Investors soon need to find alternatives for hybrids after regulators announced plans to phase them out. But not all substitutes may be suitable, argues Pendal’s head of income strategies AMY XIE PATRICK in a new fast podcast

You can also listen to this podcast on Apple or Spotify

An excerpt from this podcast

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Amy Xie Patrick, Pendal’s head of income strategies:

For years, Australian investors flocked to bank hybrid securities as a cornerstone of income-generating portfolios.

Hybrids — debt instruments issued by banks that can convert to equity in times of trouble — have been popular with everyday investors due to their accessibility.

But investors will soon need to find alternatives, after regulators announced plans to phase them out from 2027.

In her latest podcast, Pendal’s head of income strategies Amy Xie Partick explains the options for investors.

Retail investors are likely to look for substitutes in term deposits and equities – though neither are a like-for-like solution, says Amy.

TDs reduce liquidity and may not be a long-term solution as rates come down.

Equities with a dividend and franking credits can replace income – but they come with increased portfolio volatility compared to hybrids

Amy argues that an actively-managed fixed-income portfolio can be a better solution.

As an investor, Amy blends high-quality investment grade bonds for income, equities to help capital grow and government bonds to manage the portfolio through the rates cycle.

“We try to bridge that gap between what the investor wants and what is currently available.”

In its latest impact report, sustainable investor Regnan reviews the key drivers influencing its decisions and outlines its portfolio, engagement and voting activity

• Generative AI a “critical enabler and accelerator” of change
• Increased exposure to Circular Economy and Education sectors
• Find out about Regnan Global Equity Impact Solutions Fund
• Download Regnan’s 2023 Annual Impact Report

GENERATIVE AI technology has heavily influenced markets over the past year — especially in the US tech sector.

But the technology — made famous by OpenAI’s ChatGPT — is also driving innovation among companies focused on solving problems in the ESG space, says Regnan’s senior fund manager Tim Crockford.

“We are already using it to become more efficient and it has been encouraging to see how quickly some of the portfolio companies have been to integrate this powerful tool, says Tim, who oversees Regnan Global Equity Impact Solutions Fund.

Regnan Global Equity Impact Solutions fund invests in mission-driven businesses that provide solutions to the environmental and social challenges of our time.

The fund aims to deliver market-beating, long-term returns, by identifying “system changers” that innovate, disrupt and ultimately produce positive environmental, social and financial outcomes.

“It is fair to say that generative AI will be a critical enabler and accelerator for some of the system change that the transition to a more sustainable world has already embarked on,” says Crockford.

The team’s latest impact report – which covers the calendar 2023 year – lists a range of AI-related innovations that have been rolled-out by companies in the portfolio.

Some examples include:

• Qiagen, one of the leading molecular diagnostics innovators, is using gen AI in its bioinformatics platform to help accelerate drug discovery, by identifying molecular targets
• Sartorius, a global leader in bioprocess solutions, is partnering with NVIDIA, to create organoids – 3D structures created from stem cells – that could replace traditional animal models in drug discovery
• Agilent, the life science tools maker helping customers increase the efficiency of their research labs, has used generative AI to improve quality control and reduce production defects by 49%
• Ansys, one of the world’s leading software simulation innovator, has released SimAI, which can boost the efficiency of generative AI models by 10 to 100 times during the design phase
• Xylem, the water treatment and technology innovator, has partnered with software company Esri, to build a model that predicts pipe leakage, which has reduced pipe failures four-fold.

Find more examples and greater detail in the report:

While there’s little chance of a rate cut before February, Pendal’s head of government bond strategies TIM HEXT sees some value in bonds today. He explains in our latest fast podcast

You can also listen to this podcast on Apple or Spotify

An excerpt from this interview with Pendal’s head of government bond strategies Tim Hext:

This week’s Aussie inflation data was a mixed bag. While the headline number dropped into the RBA’s target range at 2.8%, the trimmed measure remained above target at 3.5%.

It will take a few more quarters until the more important trimmed measure heads down towards 3%, says Pendal’s head of government bonds Tim Hext in a new fast podcast.

“The news which will make the RBA less than enthusiastic about cutting rates in the very near term is that services inflation remains quite elevated at around 4.5%,”Tim says.

“Services make up around two thirds of the CPI basket, and that’s where things like tight labour markets, housing shortages, all those domestic issues are keeping inflation more elevated than the RBA would like.”

