Fidante recently hosted a Q&A panel of their fixed income asset managers, which included Teiki Benveniste from Ares Australia Management, Alex Stanley from Ardea Investment Management, Victor Rodriguez from CIP Asset Management and Daniel Siluk from Kapstream.
The four asset managers provide an outstanding insight into their thinking regarding current markets, inflation, interest rates the geopolitical situation and how they are applying that thinking in portfolio construction. Towards the end of the article, they discuss current opportunities.
There is a glossary at the end of the article.
We’ve seen the relationship between bonds and equities continue to evolve from a correlation perspective. What role do you see your portfolio playing in the current environment?
Markets evolve and of course correlations between different asset classes evolve. But I still believe that bonds do provide a diversification benefit in a broader portfolio. But the important thing is to decide, which type of bonds you want. Because if you just went with an index and for example, the Australian Bloomberg AusBond Index, it’s about 90% government and government related securities, and it has about six years duration.
In a rising rate environment, that’s not necessarily going to be one which protects you in an environment where risk assets are selling off. What we’re looking to do is produce a portfolio that is diversified with a low or uncorrelated position compared to traditional index type strategies. I do believe that the correlation benefits are there. It’s just the way you structure the portfolio.
I think that there’s some benefits of diversification for bonds. Apart from correlation, bonds also offer volatility and liquidity benefits within a portfolio. But in terms of the duration environment and what are the drivers of some of the cross asset volatility that we’ve seen recently, a lot of that has been expectations of higher interest rates and inflation. The way we think of about things is to not take that duration risk and to focus on a source of alpha. That’s not correlated with that duration, that’s also not correlated with the riskier aspects in the portfolio.
Can you comment on how investors can earn an increased yield by holding less liquid assets and how that fits into the overall fixed income bucket?
The illiquidity premium essentially is the extra margin you earn for the same level of credit risk, for a less liquid investment. A good example is the difference between public and private loan markets.
First, when you invest in a public market investment, someone else has already manufactured and originated that loan or that bond. The bank has underwritten and syndicated the deal. A credit rating agency has rated the deal and so forth. And then you are a price taker and a term taker. Whereas in private lending markets, we’re manufacturing the deal. We’re finding the borrower, we’re originating, we’re negotiating terms and conditions and so forth. And then we literally earn an upfront fee that we then sit down, pass on in its entirety to our underlying clients, and forms part of that additional return.
The second point is that it’s a much less competitive market, particularly in the Australian marketplace, at least. Compared to the public market where you need to raise a certain amount for a borrower who’s prepared to pay the lowest margin. And then the borrower hits that in private markets. We often do bilateral deals where we might be in competition with one other lender in the Australian marketplace. That lack of competition also helps explain why that additional return is available in less liquid private debt.
The global perspective is slightly different. I mean, I agree with most of what Victor is saying. I think globally, I would say that you have part of the illiquid market that is actually not giving you a yield premium because you’re talking about club deals where there’s a lot of competition right now in terms of capital. You don’t want to be playing that part of the direct lending space.
Where we want to play in direct lending and where we are able to generate yield over the years, is in the U.S. since 2004 and in Europe since 2009, where we’re able to generate consistent yield premium above liquid markets in the range of 150 to 250 basis points by providing what we call control direct lending, where we are the sole lender or the control lender. As Victor said, where we are not being put in competition necessarily with others, in terms of the pricing. We do the docs, and so we get the origination fees and the yield premium.
With that in mind, when you talk about control direct lending, you need a very large platform to do that. We have about 180 people just focused on originating loans globally. That’s one thing. The other thing is because you have a book of loans where you’re effectively the sole lender or the control lender, it’s very exclusive. You don’t have a lot of other managers being able to provide the same book of loans. The third benefit I think, is with control comes better downside protection, because you’re one on one with the company, you talk to the management of the company, you talk to the owners of the company, you have a seat at the table. If something starts to look a bit difficult, you can intervene pretty quickly.
That’s the benefit of the downside protection that’s coming with this scale. And if something actually goes wrong, if we do make a mistake, we have a team of people ready to jump in and work out the situation. You look at the yield, we’ve been providing over many, many cycles, but also the very small level of defaults and losses across many cycles. I think that’s what really is appealing for people.
What are some of the characteristics of the Real Outcome Fund strategy Alex?
The strategy isn’t a conventional duration risk, which at the moment is a more challenging environment. It’s a globally focused fund. We’re not just limited to Australia. We target relative value opportunities in global government bond markets and closely related derivative markets. It’s a source of alpha really that’s non correlated with other types of assets. Another feature of the real outcome strategy is an explicit inflation beta. Part of the portfolio does get allocated to inflation linked securities in Australia.
