Are high grade bonds a natural choice for strengthening your fixed income allocation JCB Jamieson Coote Bonds September 2024 In a rapidly evolving macroeconomic landscape, Australian investors are increasingly turning to global high grade government bonds as a highly defensive component of their investment portfolios. This move is predominately driven by global government bond markets offering greater portfolio diversity, enhanced return potential and broad sources of yield. In this article, we unpack the key themes influencing investors' long-term views on the value of including global high-grade bonds into a fixed income portfolio. Where are we now in the cycle? The key question facing investors today is: Where are we in the current business cycle, and when will the next shift occur? A glance at the economic growth of the world's major economies and stock markets over the past decade reveals that we've been in an extended expansionary phase. However, determining exactly when the cycle will peak is notoriously difficult. While certain indicators have pointed to an approaching recession, accurately predicting this shift remains a challenge. At a time where geopolitical tensions are intensifying and policy makers are grappling with softening global growth and persistent inflation, investors face a landscape of heightened uncertainty on many fronts. Global central banks are embarking on a synchronized interest rate cutting cycle as the narrative has switched this year from inflation concerns to growth concerns. Global inflation has moderated from its peak levels, with current annual rates of inflation at 2.50% in the US (the lowest since February 2021), 2.00% in Canada, 2.20% in the UK, 2.20% in EU and 3.8% in Australia, although forecasted to fall to 2.70%. Meanwhile economic growth has started to show some cracks, which until now has been supported by government spending. Employment remains a key determinant in the direction of growth and recent signs from the US indicate that this is turning. US employment data was recently sharply revised lower - which has triggered anxiety amongst central bankers. In response, they are eager to get on the front foot and curb labour market weakness before it deteriorates sharply. Savings are already getting depleted, and signs of rising delinquency are cautionary tales that will be exacerbated from job losses. Asset allocations can be dynamically adjusted to optimise performance during different phases of the cycle. With the recent loss of US employment momentum, are we moving from Slowdown to Recession? If so, improving asset quality and liquidity will be important to navigate the coming market environment. Chart 1: Phases in the business cycle. The economic cycle consists of four key phases: Boom, Slowdown, Recession and Recovery, which then leads back to another Boom - continuing the cycle. Expanding horizons: Unlocking enhanced alpha opportunities that may await Not all bonds are created equal. High quality sovereign global bonds offer a lower risk profile due to their stability and creditworthiness. These bonds are typically issued by governments with strong financial standing, making them less susceptible to default and economic fluctuations compared to lower-rated or corporate bonds. As a result, they can serve as a safer option for investors seeking to mitigate risk within their portfolios. Global high grade bonds currently present unique alpha opportunities for investors. Capitalising on the global interest rate cycle: With many G7 nations beginning to cut rates, increasing exposure to high grade government bonds can be advantageous. By extending the duration of high quality bonds during a period of falling interest rates, fixed income investors can achieve greater stability and lower credit risk. This strategy becomes far more attractive compared to newly issued bonds that offer lower yields in a low-interest rate environment. Highly liquid in all market conditions: The global bond market can play a pivotal role in an investor's portfolio due to its liquidity offering, with its ability to enter and exit positions to manage risk and changing market conditions. This flexibility allows fixed income investors to access their funds when needed, with a highly liquid bond market serving as a hedge against riskier assets during market volatility. Additionally, liquidity can present potential alpha opportunities, as investors can capitalise on market inefficiencies to enhance their returns. Lowering risk and volatility: Investing in a global bond portfolio reduces country-specific risk by spreading investments across multiple regions, mitigating the impact of economic or political challenges in any single area. It also provides access to different interest rate environments. Additionally, bonds from various regions often have lower correlation with domestic bonds or equities, helping to reduce overall portfolio volatility and improve stability. Optimising exposure through active management: By actively adjusting the duration of a bond portfolio, fund managers can respond to anticipated interest rate changes to maximise returns or minimise risk. They can also identify mispriced or undervalued bonds for enhanced yield opportunities and tactically allocate across different regions to capitalise on favourable economic conditions. Active managers employ risk management techniques to reduce downside risk and ensure liquidity by adjusting holdings based on market conditions, ultimately