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Over February the Australian bond market1 was down approximately 3.5%, suffering its biggest negative monthly return since 1983. In combination with its negative return in January, this episode essentially wipes 80% of the bond market's 2020 returns. Meanwhile, the 10 Year Australian Government bond yield has almost tripled since the lows experienced in 2020.

While oonly the rates market has been affected so far, in our view this could extend into risk assets (such as equities, high yield and investment grade credit) if central banks don't intervene in a coordinated fashion to avoid a 'taper tantrum' style sell-off.

The ingredients for a bond market sell-off have been brewing for some time, and while hard to predict the turning point, as active managers we must be poised to re-position our portfolios and identify investment opportunities.

The three forces responsible 

1. Rising Inflation expectations: 

• There has been a meaningful lift in inflation expectations over the past quarter resulting from positivve sentiment around the post COVID-19 recovery and reflation.
• This has been largely driven by vaccination programs getting underway and central banks` and governments commitment to supporting economies back out of the crisis
• The rapid turnaround is depicted by the 10-year breakeven inflation rate shown in Chart 1 below. Inflation expectations are many times higher than the low point experienced in March 2020 and have now crept up into the Reserve Bank of Australia`s (RBA) inflation rate target 

Chart 1: Australian 10-year breakeven inflation rate (%)

Source: Bloomberg, ABS, Australian 10-year breakeven inflation rate to 4 March 2021.

2. Rising cash rate expectations:

• In Australia, cash rate expectations suggest an RBA cash rate of 3% by late 2028. As at 26 February, with three- and 10-year Australian Government bond yields at 0.127% and 1.91% respectively, there is an embedded expectation that cash rates will rise very quickly, surpassing pre-COVID monetary policy settings into 'tight' cash rates.
• To illustrate the shift in cash rate expectations, the chart below depicts the market's pricing of the future path of cash rates on 26 February 2021 (orange curve), which is nearly three times higher than the market pricing back in October 2020 (blue curve).

Chart 2: Australian implied OIS forward 1m cash rate (%)

Source: Janus Henderson Investors, Bloomberg, monthly to February 2021, spot 26 February 2021.

• Interest rate risk (or duration), which is the sensitivity of bond markets to movements in bond yields, is a key risk for fixed interest investors to manage. The pre-conditions for adverse outcomes from the bond market1 had been brewing for a while given it is featuring a potent combination of record high levels of duration and record low bond yields. In general terms, and for illustrative purposes only, the effect of six years of duration essentially means that, even a 1.0% rise in bond yields would result in a 6% decline in capital for index investors.

Chart 3: Yield to maturity and modified duration on the Bloomberg AusBond 0+ Yr Index

Source: Janus Henderson Investors, as at 31 December 2020. Index: Bloomberg Ausbond Composite 0+ Yr Index. Note: Past performance is not a reliable indicator of future performance.

3. Question marks over central bank commitment:

• Despite the asset purchase programs and dovish rhetoric from central banks, markets are pricing in an earlier return to the RBA tightening monetary policy than the 2024 conditional commitment they've made.
• Markets are now challenging the central banks on whether they will stay the course with forward guidance and yield curve control (YCC) measures over the next three years.

How we are navigating the turmoil

Effectively navigating the more volatile rising rate environment at the key turning points will be vital given the magnitude of interest rate risk (duration). Ultimately, as yields rise, we believe it is worth taking some duration risk to capture higher yields, especially if markets overshoot.

Higher bond yields when cash rates are anchored at close to zero present very steep yield curves and the opportunity for investors to participate in both the yield and roll-down effect that adds to performance.

Today a 10-year risk free government bond, if nothing happens in markets over the next year, can deliver a return that's at least twice that of a five-year major bank floating rate corporate bond2. These are exactly the type of opportunities active managers wait for even if some volatility in the near-term needs to be tolerated. One will only know after the fact whether the strategy went too early or too late.

The team have also been focusing on capital preservation strategies to protect against a breakout in inflation expectations.

Below is an overview of our investment strategy:

Rates:

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Duration:

• We have gradually bought into the weakening bond market, with the expectation of higher returns in the future.
• While a plausible case can be made for bond yields gradually lifting over the medium to long term, the recent sharp price action seems to have brought forward that theme too quickly.
• Buying duration early will necessarily bring some near-term drawdown in return, but one can rarely pick turning points and only in hindsight will it be obvious.
• Our focus is on having the largest active position at the turning point, as it will be too late to position after markets have turned.

Inflation protection:

• Our sizeable allocation to inflation linked bonds has largely served the purpose of protecting portfolios against the market's expectation of a sharp lift in inflation. However, the best time to own inflation protection is when others don't want it or are not thinking about it, and that time is now gradually passing.
• As such, we have taken some profit through the sale of some of our holdings of government inflation linked bonds, though we have retained some exposure in order to reduce the impact of inflation expectations rising even higher should they break out to the upside.

