How is innovative index construction supporting investment decisions in a shifting interest rate environment? S&P DJI’s Jessica Tan sits down with industry experts to share insights on how market participants can better navigate uncertainty and uncover new opportunities in fixed income through index-based strategies.
[TRANSCRIPT]
Kylie Merritt:
Hello, I'm Kylie Merritt. Welcome to our latest Markets Insights video. Today, we're diving into the evolving world of fixed income and exploring how innovative index construction is helping investment managers, advisors and investors navigate a changing interest rate environment.
Joining me today are Jessica Tan, Principal of Fixed Income Indices at S&P Dow Jones Indices, Marie Tsang, Fixed Income ETF Strategist APAC at State Street Investment Management, and Jacinta King Schlosser, Senior Business Development Manager of Investment Products at ASX. Thank you all for being here. Let's get started.
Jessica, can you start by giving us a quick overview of the current Australian fixed income landscape and how the S&P/ASX iBoxx Australian Fixed Interest Indices help market participants navigate it?
Jessica Tan:
The Australian fixed interest bond market has grown by 137% over the last decade, as measured by the notional of the S&P/ASX iBoxx Australian Fixed Interest 0+ Index. Government and state government bonds have significantly contributed to this growth, with their market share increasing from 71% to 81% since July 2015.
Additionally, the last 10 years have brought significant changes to Australian interest rates, mirroring trends observed globally, with the Reserve Bank of Australia's policy rate moving from a historic low of 0.1% to a high of 4.35%. This policy environment has translated into a wide spectrum of market yields, which have ranged from below 1% to over 5% during this period.
Now, how can this index series help? As market conditions fluctuate and economic uncertainties arise, the Australian fixed interest market remains an important source of stability and income generation for many market participants. The S&P/ASX iBoxx Australian Fixed Interest Index Series can serve as a tool for understanding this landscape, enabling market participants to make more informed decisions as they seek to effectively navigate the potential challenges and opportunities presented by the evolving fixed interest environment in Australia.
Kylie Merritt:
Okay, let's go to Marie. From a portfolio construction perspective, why is diversification across sectors and maturities so important in today's environment?
Marie Tsang:
So, as you know, Kylie, the fixed income market is driven by two key risk/return drivers, so interest rates and also credit on the other hand. When you are able to achieve a good balance between rates and credit exposures, then you can have a smoother investment journey, generally speaking.
So, when it comes to sectors, government bonds typically give you pure exposure to interest rate exposures. On the other hand, corporates will give you an exposure to a mix of interest rate and also credit risk as well. Australian corporates, however, are a little bit different from their global counterparts. The interest rate exposure tends to be a little bit lower. So, all else being equal, it means that credit is potentially a stronger driver in proportion to rates.
And, why is this important? Because when you have sector diversification between your government and corporate exposures, it does enhance your risk-adjusted returns.
You also mentioned about maturity. So, we also want to see a good spread of different maturities in our bonds. So, when you think about the shorter-term maturity bonds, they will be quite liquid. They tend to have less interest rate exposure, while the longer-maturity bonds provide that level of defensiveness that investors are looking for in a portfolio.
Now, when we look at the Australian fixed income market, however, when it's on the basis of market value, you can see that there is a sort of imbalance within the sectors as well as maturities. For example, you look at the government, semi-government and sovereign sectors, they represent over 90% of the total market value.
Now, perhaps as a result of this, investors are making different choices about their allocation to fixed income. So, when you look across ETFs and managed funds, for every dollar that investors allocate to core Australian bonds, they're allocating about 67 cents to dedicated stand-alone credit exposures.
Kylie Merritt:
Jacinta, to you. What trends are the ASX seeing in fixed income products, particularly ETFs?
Jacinta King Schlosser:
Kylie, first I'll provide an overview of the fixed income products on ASX and then I'll talk about some of the trends. So, we've definitely seen an uptick or a distinct increase in the amount of fixed income products coming to the ASX over the last three years. In fact, 2023 was a record year. We had 15 new products come to the exchange and being admitted, and we've seen about 10 products per year since then.