Tim doesn’t expect a rates move before the RBA’s February meeting. “There won’t be enough information by December. The market is 50-50 on whether they’ll cut rates in February.”

For bond investors Tim sees value in some areas after the recent sell-off.

In the podcast, Tim also covers the impact of next week’s US election and war in the Middle East.

Listen to the full podcast above

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

Asset managers who engage with investee companies achieve better outcomes for investors and the community, argues Regnan’s Laura Sheehan

• Engagement with management is crucial to impact investing
• No one-size-fits-all approach when consulting with a company
• Find out about Regnan Global Equity Impact Solutions Fund

IT’S NO surprise that corporate engagement and shareholder action have become one of the most common responsible investment approaches in Australia.

Engagement generally refers to the process of asset managers “engaging” directly with investee companies and bond issuers to influence corporate behaviour and achieve better outcomes for investors and the community.

It comes under the umbrella of “stewardship” which also includes active ownership (voting), collaboration and policy and advocacy, according to the Responsible Investment Association of Australasia.

More than half (51%) of investment managers and asset owners surveyed in Australia and New Zealand had a adopted a stewardship code by 2021, RIAA reports.

Engagement is a critical component of the investment process for sustainable investor Regnan – and senir analyst Laura Sheehan sees it as an essential tool for driving positive change.

“There’s many ways to invest, and the right or wrong of that isn’t binary,” Sheehan says.

“But you can’t be something you’re not. So for me, it’s important to understand and agree with an investment approach.”

“We need to be able to identify companies that are willing to engage with us,” she says.

“Typically, companies are happy to engage when you bring something, rather than a spoiler plate, to the table.”

Sheehan cautions against a one-size-fits-all approach when it comes to engagement.

“Some high-growth companies may need more breathing room to execute their plans,” she says.

Engagement is a two-way relationship, and the key is to have a deep understanding of the business and the in which a company operates in. That ensures better engagement between investor and management.

“If you’re asking for things that are just not even realistic, or things that show you don’t understand the business, I think that’s going to impact your influence and the willingness of management to engage more broadly.”

Engagement in the resources sector

Sheehan’s experience in the energy sector has given her a unique perspective on the value of informed engagement.

“One frustration for me covering oil and gas was when people have a superficial understanding of energy systems and energy infrastructure and the lifecycle of investments, even the difference between energy and electricity.

“They start engaging but not in a very impactful way, because they might be asking for actions that don’t make sense or could never be achieved.”

At Regnan, Sheehan and her colleagues take a more nuanced approach, seeking to understand the company’s position within the broader system and how that system is evolving.

“It’s about understanding where the company sits within the context of the value chain and the system that it’s in. And it’s about understanding how the system itself is changing and how it needs to change,” she says.

As the newest member of the Regnan Global Equity Impact Solutions team, Sheehan says Regnan’s investment philosophy aligns with her own, with a focus on long-term investment horizons and searching for mission-driven companies delivering impactful solutions  to address social and environmental challenges.

“I think that’s an incredibly motivating universe to go fishing in,” she says, adding that working with people you like is also critical to success.

“I met with each person individually, and I think it was very clear for me that it would be a team of people I would be able to get along with and enjoy working with,” she says.

As Sheehan embarks on her journey with Regnan, her commitment to impact investing and meaningful engagement is clear.

She highlights the significance of the proprietary Regnan Taxonomy, explaining “It gives you the guard rails you’re looking for and the mission you’re trying to achieve, which ultimately is what you need to be doing when you’re investing for the long term.

Exclusion of fossil fuels presents minimal challenges for sustainable bonds compared to other asset classes, writes Pendal head of credit and sustainable strategies, GEORGE BISHAY  

• Sustainable portfolios across asset classes have generally excluded exposure to fossil fuels. This means some asset classes may face additional benchmark-relative risk by adopting sustainable strategies.
• There is a perception that all asset classes face these potential performance risks when prioritising sustainability. But Pendal demonstrates there is minimal impact on the performance of sustainable, active, fixed income in Australia compared to other asset classes when fossil fuel prices rise and fall.  
• Unlike some other asset classes, a sustainable approach to Australian fixed income adds minimal, if any tracking error when screening out fossil fuel exposure
• Find out more about Pendal Sustainable Australian Fixed Interest Fund

SUSTAINABLE funds typically screen out industries such as fossil fuels, tobacco, weapons, alcohol, gaming, pornography and uranium mining.

This is generally with a revenue threshold, where companies with a certain level of revenue linked to a particular activity are screened out.  