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Spread sectors3:

Having participated in the meaningful rally of spread sectors, we feel prudent to take some profit while valuations are at peak levels in the post-COVID market rally.

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Semi-government debt:

• We have more than halved our semi-government bond position amid dissipating relative value.

Credit protection:

• We have added some credit protection (through credit default swaps) as a means of more quickly reducing spread sensitivity to tail risk events.

Investment grade credit:

• We have reduced some investment grade credit in order to more selectively participate in key primary market debt issuance.

High yield:

• We have reduced holdings of high yield credit.

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We are intentionally still exposed to credit markets, but the above provides some room for risk taking should markets become unstable.

This year is shaping up to be one where active interest rate strategies, including taking advantage of higher yields, may overshadow excess returns from spread sectors. Accordingly, our strategies will emphasise this from time to time as prevailing market conditions offer investment opportunities. While we expect some volatility and drawdown, near-term volatility presents an opportunity for active managers. Ultimately, higher bond yields restore the defensive characteristics and create better value for the asset class.

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1. Australian Bond Market as measured by the Bloomberg AusBond Composite 0+ Yr Index.

2. Based on no change to the current bond yield of 1.91% for 10-year Australian Government bonds and the estimated yield of an Australian five-year major bank floating rate notes of 0.45% (as at 26 February 2020).

3. The above are the Portfolio Managers' views and should not be construed as advice. Sector holdings are subject to change without notice.

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This information is issued by Janus Henderson Investors (Australia) Institutional Funds Management Limited (AFSL 444266, ABN 16 165 119 531). The information herein shall not in any way constitute advice or an invitation to invest. It is solely for information purposes and subject to change without notice. This information does not purport to be a comprehensive statement or description of any markets or securities referred to within. Any references to individual securities do not constitute a securities recommendation. Past performance is not indicative of future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

Whilst Janus Henderson Investors (Australia) Institutional Funds Management Limited believe that the information is correct at the date of this document, no warranty or representation is given to this effect and no responsibility can be accepted by Janus Henderson Investors (Australia) Institutional Funds Management Limited to any end users for any action taken on the basis of this information. All opinions and estimates in this information are subject to change without notice and are the views of the author at the time of publication. Janus Henderson Investors (Australia) Institutional Funds Management Limited is not under any obligation to update this information to the extent that it is or becomes out of date or incorrect.

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AIM Global High Conviction Fund

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I don't know about you, but my COVID prediction record was woeful. Home furnishings boom? Nope. Motorbike retailer has best year ever? Nope. Funeral homes have their worst year ever? Definitely didn't see that coming. 

Everything is easy to rationalise after the event. But the way different sectors were impacted by COVID surprised me. A lot.

One of those is the enterprise software sector. These companies sell software to other companies. Think accounting, customer relationship management and project planning software. Unlike software sold to individuals or small businesses, where the user simply buys the product and starts using it, most enterprise software is heavily integrated into a company's operations and customised for each client.

Forager has owned a few of these businesses over the years, including Hansen (HSN) and GBST. There are a handful in the current portfolio too, such as RPMGlobal (RUL), Fineos (FCL) and Gentrack (GTK). Once ingrained in a customer's operations, they are almost impossible to remove, making for sticky revenues and attractive long-term investments.

It wasn't any surprise, then, that they were viewed as something of a safe haven in the early months of the COVID panic. In a world where some companies weren't generating any revenue at all, recurring reliable revenues from large corporates looked relatively attractive.

Yet look at the table below. On the ASX at least, many of these companies are today trading well below their pre-COVID prices.

 

 

 

 

 

 

 

 

 

 

 

 

It turns out that this prediction wasn't right either. Apparently, some of the revenue isn't as recurring or reliable as investors had come to believe.

Most enterprise software companies earn significant amounts of upfront implementation revenue. That depends on winning new clients. And some of the "recurring" revenue is related to clients requesting changes or introducing new features. With employees working from home and much bigger problems to deal with, most corporates have moved IT system upgrades down their lists of priorities.

The impact was widespread. The recovery at utilities and airports software provider Gentrack (GTK) took a big step backwards. Bravura's (BVS) UK wealth management clients have hit pause on new deployments. Sales of Integrated Research's (IRI) performance monitoring solutions have been slow.

The problems are real, but the share price reactions look overdone. The timing of a recovery is uncertain. But the deals will return, and investor optimism will likely come back alongside them.

Both Forager Funds have had their best ever years of outperformance over the past 12 months. That's been a result of capitalising on widespread over-reactions, and being willing to change our minds as the evidence came to hand. In the enterprise software sector, we're doing both.