In terms of value, the fixed income products make up, by market cap, around AUD 40 billion, just over AUD 40 billion, on the ASX, and that's across more than 100 products. Now, when I talk about fixed income products, I'm including ETFs, retail debt notes and LIVs, listed investment vehicles. Now, specifically, fixed income ETFs make up around 17% of this, so a sizable portion.
Now, looking at the trends, a key factor driving this trend is product issuers meeting investor demand. Marie and Jess touched on this, that when we saw interest rates starting to rise again in 2022, there was a renewed interest in what fixed income can add to your portfolio. So, for investors, we're providing an income without some of those risks that you might find in other ventures and, also, arguably, potentially better returns than holding cash or term deposits.
Now, by 2023, the fixed income providers were ready, and they started bringing those products to market, and our team at ASX has been quite busy, in particular this year. So, given the current regulatory framework, it's difficult for companies to issue bonds directly on ASX. And, also, with hybrids being phased out over the next several years, we've seen a resurgence in those listed investment vehicles and retail debt notes, this year in particular.
Naturally, you can trade Australian government bonds on ASX. However, in the ETF wrapper, in particular, the fixed income ETFs provide an ease of access, and they generally allow you to invest in a number of bonds. Rather than having to buy those each yourself, it's the convenience and an ease of trade at a good price.
Kylie Merritt:
Jessica, back to you. The S&P/ASX iBoxx Australian Fixed Interest Diversified 0+ Index takes a unique approach to weighting. Can you explain how this methodology works and why it matters in different rate environments?
Jessica Tan:
So, the S&P/ASX iBoxx Australian Fixed Interest Diversified 0+ Index is a diversified version of the standard S&P/ASX iBoxx Australian Fixed Interest 0+ Index. The index equal weights the following two issuer sectors, government-related sectors, which includes government, semi-government and sovereign, and under non-government-related sectors, it includes corporates and covered.
And, within the government-related sector, the index further divides into three maturity segments, 0-5, 5-10 and 10-plus years, each receiving equal weight. By limiting the weight of government-related sectors to 50%, the index reduces the concentration of government-related bonds and increases the weight in higher-yielding corporate bonds, which has historically resulted in a modest yield pickup from credit spreads.
In the absence of weight caps, the weight of the government, semi-government and sovereign bonds made up 13.61% of the S&P/ASX iBoxx Australian Fixed Interest 0+ Index by equal weighting the 0-5, 5-10 and 10-plus maturity buckets of the government, semi-government and sovereign bonds. A 16.67% weight is given to each bucket, and the impact of the interest rate fluctuations specific to any single maturity segment is minimized.
Equal weighting has historically led to more consistent performance over time as the performance of shorter and longer maturities balance each other out.
Kylie Merritt:
Marie, how are advisors using ETFs to access fixed income markets, and what role do ETFs play in portfolios?
Marie Tsang:
Advisors are increasingly using ETFs for their transparency, low cost and also liquidity. Just to illustrate on the cost effectiveness of ETF exposures, if you look across the asset classes, the median fee across ETFs is 0.45%, or 45 basis points. Meanwhile, the median fee for a managed fund is 0.95%, or 95 basis points. As Jacinta also highlighted, you do get access to a diversified portfolio generally speaking when you access a fixed income ETF. So, it is a very convenient access in a single trade for most investors.
And, in terms of core fixed income exposures, which we're talking about today, these can have that sort of defensive, risk mitigation role in broader portfolio construction. However, having said this, when you look at the fixed income universe more broadly, it is a very diverse set of exposures, and, therefore, advisors can certainly use different types of exposures beyond the core fixed income to build out their strategic asset allocations or, more tactically, express their views, whether it be on the interest rate cycle, credit conditions or broader macroeconomic trends.
Kylie Merritt:
Jacinta, with more than 80 fixed income ETFs now listed on Australian exchanges, how is the ASX supporting innovation and access in this space?
Jacinta King Schlosser:
We've streamlined our admission process over the last few years to make it more efficient, but without losing the compliance rigor and requirements. We have amended rule changes to broaden the scope of products that we can bring onto the exchange. We have also improved the ability for more market makers, which improves liquidity. And, our admission teams and post-admission team, which I'm a part of, we provide excellent support to issuers by way of resources, guidance and referrals to partners where required.