Different asset classes have different potential exposures to fossil fuels.

Fossil fuel companies typically make up a large part of equities indices (about 15 per cent of the ASX 300 in July 2024).

By contrast, issuers involved in fossil fuel extraction, exploration or refining are a small component of the Australian fixed-income benchmark.

Chart 1 below shows these issuers make up only about 0.1 per cent of the Australian fixed income benchmark, according to the rules applied to Pendal Sustainable Australian Fixed Interest Fund (see Chart 1 footnote below).

However, there can be variations in the exclusions of different funds.

For example, in Australian equities a fund’s revenue threshold can dictate whether a company such as BHP (at about 9% weight in the ASX300 index) is included or not.

BHP’s revenue includes coal mining. Other iron ore miners such as Fortescue Metals and Rio Tinto are not typically excluded.

Notwithstanding these variations in exclusions, active performance in the average sustainable equity fund is influenced by changes in oil prices.  

As a result of these differing levels of benchmark exposure, sustainable fixed-income portfolios in Australia are less sensitive to the movements in oil prices than equity counterparts.  

What drives the active performance of Pendal Sustainable Fixed Interest Fund?

Active credit management is the main driver of excess returns in Pendal Sustainable Australian Fixed Interest Fund.

The green circles in the chart below highlight periods when the manager’s active de-risking and re-risking of its credit exposures process led to strong outperformance.  

These returns are driven by active management and are delivered despite rising oil markets.

The black circle highlights a period of rising inflation concerns due to Covid supply chain issues driving goods inflation and central bank hiking fears.

This led to a risk-off event in credit markets which saw most active fixed-income funds underperform the benchmark. 

 

Given the volatility of oil markets, Pendal Sustainable Australian Fixed Interest Fund has delivered consistent returns, outperforming its benchmark in 75%¹ of months since inception to July 2024.   

The chart below illustrates the number of excess return months under different buckets of excess returns.

Social and environmental benefit + portfolio diversification benefit

Many sustainable fixed-income investors are attracted to ESG-labelled bonds which aim to address green, social and sustainability issues.

The proceeds of these bonds are usually ring-fenced for specific environmental or social projects to support climate stability and/or the underserved in society.

The Australian ESG labelled fixed-income market was valued at some $A124 billion in August 2024, constituting 7.6% of the total Australian fixed-income benchmark.

The ESG-labelled bond market offers sustainable Australian fixed interest managers exposure to an additional opportunity set beyond traditional fixed income – environmental and social projects across varying sectors, credit qualities and tenors.

These labelled bonds can complement an overall fixed-income portfolio, bringing added diversification benefits.

The credit spread on these bonds may not directly follow the credit spread on an equivalent vanilla bond issued by the same issuer. This arises from the different technical supply and demand factors affecting these types of bonds.

These bonds are desirable and often in greater demand than vanilla counterpart bonds.

The Australian fixed interest market has ESG labelled bonds in 13 of its 14 sub-sectors (transport is the only missing sector), providing investors with the ability to diversify across numerous sectors.

In August 2024, the Pendal Sustainable Australian Fixed Interest fund held more than 66% in ESG-labelled securities.

Sustainable fixed income as part of your core fixed income allocation

Unlike sustainable equities, which may underperform during periods of rising oil prices, Australian sustainable fixed-income exhibits minimal sensitivity to oil markets or any other screened activities.

This differentiation allows investors to integrate sustainable fixed income into their overall core fixed interest allocation with minimal additional benchmark risk.   

By incorporating Australian sustainable fixed income alongside other traditional assets, investors can achieve a robust portfolio while also supporting climate stability and/or the underserved in society.

¹ Pendal Sustainable Australian Fixed Interest outperformed the Bloomberg AusBond Composite 0+yr in 72 of 96 months from inception (Aug-16) to July 2024, gross of fees.    

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Find out more

Pendal Sustainable Australian Fixed Interest Fund is an Australian bond fund that aims to outperform its benchmark while also seeking investments in securities that target environmental and social outcomes.

The Fund is designed for investors who want income, diversification across a broad range of fixed income securities and are prepared to accept some variability of returns.

It is one of the few sustainable fixed-income offerings in the Australian market.

The fund is managed by Pendal’s head of credit and sustainable strategies, George Bishay. George holds a wealth of experience in portfolio management and credit analysis.