It does provide that benefit in a rising inflation environment. But I think the other thing that’s also really important is volatility control. We have an explicit 2% target in terms of our volatility budget. That allows us to have a low performance volatility through extreme periods. The final point that I would add is that the strategy is also daily liquid as well, because it’s invested only in the highest liquidity securities.
What role can credit play as a diversifier?
I think the role of credit is that carry trade and also diversification. It’s about yield and diversification. At the moment when you are looking across the asset classes that we manage in credit from liquid to illiquid, the yields range from 5% to 8%. Within that range, you also have asset classes with very little interest rate duration. You have asset classes with a broad range of industries which helps, at a portfolio level, diversify from what you already have in your traditional fixed income and in equity. You look at the range of investments and there is almost no interest rate duration, no exposure to Australian banks, no exposure to RMBS, no exposure to all the things you normally get exposure to in income strategies or an Australian portfolio.
Within the current environment, how can investors earn an attractive yield and or return while still protecting their portfolio?
In terms of opportunities right now, I’ll focus on the relative value between public and more liquid markets and private debt markets. Twelve months ago, we were pretty much at our maximum allocation to private debt. The illiquidity premium was pretty much at its widest.
That illiquidity premium is still attractive, but not as attractive as it was in 12 months ago, even six months ago. We’re starting to make a shift more towards public markets. Not in an aggressive way, because we haven’t seen, for example, any forced redemptions out of funds yet. We haven’t really seen the whites of the eyes in terms of the marketplace, but that’s what we are mindful of as we sort of look at relative value.
The opportunity set always exists. It doesn’t really matter on the economic environment. As Victor said, there are opportunities in public markets because spreads have widened significantly. Those opportunities vary by geography and by jurisdiction. One of the opportunities we’re seeing at the moment is foreign issuers coming to the Australian dollar market because their local curves or their local spread curves have widened so significantly to the extent that they’re in need of that funding.
We can be fairly aggressive with our pricing. The other opportunity is given our size, is that you want to be a liquidity provider in times of stress. Unfortunately, as a result of the global financial crises, there’s been more regulation put on the banking system. The banking system is a lot stronger today than it was pre-crisis. Banks are certainly part of the solution rather than part of the problem in terms of the post COVID recovery. But the point is that those investment banks don’t have the balance sheets or don’t have the resources to bid on assets in times of stress. To the extent that we can become a liquidity provider, and we’ve always maintained a certain element or allocation of the portfolio to very liquid securities like government and government like assets, which we can quickly turn into opportunities to buy credit and be that liquidity provider. Opportunities certainly exist.
Excellent. That does actually conclude that portfolio construction part of the symposium. We’ll now move on to the Q&A section. Obviously, each of the managers do manage different fixed income assets and different portfolios and have different objectives and risk budgets, but over the next 12 to 18 months, what type of yield or return could investors expect?
All right. As I’ve done so far, I think I’ll split the answer into liquid markets and illiquid markets. In liquid markets at the moment, if we look at what we have in our liquid fund, the global credit income fund, we get around 4% yield. We’ve got about three years of current duration. We feel pretty comfortable with the income generation in the fund. That 4% current income being generated from the securities we hold. But it’s going to be the same thing as last year where the fund did 4% and then had almost no volatility.
I think we had 0.7% volatility for calendar year ’21. Looking ahead, there’s a lot more uncertainty with potential credit spread widening. I think volatility will be greater, but the income generation will be there. And then at some point, those higher yielding, higher spread investments present an opportunity for us to achieve even higher income. On the illiquid side, as I said there’s a lot less marked market volatility. We’ve got about 7.5% yield in the portfolio at the moment. We generate origination fees of around 2% on the direct lending part of the book. They’re less volatility and offer the same principle, anchoring your return and current income with low duration exposure.
Our strategies are very high turnover, high trading activity strategies. We’re not buying and holding securities for their yield or their coupon. Particular yields or macro states of the world are not relevant drivers of our future return expectations. I might have to bring it back to the objectives of the fund and say that over the investment horizon, we’d expect all the targeting as a cash and CPI plus 2%.
People have starting to add duration back into portfolios. Is it good timing or too early?
On a risk adjusted basis, one has to be very careful at the moment in the sense that we’ve just come off the back of a decade where it’s nearly always paid to invest in yields. A lot of those views were driven by the idea that structurally inflation was going to remain low. I think that’s a big open question at the moment.
