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 current markets. There is a glossary at the end of the article.
Host:
How is the rapidly changing macro environment influencing your asset allocation as well as new opportunities?
Dan:
Asset allocation isn’t just defined by whether you’re investing in financials or corporates or securitised assets, because we’re a global manager. You’re in an environment today where central banks are hiking rates, QE programs are coming to an end.
You can say in some jurisdictions, Europe, for example, their QE program included the purchase of corporate bonds. It drove corporate credit spreads to artificially low levels. However, QE is coming to an end, and we’ve seen spreads widen in places like Europe and Australia. Where Australia used to offer a wider spread or a more attractive return for a given issuer or part of the credit curve, we’re now seeing some pretty attractive opportunities offshore.
Because we’re looking at different countries around the globe that operate at different points in their economic cycle, and whether central banks are hawkish or dovish or on hold impacts the way we allocate duration risk as well.
One example might be New Zealand. At the moment, it seems like higher interest rates went a little too far, certainly ahead of other developed market central banks. So, you can buy assets in the front end of the New Zealand curve and get some really attractive roll down, which leads to capital price appreciation. We are looking at that asset allocation from a global perspective, looking for the best risk adjusted returns within our framework.
Host:
Victor, if you can give us just insights from a security selection perspective in particular with private credit?
Victor:
There’s a lot of uncertainty around. One principle we like to abide by is keep it short, stupid. So both in private lending and public markets shortening the tenor of your average investment holdings helps reduce the susceptibility to widening credit spreads in volatile times.
That’s an important consideration. On the private lending side, we tend to steer clear of cyclical industries. With rising rates we could see a slow down in growth. Particularly for those more cyclical sectors, we tend to avoid those even during more benign times, but certainly right now, unless we can engineer an outcome, where leverage for example is extremely low.
Finally on the public market side, I agree with the idea that in focusing on individual investments right now. Offshore markets, particular in Europe where spreads have widened more. We’ve got to be careful because there’s some fundamental reasons that perhaps are driving that.
But nonetheless, focusing on some of those investment opportunities offer a real potential outcome. Secondly, just be wary about chasing some of those public market investments that we tend to define as semi-liquid. They’re liquid in good times, but when you need that liquidity, they’re completely illiquid.
Host:
Alex, can you please give us some insights with respect to central bank hiking activity and balance sheet normalisation, what that could mean for investors across rate markets?
Alex:
I do think central bank actions will contribute to further dislocations. Taking a step back, all major central banks have either commenced tightening cycles or are preparing the ground to do so in the near future. We don’t take active duration risk within our portfolios compared with pure relative value investors. But it’s not hard to look at the world at the moment and see that it’s going to be a very difficult risk reward balance for those heavy duration type strategies.
You only have to think about the dynamics for inflation and what the risk reward there is. We’ve seen a situation where there’s a lot of supply side pressures and other issues that are pushing inflation up and there’s a risk that increasingly becomes embedded within expectations. I think if you look at the way that central banks are behaving, we’ve moved from getting on top of inflation before it became a problem to one where they’re looking like they might be behind the curve.
I think that will create further volatility and dislocations going forward. I think a final point is if you just look at the way that the yield curves have behaved, the markets started to develop a conviction around a faster tightening cycle over the next couple of years, but a lower end point. That lower end point is because they’re also taking off balance sheet normalisation with the QE programs. But I think that’s something that could be challenged as the cycle moves on.
It’s never a smooth process, and that sort of longer run rate expectations are something that I think could also have implications for other asset costs.
Host:
Whilst we’re on the topic of the interest rates, are you expecting a reassessment of fair value across credit securities as we move into a higher rate environment?
Teiki:
I mean, credit is a very broad space, many different asset classes. The first thing I would say that there’s going to be different parts of the credit market reacting differently to what’s happening there. The first thing we need to start with is looking at the fundamentals. Do we think that the hiking of rates or higher inflation will lead to more defaults? We actually feel that the fundamentals are looking pretty good.
Companies have pushed out their maturities to beyond 2023. There is cash in the balance sheet. They’ve repaired their balance sheets over the last year. The consumer in the U.S. is also looking pretty strong. We don’t feel that we’re going into an environment of broad based defaults and concerns from a financial standpoint. However, inflation and higher rates will create dispersion in the market, both from an asset class perspective, but also from an individual company perspective.
Some companies will have the pricing power to pass on higher costs. We think credit selection is going to be incredibly important in such an environment. That’s from a bottom up perspective. From a top down perspective, you look at the different asset classes, and obviously in a rising rate environment, fixed rate bonds are going to suffer more than floating rates. Fixed rate bonds, fixed credit spreads, don’t move, let’s say, but the risk for rate move goes up. The only way a fixed rate bond can adjust is by the price going down. You’ll get volatility by just rates going up and credits staying the same.