With over three decades working in financial markets, he has worked across numerous fixed income, credit and money market portfolios in portfolio management, credit analysis and dealing roles. He has managed dedicated sustainable fixed-interest portfolios for more than 15 years.

 

What does a potential August RBA rate hike mean for Australian fixed-income investors? Pendal’s head of government bond strategies TIM HEXT explains in this fast podcast

You can also listen to this podcast on Apple or Spotify

An excerpt from this interview with Pendal’s head of government bond strategies Tim Hext:

Australia appears to be at different stage of the rate cycle compared to international peers – a “lagging cycle compared to the rest of the world”, as Pendal’s Tim Hext puts it.

“Globally, people are looking at very high interest rates and going: ‘We just don’t need them anymore.’

“In Australia though, inflation’s proven to be quite sticky around 4% in the last couple of quarters. The RBA’s patience is being tested.”

August is a live meeting in terms of potential rate changes – and next week’s CPI figures will be key to the decision, Tim says in a new fast podcast.

A higher-than-expected number could prompt a hike. A lower-than-expected number would mean rates stay where they are.

However, if an August rate hike eventuates, investors should largely ignore it, Tim says.

“I think they will be cutting rates early next year. Whether they hike in early August or not, I think the environment will be far friendly for inflation. “

Tim explains why in the podcast.

Listen to the full podcast above

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

It’s a promising time for fixed-income investors, but investors should be aware of potential risks around rates, inflation and a Trump presidency. Pendal’s GEORGE BISHAY explains

• Rate cuts still likely due to falling inflation, not recession fears
• Active credit management important
• Find out about Regnan Credit Impact Trust
• Find out about Pendal Sustainable Australian Fixed Interest fund

THE services side of the economy – particularly wages and rental inflation – have held up prices in recent times.

But forward indicators monitored by Pendal’s income and fixed interest team show the drivers of these two factors weakening.

That means inflation in developed markets should continue to fall, allowing central banks globally to start cutting rates, argues Pendal’s head of credit and sustainable strategies, George Bishay.

“That means central banks globally can start cutting rates,” he says.

“My view is that central banks will cut rates because inflation is coming down — not because we are going into recession.”

It’s an important distinction, because when an economy goes into recession, bonds usually perform well, while credit and equity markets can underperform.

“If inflation is falls, that’s a bullish environment for bonds as central banks will cut cash rates and interest rates in general should come down.

“This is also bullish for credit and equity markets.”

What a Trump White House means

The key risks to this view is if oil prices rise or if Donald Trump beats presumptive Democratic nominee Kamala Harris in the US presidential election later in the year, Bishay says.

“If Trump wins the election, will he have the ability to change policy? Will he have a majority in both houses of Congress? 

“If he does, then that’s problematic for bonds because ultimately that’s likely to be inflationary,” Bishay says, nominating tax, immigration and trade as key areas of policy to watch.

The impact of a Trump Presidency is more skewed towards longer-term bonds because his policies would likely have a medium-term impact on inflation, he says.

“The short end continues to perform because central banks will be easing rates as current inflation comes down.”

Active management remains important for fixed income

With so much uncertainty in the market, active management of credit portfolios is critical.

“Most credit managers in Australia are buy-and-hold managers. In periods such as Covid, performance of those strategies can get hammered before eventually recovering.

“Volatility of their returns can be quite high.

“We prefer to actively de-risk and re-risk our credit exposures, based on a top-down process.

“If we have concerns about the macro environment, we will reduce risk across the board on credit exposures. That tends to support outperformance because it minimises downside risk.

“When we have more confidence in the market, we re-risk and participate in the upside benefit.”

The three main pillars of Pendal’s top-down process are a qualitative view, quantitative models and technical analysis.

“When the three pillars line up, we de-risk or re-risk the portfolios and that’s been incredibly powerful.”

Investors have been getting used to good news on inflation. But does the latest data suggest we’re getting ahead of ourselves? Pendal’s head of bond strategies TIM HEXT reviews the evidence

You can also listen to this podcast on Apple or Spotify

An excerpt from this interview with Pendal’s head of government bond strategies Tim Hext:

Is there still opportunity in government bonds, despite US inflation data surprised to the upside?

“People like myself are paid to worry about weekly fluctuations, but I think for investors the trend is still in place,” says Pendal portfolio manager Tim Hext.

“We have higher interest rates than we need given the inflation backdrop now, as opposed to 12 months ago.

“Central banks have recognised that and will deliver on cuts.

“People like me are paid to delve into how many and when. But the theme is still lower rates in the US across the year, and Australia will likely follow towards the back after the year.