enhancing the overall performance of the portfolio. Chart 2: Global Government Bonds Have Outperformed International Equities During Major Sell-Offs Global government bonds are among the safest investments in an investor's portfolio, offering capital preservation and helping to reduce equity volatility due to their long-term negative correlation with stocks. They also provide stability to portfolios, especially during market downturns. We can observe how global sovereign bonds perform during periods of financial market crises and significant events in the chart below. During the dot-com crash, the global financial crisis and European debt crisis, global government bonds outperformed equities providing capital preservation and a hedge against the equity market collapse. During the COVID-19 pandemic, global sovereign bonds and equities once again exhibited contrasting performances, although the dynamics were more complex than during previous crises. The pandemic caused a sharp, short-term market shock in early 2020, followed by an unprecedented recovery, largely driven by aggressive fiscal and monetary stimulus. Source: JCB team analysis based on data from Bloomberg. *CC JCB Global Bond Fund hedged to A$ (class A). Intl Shares are MSCI world ex Aus hedged to A$TR index. How should investors position fixed income portfolios as global rate cuts begin? When considering the long-term value of fixed income, high grade bonds stand out as one of the safest investments in an investor's portfolio. Not only do they preserve capital but also help reduce equity volatility due to their long-term negative correlation with stocks, ultimately stabilising portfolios during tough market conditions. We believe that now could be an ideal time to lock in elevated income levels and broaden fixed income portfolios to include a variety of global bonds. The onset of the cutting cycle is likely to lead to a decrease in bank deposit rates, making government bonds a more attractive option for investors seeking capital appreciation. As a significant amount of dollars currently parked in money market funds is expected to flow into the government bond sector, this shift is further supported by the frothy nature of the private credit market, which has more than doubled in size since 2019. Interest rate cuts mean private credit's floating rate is less attractive, redirecting capital away from it into higher interest bearing assets. The transparency and liquidity of government bond funds provide a compelling argument for this reallocation.   Adapting to market changes: why global sovereign bonds matter now Falling interest rates signal a shifting investment landscape, presenting new opportunities for asset allocators. Rate cutting cycles underscore the importance of diversification, especially as economic conditions can change rapidly. Funds operated by this manager: CC Jamieson Coote Bonds Active Bond Fund (Class A), CC Jamieson Coote Bonds Dynamic Alpha Fund, CC Jamieson Coote Bonds Global Bond Fund (Class A - Hedged)

Government Bonds and High Yield Credit Compete for the Podium in a High Interest World JCB Jamieson Coote Bonds August 2024 When you're chasing those enticing yields, high yield credit funds can seem like a golden ticket. They promise strong returns compared to other asset classes, which might make them look like the smarter choice. But before diving in, it's crucial to understand that not all fixed income assets are created equal. High returns come with their own set of risks, and knowing what those are can help you make more informed investment decisions. The emergence of private credit funds As banks cut back on corporate lending, private credit funds have become more popular, offering more competition and financing options. These funds aim to generate returns through various strategies, which require careful consideration. Key factors include: Sector Focus: Investing in different areas, like property construction or stable industries. Business Stage: Lending to well-established companies or distressed. Capital Structure: Positioning in the loan's repayment priority (e.g., first lien vs. unsecured). Loan Terms: Setting strict or flexible terms and borrower controls. Understanding these aspects helps investors make informed decisions in this growing market. Credit funds, including those focused on more speculative private credit and property construction loans, often attract investors with the promise of higher returns. These funds offer elevated interest rates because they invest in debt issued by companies with lower credit ratings. While the potential for greater income is appealing, it's essential to understand that these higher yields come with substantial risks. Liquidity: The core concern A hallmark characteristic of genuinely defensive assets is liquidity. Private credit funds often have lower liquidity due to long lock-up periods, longer lead-times for redemptions and infrequent fund trading windows. Since these funds tend to involve direct lending to organisations, the loans do not trade on exchanges, therefore the secondary market to recall or trade capital is extremely low and difficult. For example, during the early days of Covid-19 in March 2020, many fixed income funds, both traditional and alternative, raised sell spreads to effectively gate investor capital, showing that what seemed like a safe investment could be problematic in times of crisis. Default Risk (Volatility): Compromising your hard