2. Defence can be the best offence

A well-chosen exposure to fixed income has the potential not only to reduce portfolio risk, but also to at times outperform equities.

Falling interest rates are generally welcomed by investors, who anticipate the economic stimulus a rate cut provides, and the boost to equity valuations that can result.

Sometimes, however, falling interest rates can reflect concerns about declining corporate earnings, and the worry is that deteriorating economic conditions mean that returns from shares are much less certain. We arguably face such a scenario today.

In this type of environment, the more predictable income and capital returns from bonds become even more attractive.

Although bond yields are low, investors should remember that income is only part of the bond story. Falling yields in recent times have meant that fixed coupon bonds have generated very healthy capital returns. In an environment where equity valuations may be stretched, bonds can not only reduce portfolio risk, but also have the potential to outperform equities. As an example, the average yield to maturity on Australian bonds over the two years ended 30 September 2019 has been 2.23% p.a. whilst the annualised total return has been 7.35% p.a.²

It is vital to understand, however, that not all bond exposures are created equal. We believe that broad duration and credit provide the majority of fixed income fund returns – and so it is essential that a fixed income allocation offers exposure to these sources of return.

Many Australian fixed income funds benchmark to the Bloomberg AusBond Composite Index. We see this particular benchmark and funds that track it as an inefficient solution for bonds, as the AusBond Composite has a large allocation to short-dated government securities that offer little diversification (due to a lack of duration), while also paying nothing above cash/bank bills.

Instead, we believe long-duration fixed coupon bonds (both corporate and government) provide the solution.

Long-dated investment grade corporate bonds historically have tended to behave like government bonds (as they are priced off the government curve), but with a meaningfully higher yield. Alternatively, for investors seeking lower-risk fixed income exposure, long-dated government bonds provide an attractive alternative.

CRED and AGVT comparative performance: 30 September 2019

^{Source: Bloomberg. Shows performance of indices CRED and AGVT aim to track and does not take into account the ETF’s fees and costs. Past performance is not an indicator of future performance.}

² As represented by the AusBond Composite Index. Past performance is not indicative of future performance.
³ Source: Morningstar
⁴ Source: Morningstar Direct. Universe defined as ‘Australia Fund Bonds – Australia’ (Morningstar Category). You cannot invest directly in an index. Past performance is not an indicator of future performance.

3. Real assets for real returns

With reliable revenue streams, real assets can provide potential for strong income and attractive returns that are not tied to the economic cycle.

In uncertain times, investments that demonstrate resilience are prized.

Many equity investments provide returns that vary with the economic cycle, and so in times of economic uncertainty can be particularly vulnerable.

One class of assets that historically has proven resilient in economic downturns is real assets – this includes assets such as listed property, utilities and infrastructure, including toll roads, airports and electricity grids.

These real assets provide relative cash flow certainty as their fortunes are less tied to the economic cycle. They typically have long-term, built-in contracts that allow revenue to be increased in line with, or above, the inflation rate. An investment in real assets therefore offers a high level of in-built protection against inflation.

Historically, assets such as toll roads, ports and airports have performed well in falling interest rate environments, as their more predictable and often regulated cashflows become worth more in today’s dollars as rates fall. Listed real assets have tended to show lower volatility and suffer smaller drawdowns during broad market declines.

Real assets also benefit from population growth, as there is an increasing number of people driving on toll roads, using electricity or flying to and from airports.

For those interested in this investment thematic, we believe a diversified exposure to real assets is the best approach, avoiding the sector and stock concentration that comes with, for example, an investment solely in A-REITs.

Legg Mason Martin Currie Real Income Fund

Since inception performance (net) to 31 July 2019

^{Past performance is not a guide to future returns. Source: Martin Currie Australia as at 31 July 2019. Data calculated for the representative Martin Currie Australia Real Income account A$ net of management fees. Periods over a year are annualised. Inception Date: 1 December 2010. This strategy is not constrained by a benchmark, however for comparison purposes, it is shown against the S&P/ASX 200 Accumulation Index and the blended 50% A-REIT 300 Index / 50% S&P/ASX Infrastructure Index.
Indicative only, actual portfolio may differ. As the BetaShares Legg Mason Real Income Fund (managed fund) ASX: RINC commenced in February 2018, this information is based on the unlisted Legg Mason Martin Currie Real Income Fund, a comparable fund managed by Martin Currie Australia using the same strategy to illustrate how the strategy has performed over a long time period.}

01

BetaShares Legg Mason Real Income Fund (managed fund)

ASX Code: RINC

---

•  Holds a portfolio of listed Australian real assets such as A-REITs, utilities and infrastructure securities

•  Actively managed exposure to high quality real asset businesses that demonstrates sustainable and growing income streams

•  Strong diversification of company risk relative to A-REIT Index

•  Attractive income potential – forecast portfolio yield as at 30 September 2019 of 5.5% p.a. (including franking and before fees)⁵

•  Mercer’s best-performing Australian equities fund strategy over the year to 30 June 2019 (17.4%)⁶

•  Lonsec – Recommended, Zenith – Recommended

 

Learn more

⁵ Yield forecast is calculated using the weighted average of broker consensus forecasts of each portfolio holding and research conducted by Legg Mason Australia, and excludes the Fund’s fees and costs. Franking credit benefit assumes a zero tax rate. It is not to be interpreted as the offset achieved by unitholders during this period. Actual yield may differ due to various factors, including changes in the prices of the underlying securities and the number of units on issue. Neither the yield forecast nor past performance is a guarantee of future results. Not all investors will be able to benefit from the full value of franking credits.
⁶ Source: Mercer. Past performance is not indicative of future performance.

4. Smaller companies, bigger growth profiles

Mid- and small-cap companies can benefit more than large cap stocks from low interest rates, and may offer higher earnings growth potential than the top 20.

Investors can tend to think of the sharemarket as a homogeneous entity whose ‘parts’ move in line with the ‘whole’. However, this isn’t always the case. Different ‘size bands’ of the equity market perform differently – and different tiers of the market often don’t move in parallel.

So how do different parts of the market react to changes in monetary policy? When the RBA changes interest rates, it is naturally trying to influence the domestic economy. Is the impact felt across the board, or is it felt more strongly in some sectors than others?

In low interest rate and low-growth environments, stocks that offer secular growth should command a greater premium than cyclical stocks or financials, which should benefit the Australian small and mid-cap sector to a greater extent than large caps. This is because “secular” growth is not tied to the growth environment in the same way “cyclical” growth is.

Mid and small-cap stocks currently also offer higher earnings growth potential than the top 20 Australian stocks. As of September 2019:

• the mid-cap part of the Australian market has an estimated forward EPS growth ~38% higher than the Top 20 – but trades on a P/E multiple only 5% higher
• the small-cap part of the market has an estimated forward EPS growth ~16% higher than the Top20 – but trades on a P/E multiple ~7% lower ⁷

For these reasons, we believe smaller Australian companies, in preference to larger ones, offer the potential for better total returns in a low interest rate environment.

^{Source: Bloomberg. As at 30 September 2019. Past performance is not indicative of future. performance.}