“Cash rates in Australia are 4.35%. We think you’ll see them towards 3.6% by the end of this year, possibly a little bit lower into 2025.

“If you think about term deposits, you’re going to face an environment where getting in the high 4s and even in some cases low 5s won’t be there in the second half of the year.

“You’ll start to see more in the low 4s and possibly high 3s.

“When you look at bonds at this point in time – depending on whether you buy a government bond, a state government bond, or a bank bond – you’re still getting 4 point-something or 5 point-something as your yield.

“That’s going to out-do term deposits in the medium term. “So there is a bit of juice left.”

Listen to the full podcast above

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

Reckon you’ve got 2024 figured out? Stay on your toes, because markets could go in any direction this year. Pendal’s head of income strategies AMY XIE PATRICK explains her thinking in our latest podcast

You can also listen to this podcast on Apple or Spotify

An excerpt from this podcast

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Amy Xie Patrick, Pendal’s head of income strategies:

At the start of 2023, the investment base case was a US recession, an inverting yield curve and an end to the inflation fight.

There was optimism about China reopening after the end of zero-Covid restriction policies.

Now, at the beginning of 2024, it couldn’t be more different, says Pendal’s head of income strategies Amy Xie Patrick in our new podcast.

Recession is now nobody’s base case, says Amy. China is the last place people are optimistic about in their world views.

It’s all evidence that investors will need many levers to pull when navigating this cycle, she says.

“Risk number one is that a soft-landing narrative led by the US economic story may not end up being the case,” says Amy.

“The biggest risk is always what’s outside of consensus. It’s not to say that consensus can’t happen, but if the consensus is the case, markets tend to be priced for it. “

Another risk is markets pricing in six Fed cuts, despite data showing resilient growth.

In her new podcast, Amy explains how she is preparing for risks – and opportunities – the market may not be considering.

With interest rates peaking, and depressed valuations, small and mid-cap stocks could be poised to outperform, argues Regnan’s TIM CROCKFORD

• Small, mid cap valuations depressed
• Europe, Japan, Indonesia, Brazil best opportunities
• Find out about Regnan Global Equity Impact Solutions Fund

VALUATIONS of smaller and mid-cap stocks have reached an extreme level in some parts of the world, believes Regnan portfolio manager Tim Crockford.

Global equities investors should be starting to consider allocating to smaller and mid-cap stocks or “SMIDs”, Crockford, who leads the equity impact solutions team at Regnan.

“People have taken money out of equities and much of that has gone from passive investments and systematic strategies, points out Crockford.

“So the $1 billion and $3 billion companies are disproportionately affected compared to the $100 billion or $300 billion company,” he says.

“Our macro view is that it’s going to get worse before it gets better. But financial conditions are likely to start loosening on account of the market speculating that we’ve seen peak rates.

“What the macro environment does is remove a major headwind SMIDs have faced for three years and gives them a bit of a tailwind going into next year, albeit with elevated volatility initially.

“That’s because when liquidity comes back into the market, we should get the opposite effect of what started when financial conditions started to tighten in 2021.

“We expect that to close the relative valuation gap.”

Where to look for SMIDs

There are tens of thousands of “SMIDs” stocks in developed and emerging markets.

So where to look?

Start by looking outside the United States, says Crockford.

“In terms of developed markets, Europe and Japan offers opportunities.

“In terms of emerging markets, it’s places like Indonesia and Brazil.

“In those economies, valuations are still very attractive given where they are in the cycle. There is clear opportunity there.

“We are still looking at interesting companies in the US — and perhaps some companies there will make their way into our portfolio at some point.

“But on a stock-specific basis, the ones we like are still trading on valuations that are a bit less forgiving if we do go into an economic downturn in 2024.”

Look for growth

Beyond geography, Crockford’s team is looking for companies that will show growth over the next 12 months — or where a valuation is so depressed it’s priced for a highly negative drop in growth in 2024.

“We are looking for companies that are able to generate organic cash flows to fund at least part of their growth.

“And the remainder of the funding needs to be covered by debt that isn’t going to burden, or reverse, the positive effects of potential future cash flow growth.”

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About Tim Crockford

Tim Crockford leads Regnan’s Equity Impact Solutions team and is senior fund manager of Regnan Global Equity Impact Solutions Fund. Tim previously managed the Hermes Impact Opportunities Equity Fund after co-founding the Hermes impact team in 2016.