I’m saying this from the perspective of a manager that doesn’t take active duration risk. But what relative value strategies can do is they’re a very portable source of alpha. They can be poured on top of portfolios that do want to take that tactical view on duration.
I’m going to echo some of what you’ve just said in the sense that we’re not a manager that has an overlay of duration. We’re going to be looking at the attractiveness of high yield bonds versus syndicated loans. We’re going to basically be just focused on income but as a source of return.
When people hear income, they think income that I need to go and pay for something. No, here we’re talking about income as a source of return, which we feel is a much more stable source of return than making capital gains. I think when we think about duration, we are always thinking about it, not as an overlay, but whether investing in a single B bond of a company is better than investing in its single B loan. That’s how we think about duration.
Answering with that in mind, we think that there are starting to be places in the fixed rate world where you can see some value appearing, but it’s just the beginning. We’re not shifting in any meaningful way for now. We think there’s still some more way to go there.
From my perspective, I think we’re in a period of adjustment. We’ve been through an environment post GFC where low rates and QE did not stimulate sustained inflation, did not stimulate sustained growth. For me it took a couple of events to kind of turn things around so now that we can look back and see that perhaps these have been inflection points. One of them was the Trump election. Trump came to power with a deregulation focus and a pro-growth kind of fiscal type reform focus.
That really drove unemployment lower and drove growth in the U.S. higher. Then COVID come along and that sort of put a dent in a lot of people’s plans. But the recovery from growth… from COVID was not driven by monetary policy, it was driven by fiscal policy. Monetary policy alone probably would not have resulted in the recovery that we are now seeing today. I guess this is more of a philosophical kind of longer term question. That is, is monetary policy going to be the savior at every crisis or every recessionary event that we get in the future or are central banker’s going to look towards the governments and the fiscal side of the equation to bail economies out?
For me that means larger debt, deeper deficits, larger amount of bond issuance, larger amount of bond issuance means higher yields.
Going back to your original question, is it time to buy duration? For me, it feels a little bit early. But what’s the time period? What’s the time horizon that the investors are looking at? Look, we certainly don’t structure the portfolio for these 3, 5, 10 year type trends, but those sort of themes in the back of my mind are long term. You need to be a little bit more creative in the way you allocate to bonds if you’re looking for that diversification benefit as we’ve been discussing.
With the Russian oil sanctions, has the geopolitical situation changed your outlook on inflation and the number of rates rise in the U.S.?
I think the commodity price impact has come at a time when supply pressures in the world generally are already a pretty big constraint in pushing inflation higher. It’s difficult timing from that perspective. In terms of how it affects the different rates markets it depends, because in Europe, for example, they’ve got much higher trade exposures with Russia.
I think 40% of natural gas imports and 30% of oil imports are from Russia. There’s a greater, if you like, stagflationary risk there.
When you’re looking at markets like Australia and the U.S. there’s less so from that kind of direct trade perspective, but there is in terms of what commodity prices are going to be for things like petrol and whether it can force the central banker’s hands.
I think he’s exactly right. It puts the Fed in a tough place. Basically, they are in a situation where they need to try and control inflation, but then there are things happening that maybe global growth is not going to be as strong as they thought. It’s a very difficult place to be in. That just increases the fear factor in the markets as well. Trade spreads have reacted by going wider. It’s not because fundamentals are looking less attractive. It’s really because of the fear factor and flaws.
It’s the same themes that we’ve been talking about. It just accelerates that dispersion, it creates that environment where there’s going to be winners and losers, and you’ll need to be very selective in your credit selection.
We’re not macro investors of course, but clearly what’s going on in Europe is having broader ramifications. I just make the point echoing some of what’s already been said. But central banks have had it pretty easy for a while now. This geopolitical crisis against a backdrop of high inflation, the dreaded stagflation word seems to be a very real potential outcome. What central banks do to navigate through that is anyone’s guess. We’ve seen domestically the RBA, not that long ago, pretty adamantly saying we’re not moving till 2024 and the market ignored that. They’ve had to retrace. I mean, who knows the way things are happening, they might be proved right in the end.
The uncertainty is extreme. To Teiki’s point, for credit markets it’s mean there’s high volatility and spreads are widening, and we’re just actively looking to seek out opportunities against that backdrop.
I think it’s a little bit funny that portfolio managers, traders after the COVID crisis or in the midst of the COVID crisis, pretty quickly became virologists and epidemiologists. All of a sudden now it’s as if they’ve become geopolitical scientists and understand what’s in Putin’s mind. The fact of the matter is we don’t. I’ve got no idea what Putin’s going to do tomorrow, next week, next month.