earned capital The primary risk associated with credit funds is default risk. This refers to the possibility that the issuer of the bond or loan may be unable to meet its interest payments and/or repay the principal amount. This can become a real possibility during times of economic stress. The value of these investments can fluctuate dramatically based on a range of factors, including market sentiment, company-specific news, or broader economic deterioration. For example, if a company issuing high yield bonds reports poor earnings or faces operational challenges, the value of its bonds may drop. Similarly, changes in interest rates or economic downturns can lead to sharp declines in the value of high yield credit investments. This volatility means that while you might experience higher returns during periods of economic growth, there's a substantial risk of seeing your investment value decline during downturns or periods of market uncertainty. As with Olympic contenders, where unexpected outcomes can shift the podium positions, in the investment arena, a single default can have significant repercussions. The risk is magnified in high yield credit funds, where issuers are often less stable and more susceptible to economic fluctuations. Just as a single misstep in a crucial race can cost an athlete the gold, a default can lead to substantial losses for investors. Transparency Risk: The price of potential high returns Valuation is a key piece of private credit, affecting returns, risk, the cost and availability of capital. Since valuations are typically periodic with long lags, they may not reflect current market conditions or asset performance. This issue can be worsened where a fund may not fully account for borrower difficulties in its valuations. Inflated valuations can reduce loan liquidity, as there's less incentive to redeem at true values. Unfortunately, this trend is becoming more common across the private credit industry. Property Construction Loans: additional risks Property construction loans, a subset of private credit funds, come with their own set of risks that can amplify the overall risk profile of high yield credit funds. These loans are typically provided to developers for building residential or commercial properties and are often characterised by high interest rates due to the inherent risks involved. Construction projects can face numerous challenges in tighter times, such as delays, cost overruns, and regulatory hurdles. If a project encounters significant problems or fails to complete on time, the borrower may struggle to repay the loan, increasing the risk of default. The financial health and track record of the developer is critical in assessing the risk of default. Such loans can also be less liquid compared to other investments. If you need to exit your investment before the construction project is completed or the loan matures, you might face difficulties in finding a buyer or could have to sell at a discount. Balancing Risks and Rewards Investing in high yield credit funds and property construction loans can be a way to achieve higher returns, but it's important to weigh these rewards against the associated risks. Credit investments can offer attractive income opportunities, but they come with the potential for significant volatility and default risk. Property construction loans add another layer of risk. To navigate these risks, a diversified investment approach can help. Balancing high yield credit funds with more stable investments, such as government bonds or investment grade securities, can provide a buffer against the volatility and risk of high yield investments. Additionally, thorough due diligence on the underlying assets and careful consideration of the economic environment can aid in making informed investment decisions. Ultimately, the quality of private credit depends on the investment managers behind it. Their expertise in assessing and monitoring loans, managing risk, and protecting capital is key. Additionally, their experience, industry relationships and track record across various market cycles are essential factors. Government Bonds: A safe haven in a volatile environment Government bonds typically perform well during periods of economic uncertainty and downturns. With sustained inflation and higher interest rates, the real return on existing bonds can become less attractive compared to new issues, which might offer higher yields. However, government bonds retain their appeal due to their stability and lower risk profile. And, within a government bond fund, portfolios are diversified with individual bonds maturing being steadily replaced by newer issues, which helps these funds keep pace with return needs. Government bonds inherent safety can attract investors looking for a refuge amid economic volatility. When interest rates eventually start to decline, the value of existing government bonds with higher coupon rates is likely to rise. Lower rates mean that newly issued bonds will offer lower yields, making existing bonds with higher rates more valuable. Additionally, as the economy begins to recover and inflation pressures ease, government bonds will likely benefit from renewed investor confidence and demand. Navigating Higher Risk in a Challenging Environment Credit funds react differently to the economic landscape. In the current environment of high inflation and interest rates, the risk of default among companies with weaker credit ratings increases. As