparent, yet fears of dramatic growth appear somewhat optimistic and unrealistic, as the US economy faces the following headwinds:

(i) tepid ex-US growth will continue to constrain exports, especially from what seems to be a perpetually recessed Europe, and now the Asian region, especially China

(ii) higher long dated US mortgage rates, which acts just like a tightening of monetary policy, and will slow growth in the housing market in the second half of 2013

(iii) fiscal drag from the sequester on US government spending will continue to constrain growth

(iv) a higher oil price is currently acting like a tightening of monetary policy on US spending

(v) a stronger US dollar will impact the US export sector in the second half of 2013

In other words, fears of an acceleration of US growth are somewhat overly optimistic in our view, even though these optimistic assumptions have, already, seen secondary market yields rise, as shown in Figure 3 below, which shows the yield on a thirty year bond 100bps above the 30 year fixed swap rate.

Figure 3

Conclusion

Australian portfolios are typically swamped with equity risk, and fail to have the sort of interest rate risk that can help insulate the portfolio from negative growth surprises. While we have enjoyed the opposite type of growth surprise of late, the regional slowdown, as stimulated by a moderation of Chinese growth, is making many investors think twice about equity exposure. A collapse of growth expectations has already seen the Australian equity market decline significantly, relative to the US market since March 2013 and the slowing of China should continue to impact local equity pricing. This context makes the search for better portfolio design ideas critical, and we have shown that longer dated fixed rate bonds typically cut portfolio risk while improving return in the medium term. Importantly, recent rises in yields provide the opportunity to implement longer bond portfolios, thereby stabilising portfolio return. Examples of some bonds that might be considered are the QTC 2033 bonds, the TCV 2043 zero coupon and the Sydney Airport 2030 ILB.