Paid on both sides: Yarra’s Darren Langer on yield, home bias and why bonds are defensive again

With 10-year government bond yields above 5 per cent and credit spreads near their long-run average, Yarra Capital Management’s Darren Langer argues that fixed income once again does the job investors buy it for. But, he says, active managers beat the index by knowing where on the curve investors earn their pay.

Langer, the firm’s co-head of Australian fixed income, describes the current fixed income market as the “most balanced” he has seen in a long time. The market pays investors for both interest rate risk and credit risk at once. Ask him how long that balance will last, though, and he steers the conversation back to what matters most.

“Ultimately, fixed income markets are about yield,” he says. “So, while yields remain at reasonable levels, the balance between credit spreads and rates is a secondary issue.”

That doesn’t mean the mix is fixed. Inflation, growth and competition for funding all shift the relative value of each part of a bond’s yield.

Langer sees that competition intensifying. Government debt keeps growing. AI hyper-scalers keep borrowing massive amounts of money to fund an unprecedented infrastructure and data-centre buildout. If inflation stays elevated, yields are likely to stay higher than in recent years, and spreads could widen, too.

The usual pattern follows the economic cycle: lower rates and wider spreads in recessions, higher rates and tighter spreads when growth is strong. “It’s this sway from one to the other that makes active management essential,” Langer says.

The case for staying home

For advisers deciding how much fixed income to hold onshore, Langer makes a firm case for Australia. The country holds a AAA rating. Its government debt runs at around 50 per cent of GDP. Its budget position is stronger than that of many Western nations.

The global benchmark looks very different. Countries running persistent deficits carry debt above 100 per cent of GDP. Together, they make up roughly 70 per cent of the Global Aggregate Index. An investor tracking that index therefore holds heavy exposure to deeply indebted governments.

“It may not mean we are heading for sovereign defaults,” Langer says, “but on balance these heavily indebted nations should ultimately pay a higher premium for funds.”

He doesn’t dismiss global bonds. They still offer diversification across economies, policy cycles and issuers. He won’t put a number on the split. That depends on the client, he says, and an active manager can move where the risk-reward trade-off is best.

But he sees a broader benefit in the home market. “At a time when global affairs are more uncertain than for many decades, the more stable political and economic domestic environment should insulate investors from some of that uncertainty.”

Where the curve stops paying

Langer has argued that long-dated credit isn’t paying investors enough for the risk. The detail sits in how spreads behave along the yield curve.

The relative-value shift begins beyond about five years. By around eight years, semi-government bonds offer a bigger spread pick-up than corporate credit. Yarra therefore favours semi-government bonds from five to 15 years, where spreads over Commonwealth government bonds remain attractive.

But further out, that advantage narrows, and by 15 to 30 years the spread pickup per year turns negative. At that end of the curve Langer prefers Commonwealth bonds, where the yield is attractive even without any additional spread.

Put simply, a little extra spread at long maturities doesn’t make up for the much greater price volatility that comes with it. Investors wanting longer duration can get it more cleanly and with better liquidity through government paper. That route avoids corporate downgrade and event risk.

RMBS: a structure, not a housing bet

At a time of negative headlines about Australian housing, Langer is firm on residential mortgage-backed securities. “AAA-rated RMBS in Australia are as close to risk-free as a credit-risky asset can be,” he says. “This has more to do with the structure of the securities than with housing itself.”

He describes RMBS structures as mini-banks, with each tranche a “layer of capital.” Every tranche below AAA absorbs losses before the AAA holders lose any income or capital.

The AAA tranche also has a high degree of subordination, which is well paid-for by the spread. And the bonds repay capital over time as borrowers pay down the underlying mortgages. The highest-ranking tranche receives repayments first. That steadily reduces credit exposure compared with a bond that repays only at maturity.

House prices have risen sharply since COVID. Langer says even a 10 per cent–20 per cent fall from current levels is unlikely to affect any part of the capital structure. The bigger risk to housing is unemployment, which can force owners to sell and deepen price falls.

Yarra judges RMBS against bank bonds, since Australian banks are heavily exposed to housing as well. RMBS usually pay a higher spread and carry higher credit ratings.

Owning the best parts of each sector

Langer describes the Yarra Australian Bond Fund’s current positioning as “owning the best parts” of the sectors. In practice, that means the fund favours:

• ‘short’ credit (that is, less than five years);
• ‘mid to long’ semis (long-term semi-government bonds issued by Australian state and territory Treasury corporations with extended maturity horizons (from 10 to 15 years);
• ‘mid maturity’ SSAs, which are high-quality debt securities that Sovereigns, Supranationals and Agencies (SSAs) issue and that mature in the medium-term portion (the “belly”) of the yield curve, typically between five and seven years; and
• Long to ultra-long Australian commonwealth government bonds (ACGBs), with maturities from 12 to 30 years) .

In credit, he says the best yield pick-up at the moment exists in the one- to three-year portion of the yield curve, while in the semi-government sector, that sweet spot is in the 12-to-15-year area.

The duration call, and what could break it

Yarra has been running an overweight duration position on the view that the RBA may need to cut sooner than the market expects. The reasoning is that the RBA has raised rates in an environment where financial conditions were already tightening, which raises the risk of a sharp fall in growth.

The war in the Middle East has complicated that view. The longer it goes on, the harder it becomes for the RBA to cut to support growth while oil and commodity prices keep inflation concerns high. “We continue to think growth will disappoint,” Langer says, “but this view is predicated on a less-prolonged disruption to oil and trade than the market is implying.”

He names two developments that would overturn his view that rates must fall over the next 12–18 months. The first is stronger growth; the second is inflation accelerating sharply. “Inflation is currently high, but it is not accelerating rapidly,” he says. If it did, and expectations became unanchored, “lower rates would become highly unlikely.”

Defensive again

Langer’s strongest view is on the role fixed income plays in a portfolio. He rejects the contention, popular since 2021–22, that bonds are no longer defensive.

“A single, highly unusual period is not a reason to ignore an asset class that has performed its role in portfolios under most circumstances,” he says. Instead, the lesson of 2021–22 was the limits of any asset class in extreme conditions.

What made bonds defensive was always their income. “In 2021–22, rates were at or close to zero and credit spreads were also very low, so income was negligible and the level of protection was correspondingly limited.”

Today, 10-year government bond yields are above 5 per cent and above their 20-year average, and spreads are close to their long-run average. Fixed income, he concludes, is more likely to behave as expected.

He is also careful not to oversell it. “Too much is often expected of fixed income,” he says. It won’t fully protect investors from a large drawdown, but it can soften losses while providing income. For advisers whose clients have treated bonds as a place to park money between decisions, that may be the most useful message.