interest rates start to decline, the situation for high yield credit funds may improve, but not without complexities. Lower rates can reduce the cost of borrowing for companies, potentially easing some of the financial pressure and reducing default risk. However, the recovery in high yield credit markets might be uneven, depending on how quickly economic conditions improve and the specific financial health of the issuing companies. In light of these dynamics, it's crucial for investors to consider how shifts in economic conditions could impact their portfolios. Government bonds may offer increased value as interest rates decline, while high yield credit funds might see some relief if economic conditions improve. For a balanced investment approach, incorporating government bonds can provide stability and potential capital appreciation in a declining interest rate environment. Meanwhile, carefully selected high yield credit investments might still offer opportunities for higher returns, but should be approached with caution and a clear understanding of the associated risks. Which Investment Takes Gold? So, where does that leave investors? High yield credit funds and government bonds each play distinct roles in an investment portfolio, much like different events on the track. High yield funds are akin to the high-risk, high-reward sports, where taking on greater risk can lead to the potential for impressive returns, much like a daring pole vault or a thrilling sprint. These funds might suit investors prepared to handle the volatility and aim for those high yield medals. On the other hand, government bonds are like the marathon--steadily paced and reliable. For investors seeking stability and a steady income, government bonds are your marathon runners, providing a dependable performance over time. They are well-suited for investors who value consistency and want to avoid the unpredictability of higher risk investments. Ultimately, the choice should align with an investors financial goals, risk tolerance, and how they view the economic landscape unfolding. Funds operated by this manager: CC Jamieson Coote Bonds Active Bond Fund (Class A), CC Jamieson Coote Bonds Dynamic Alpha Fund, CC Jamieson Coote Bonds Global Bond Fund (Class A - Hedged)

Data Dependency and Fiscal Stimulus Complicate Inflation Fight JCB Jamieson Coote Bonds May 2024 Financial markets have dealt with a large volume of economic data and communication from central bankers in recent weeks. Despite some overly sensationalised media coverage and short-term predictions, we believe that the central banks' messaging has remained consistent across jurisdictions.   The US Federal Reserve (US Fed), the global leader in setting market trends, and the Reserves Bank of Australia (RBA) domestically, have both cautioned patience with monetary policy, as already restrictive settings continue to work through the system, lowering growth and demand whilst bringing inflation back towards target. This process is frustrating in the day to day, in that inflation data doesn't move in straight lines - seasonal factors, annual price increases, one-off adjustments, flash sales, and other variables create a bumpy, unpredictable, and somewhat volatile path. Even well-resourced teams of economists at major investment banks consistently get their estimations markedly wrong, reflecting the inherent volatility in this process. Take the latest CPI quarterly release in Australia, which was widely predicted to be 0.8%. When the actual figure came in at 0.96% (rounded up to 1.0%), the unexpected result triggered a significant market reaction, leading to the removal of any expectations of a rate cut from the RBA. What makes this even more galling for forecasters is that with a monthly inflation series, they already have about two thirds of the dataset before the quarterly figures are released. This makes forecasting errors even more surprising and exacerbates the market's reaction when a when a relatively small portion of new data has an outsized impact. This may be more detail than you require as you read this over your morning coffee. Of course, forecasting errors can also work in reverse, as we have seen some large undershoots versus expectation over time. Yet the sequencing of these dataset surprises drives market sentiment, and sadly, central bankers are now wedded to react to a 'data dependent' approach, risking falling behind the curve. The key takeaway here is that while inflation in Australia peaked at 7.8% in the fourth quarter of 2022, it has since steadily fallen to 7.0%, 6.0%, 5.4%, 4.1% and now 3.6% over the preceding quarters. This downward trend, though slightly slower than the RBA forecasts, has been the direction of travel for 18 months. The fight against inflation is not yet over, but it is well advanced, whilst the battle rages on under restrictive interest rate settings. The US economy, which has long been the 'exception' in a souring global macroeconomic story, has suddenly slowed significantly.  Whilst the incoming numbers remain solid, they are markedly weaker than we had received previously, with a shock miss on components like GDP, the employment report (Non-Farm Payrolls), initial unemployment claims and a host of second-tier manufacturing and activity data.  