The interest paid on floating rate bonds, resets every three months. If interest rates go up, you actually you get more income as an investor. At the moment, we really like trading floating rate bonds. What’s also very interesting is that when you look inside the fixed rate bond universe, investment grade has actually underperformed high yield. Because while high yield is more credit risk, it has less interest rate risk duration. It has about half the amount of duration. Investment grade is eight years, high yield, about four years. You see those different patterns happening where not only do you start with credit selection, but also you look at the broad universe of credit, then you’re going, okay, where can I get the best credit value? You have to be able to play that credit value in such an environment.
Host:
With inflation being so topical, it would be great to get your insights and views on the impact that this can have to credit investments.
Dan:
Well, I think the first thing to do is really differentiate between different types of inflationary environments. Typically, when inflation is rising, it’s rising for good reasons. It’s because growth is improving. There are asset classes that actually behave well in a modestly or controlled rising inflation environment. Real assets, property infrastructure obviously does well. Even the stock market does well in a fairly modestly rising inflation environment. And then so too, because of their correlation to equity. So does credit.
Now, of course, we’re not in that sort of environment today. Last year, central bankers were talking about the fact that inflation is transitory. After a number of months, they certainly let go of that narrative. Today we’re in uncertain times. I think one of the key takeaways to mitigate that risk from the uncertainties around rising inflation is just to keep duration low. A lot of speakers have already talked about the fact that duration is going to lead to that volatility of returns. Central banks, the Fed in particular seems pretty hell bent on fighting inflation. You want to keep duration risk at a minimum on this environment. That’s going to be the key.
Host:
It would be great to hear your insights as well and shed some light on the private credit perspective as well.
Victor:
Private debt is predominantly, almost entirely floating rate so you are kind of insulated against inflation. But we think it’s disingenuous.
Domestically, our number one concern is the consumer. Think about the average consumer with five times their salary as a leverage position on their mortgage. They’re paying out 30% of their income right now. How susceptible are they to one, two or three percent increases in rates and what does that outcome look like? What private debt specifically allows us to do is open up the universe of investments that we can access. There are companies that aren’t listed on the stock exchange that don’t issue in public bond markets, and we are able to access other areas of the market and the economy that aren’t so exposed to that inflation environment and the higher rates environment.
Host:
We are expecting volatility across our markets to persist for some time. We obviously hear about the risks associated with that, but what are the opportunities that this does present for your area of investing?
Alex:
Within a relative value, fixed income strategy, we are able to directly target interest rate volatility within the portfolios. One upshot of a volatile environment for rates is that part of the portfolio. There’s also a second round benefit in the sense that the drivers of interest rate volatility at the moment and the backdrop that we’re in is one of extreme macro uncertainty. That macro uncertainty gives rise to flows, which also create relative value trading opportunities. And then I think a third thing is just having a look at what the world has become.
Over the last two years, the largest central banks in the world bought $12 trillion roughly worth of bonds. They’re now stepping back from those QE purchases. That really changes the game in terms of the supply and demand balances that are out there in bond markets and government bond markets. But I think the way that that plays out going forward is going to be different by different areas of the world and different geographies. I think it will really pay to have that micro focus on what’s happening in all the different yield curves around the world.
Teiki:
I think first I’m going to echo what’s been said about credit and the focus on avoiding defaults. At the end of the day, you’re in an asset class that has a sort of nominal value. The first thing you have to do is I feel comfortable that you’re lending to companies that whatever happens to inflation and spreads, if you hold onto that credit to maturity, then you get your principle back and the coupon along the way. That’s the first thing to be really focused on.
Then you look at the environment and the volatility and you say, okay, what does it create in terms of opportunities? On the liquid side, what it means is that you’re going to have certain parts of the market or certain bonds, for example, that have been issued, let’s say at a hundred dollars of nominal value that are performing, they’re still paying their coupon, but they’re trading at a discount. You can potentially buy them in the liquid market with a discount. Buy them at $95, collect the coupon, get $100 back at maturity. That’s the sort of absolute opportunity that you can get when bonds start trading at a discount. Then obviously what’s been said about relative value, you can do the same thing across those credit markets. When does fixed rate become more attractive in a certain rating?
For example, you can have single B rated bonds and single B rated loans, the same credit risk, but then because of flows, they have different credit spreads. You have attractive entry points into bonds versus loans and vice versa.
When the tide goes out, you see who’s overstretched and wearing the shorts. Basically, that creates an opportunity for investors that are able to provide rescue capital. We have a very large team of people dedicated to that. We can do that in the private part of the portfolio.
That concludes the first part of the webinar, in Part 2, the panel discuss practical applications of these strategies in a defensive portfolio.
Glossary
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.
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
Tenor – The term tenor describes the length of time remaining in the life of a financial contract.