Kylie Merritt:
And, just looking at performance, how has the S&P/ASX iBoxx Australian Fixed Interest Diversified 0+ Index held up in volatile markets?
Jacinta King Schlosser:
Over the past decade, the S&P/ASX iBoxx Australian Fixed Interest Diversified 0+ Index has consistently outperformed annually regardless of policy rate changes as shown in the exhibit. Its equal-weighting strategy across sectors and maturities has led to stable gains, with government and non-government bonds balancing each other out.
During periods of rate cuts or stability, this index outperformed the S&P/ASX iBoxx Australian Fixed Interest 0+ Index thanks to higher allocations in corporate and covered bonds and longer-duration government bonds. This sensitivity to interest rate changes allowed it to benefit from rate cuts.
Back-tested performance history indicates that the index diversification is advantageous during downturns. In 2021 and 2022, when inflation rose and the Reserve Bank of Australia increased rates by 3%, the S&P/ASX iBoxx Australian Fixed Interest 0+ Index suffered losses of 2.91% and 9.69%, while the S&P/ASX iBoxx Australian Fixed Interest Diversified 0+ Index limited its losses to 2.37% and 9.59%, respectively, due to its balanced bond split.
In summary, the S&P/ASX iBoxx Australian Fixed Interest Diversified 0+ Index has shown resilience across various interest rate environments, consistently outperformed during stable periods and both rate hikes and cuts.
Kylie Merritt:
Okay, so Marie, what does this tell us about its potential role in portfolios?
Marie Tsang:
The S&P/ASX iBoxx Australian Fixed Interest Diversified 0+ Index has historically demonstrated better risk-adjusted returns than an ordinary Australian fixed income index. We have also shown the performance of Australian equities just for comparison purposes here.
And, while you can note that over many of the time horizons shown that Australian equities have delivered double-digit returns, it does so at significantly higher risk. So, for many investors, I'd say the take-away here from a portfolio construction perspective is that, if you do combine the fixed interest with your equity and other risk exposures, that it can potentially help you to build a better risk-adjusted portfolio.
Kylie Merritt:
Okay, a question to all of you. Education is clearly a big part of helping advisors and investors understand these evolving strategies. Can I ask what are each of your organizations doing to support education in fixed income? Jess, start with you.
Jessica Tan:
At S&P DJI, education is at the heart of what we do, from producing timely market insights and methodology content to hosting our Annual Indexing & ETF Masterclass, with all resources freely available at www.spglobal.com/spdji/australia, ensuring industry professionals have access to the knowledge they need to navigate this evolving landscape.
Kylie Merritt:
And Marie, what about at State Street?
Marie Tsang:
At State Street, we have a structured educational framework for clients and prospective clients as well. We provide information that's product-specific as well as market insights on a timely manner to potential investors so that they can build, select and implement their fixed income portfolios. Through these educational activities, we are aiming to serve a diverse range of investors, empowering informed decision-making.
Kylie Merritt:
And the ASX?
Jacinta King Schlosser:
At ASX, we run several programs throughout the year, so several educational programs, and they provide content to all areas of the market, so investors, advisors, brokers, students, and even those that are at the beginning stages of their investing. And, we do numerous things.
So, we have a newsletter, a monthly newsletter that goes to our subscriber investors and also advisors. Within that, we run a webcast series. We also have a podcast called The Ideas Exchange. And, we also have some signature in-person and live events. So, the ASX Investor Day that we run in May and November each year, and also the Advisor Day that we run in June. And, we regularly invite some of our portfolio managers, investment specialists and economists to present. Sometimes, we'll put them in the hot seat and interview them, or they'll present for us.
And, Marie is a regular contributor, so thank you, Marie. She's done a lot with us over the last year and a half, and you can catch some of her recordings on our on-demand content on our website. So, the fixed income ETFs are featured throughout the year, and you can learn more that way.
Kylie Merritt:
Alright, thank you all so much for joining us.