This has taken the US "economic surprise" index to a negative reading. Markets are now focused on how the interplay of slower growth will affect prices (and inflation) in the coming quarters, trying to calibrate the timing of central banks that have become unashamedly 'data dependent'. The significant failure of models used to calibrate policy through the COVID-19 period has made central bankers highly reactive, no longer willing to back their judgements on years of policy learnings and economic theory to move policy ahead of the cycle. Ordinarily, as growth slowed, central bank policy levers would already be in motion to address the slowdown and expected cooling inflation outcomes associated with weaker demand, acknowledging that policy works with long lag times. Now, as data dependency is 'policy de jour', the danger is that economies may slow more than necessary before central banks act to curb a downturn. This delay could lead to more severe corrective measures, as central banks struggle to address a substantial loss of economic momentum. We have heard various terms to describe economic trajectories, such as 'hard,' 'soft' and 'no' landing.  If, like an aircraft, the economy hits stall speed, the pilots' attempts at recovery will be a lot more severe than if they'd simply eased up a little ahead of time.  Central bankers are often criticized for waiting until ''something breaks'' before taking decisive action. This was evident during the Global Financial Crisis (GFC) over a decade ago when rates were held at similar levels to today until a catastrophic episode was unavoidable, prompting rates to be slashed by more than 5% to jump start economies and reverse the damage caused by overly restrictive rates from the pre-2008 period. With this concept in mind, our baseline position at the start of the year was that central bankers would aim for a non-stimulatory rate cutting cycle in the back half of 2024. This was expected to be led by Europe or the US, commencing around the middle of the year. Such a strategy could help smooth the economic cycle, offer some relief to consumers and borrowers, and ideally avoid the negative consequences of keeping rates too high for too long.  That is still seemingly on track for Europe, with the European Central Bank (ECB) likely leading the way, followed by Canada, the UK and New Zealand. However, the expected timing for the US to lead the rate-cutting cycle has shifted further out.   An interesting development is Sweden's Riksbank, which just leapfrogged the pack by cutting rates from 4.00% to 3.75%, whilst observing similar economic outcomes to our own domestic data, weak growth, deeply negative retail sales and cooling (though still above mandate) inflation. Perhaps some central bankers are still moving ahead of the curve. In the US, the trend has slightly reversed, with inflation moving from a low of 3.1% up to 3.5% over the last five months. Despite this uptick, the US Fed retained its easing bias and reduced the scope of its Quantitative Tightening program during its May meeting, helping solidify expectations around bond yields. A short covering rally followed thereafter, which all asset markets have enjoyed, lifting bonds and equities alike. From prior communications, the US Fed indicated its intent to cut rates, retaining an easing bias. However, the slight increase in inflation has complicated the process, delaying market expectations for rate cuts to later in the year.  While monetary policy is fighting the good fight against inflation with restrictive policy settings, US fiscal policy remains highly stimulatory, with public spending running at around ~6% of GDP.  Much of the economic growth in the US has been fueled by this large public sector spend, which has been exceptional against other jurisdictions and looks to continue in an election year. As a result, this continued fiscal stimulus could create some friction in achieving normalisation of inflation.   The RBA has found that recent surprises in our own inflation were predominantly due to education and insurance, which we think has heavy seasonal annual reset, and is unlikely to be repeated in following quarters. Calling the near-term inflation pathways remains difficult. Plenty of things can work sequentially against further progress in the near term, like a stimulatory federal budget, larger fair work outcomes on minimum wages, geopolitical flare ups driving energy prices higher or global shipping disruptions to name a few. On the other hand, there are reasons for optimism.  Oil prices are well off their highs despite recent geopolitical tensions involving Israel and Iran. Slowing economic activity has tempered discretionary spending, as evidenced by deeply negative retail sales. We've also seen declines or stabilisations in rent and used car prices. In the 10 years prior to COVID-19, Australia's average quarterly inflation rate was 0.52%. If we assume that the next few quarters are much higher at 0.8%, inflation could fall to 3.2% by the end of the third quarter, against the RBA estimate of 3.8% by year end.   These contrasting forces create a complex landscape for policymakers, and while there is room for inflation to fall below the RBA's forecasts, data dependency will continue to drive monetary policy decisions. The uncertainty surrounding these various factors suggests that flexibility and careful analysis will remain critical as the RBA navigates the path ahead. Author: Charlie Jamieson, Chief Investment Officer Funds operated by this manager: CC Jamieson Coote Bonds Active Bond Fund (Class A), CC Jamieson Coote Bonds Dynamic Alpha Fund, CC Jamieson Coote Bonds Global Bond Fund (Class A - Hedged)