All I can do is look at the signs that markets are telling us. What’s happening with volatility, what’s happening with risk in risk assets, what’s happening in liquidity because we haven’t seen wholesale redemptions yet in fixed income in investment grade and high yield. That can certainly create or exacerbate the problem that we’re already seeing in what is ostensibly just weak sentiment around the uncertainty. Look, it’s important to focus on fundamentals. I think one of the stats I saw was that S&P 500 companies has 0.1% or 10 basis points of their sales go to Russia. Russia is probably not as economically important.
But to the extent that you’ve got S&P 500 companies that get most of their revenue, sales, profits, et cetera, from whether it’s U.S. or other developed nations. You need to pick those potential winners and losers as well. Fundamental bottom up analysis becomes increasingly important.
Is there any concern with stagflation?
One element of stagflation, which is a precursor, is high unemployment. I mean, we’re at pretty low levels of unemployment. In Australia, we haven’t seen these low levels of unemployment since pre GFC. U.S. Hasn’t quite hit their sort of Trump era lows, but certainly not too far off. We’re in a slowing growth environment as growth is decelerating. Even before Russia, Ukraine, it was decelerating.
We expected that because the stimulus has worn out. Whether people have spent their checks or kept their stimulus checks for a rainy day, monetary policy obviously is on a tightening cycle. We expected growth to slow. I think for us to get into a recessionary environment and therefore stagflation, there has to be either a big policy error or another exogenous shock.
What are the best opportunities in your investment universe?
I think spread widening. The soured sentiment globally as a result of hiking cycles, and of course, Russia and Ukraine is leading to a few opportunities in the public space, particular issuers, desperate to fund. We as investors today have the pricing power. I think that’s where one of the big opportunities is.
Look, we spread our risk across a lot of different, small size positions. There’s lots of little mispricings that are emerging because of the high levels of macro uncertainty because of the supply demand balance. Changes in the central bank stepping away from markets and because of increased volatility. There’s lots of little things.
We’re staying on the floating rate end of the spectrum. Short duration, high levels of current income, but then at some point, the value in the fixed rate part of the liquid market will come back and we will be ready to take advantage. And then in the illiquid part of the portfolio, it’s the same story. It’s harvest liquidity premium, the origination fees and make sure that you’re there to provide capital to people that need the liquidity, and look for opportunities to work out capital with really good companies that maybe have overstretched. That’s what we’re seeing as opportunities going forward.
Very briefly, I’d say less cyclical private debt opportunities are still a standout. Industries like healthcare, for example, still provide very decent opportunities. But keeping a watching brief on this idea that public market spreads are starting to underperform and widen and so making that switching to somewhat more liquid opportunities is something we’re starting to look at.
Alpha – Alpha is used as a measure of performance, indicating when a strategy, trader, or portfolio manager has managed to beat the market return over some period.
Beta – Beta is a measure of the volatility — or systematic risk — of a security or portfolio compared to the market as a whole.
Carry trade – refers to a trade where you borrow and pay interest in order to buy something else that has higher interest. For example, with a positively sloped term structure (short rates lower than long rates), one might borrow at low short term rates and finance the purchase of long-term bonds. The carry return is the coupon on the bonds minus the interest costs of the short-term borrowing.
Coupon – Interest payment
Credit – Corporate bonds
Credit Curve – The credit curve is the graphical representation of the relationship between the return offered by a security and the time to maturity of the security. For example, companies can issue many bonds, that have a range of maturities. Each maturity and its return are plotted on a graph and then a line between the various maturities can be drawn to form the credit curve. The credit curve measures the investors’ sentiments about risk and can affect the return on investments. The difference between the first maturity on the curve (the short end) and the last maturity of the curve (on the long end) determines the steepness of the curve.
Credit Spreads – The difference between two securities’ yields based exclusively on the variation in credit quality. For example, a AAA rated Australian Commonwealth Government bond and a lower rated corporate credit with a single A credit rating. For investors to accept the higher risk corporate bond, they must be paid more. The difference in margin between the government bond and the corporate bond is known as the Credit Spread.
Duration – Duration measures a bond’s or fixed income portfolio’s price sensitivity to interest rate changes.
- Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s price by its total cash flows.
- Modified duration measures the price change in a bond given a 1% change in interest rates.
- A fixed income portfolio’s duration is computed as the weighted average of individual bond durations held in the portfolio.
Fed – US Federal Reserve
Stagflation – Stagflation is a period when slow economic growth and joblessness coincide with rising inflation.
Tenor – The term tenor describes the length of time remaining in the life of a financial contract.