3 sacrifices to consider if you want higher yield
Investors have been demanding more liquidity from their investments ... even in the realm of fixed income. Perhaps still jaded from last year's drawdowns (and tapping into the subsequent rebound), or perhaps with an eye on the inflation figures coming out of the US.
I recently sat down with Mark Trevarthen, Vice President at Credit Suisse, to discuss some of the key trends in fixed income markets, from inflationary pressures and a hawkish central bank to why Mario Draghi is "The Man".
One key lesson Trevarthen has learned is this:
"If you want to extract yield from the market, you need to make a sacrifice in one of three areas. One is the duration piece. One is the credit risk piece. And then the final one is liquidity piece," he said.
If liquidity must remain firmly on the table, which do you sacrifice? In this video, we've taken a deep dive into the threats and risk in fixed markets and where the best opportunities lie.
This transcript has been edited for clarity.
We've obviously had lower for longer rates for a very long time. Is your outlook on that shifting? And what does that mean?
So I think, the lower for longer, Mia, is still very much in place. There have been some subtle changes to that, looking into the medium to longer-term, I'd say. So, we've definitely now got the taper conversation on the table, but it's important also to stress that there are different things happening in different parts of the world. And so, only a couple of weeks ago, the ECB came out and spoke about the state of the Eurozone economy and said very, very clearly, sent a very strong signal that rates are staying low for longer. The US is a little bit further forward and they've started to talk about tapering and they've started to manage the market's expectations around the timeline there, and I think, have stressed that the economic data is going to drive the decision there.
Here domestically, in the last two months, things have changed significantly. I think it's fair to say that Australia was really firing on all cylinders coming into mid-year. And I think the conversation is very much about, is the RBA going to be exiting their quantitative easing programme, starting with the tapering of the bond purchases? And now of course, out of left field, we had this outbreak and it really snowballed, such that now the conversation is about, not just holding off on the tapering, but maybe they will have to add stimulus to the economy. So there are different things happening in different corners of the world. But the key driver, the US, definitely, the days of easy money, we're closer to the end of that, than the beginning.
Looking at the US, looking at the Fed, a lot of the conversation lately has been around inflation. Is it transitory, or is it here to stay? What are your thoughts on that?
I think, broadly speaking, we're going to see higher rates of inflation going forward. A lot of the spikes that we've seen are not sustainable, so they are transitory, and the Fed is very, very clear. As recently as a couple of days ago, at Jackson Hole, Jerome Powell was at pains to say, this is transitory. We're looking through a lot of these numbers, but certainly, there is a lot of stimulus out there, and there's a big fiscal package in the works from Biden. There's possibly an infrastructure package on the near horizon as well. And those, added together, are inflationary for certainly the US economy. And that, in turn, is going to be a bit of an undercurrent for global inflation. We all know and we've experienced it firsthand, rising prices. And so, there is a broad pickup, but I think that the high spikes that we're seeing are purely transitory.
Knowing that it's transitory, do you think that investors need to action the inflation data that they're seeing in the short term, or is it a matter of holding tight and riding through the storm?
I think investors need to position for higher inflation going forward. That's certainly the view of our global investment committee. We see a broad pickup in long dated bond yields over the next 3, 6, 12 months. And that is driven largely by our view on inflation. So we see that very much as being part of the investment conversation. And so, very much the sorts of sub-asset classes, if you like, within fixed income that we're talking to our clients about, are based on the prospect of higher inflation and trying to guard against that, because of course, inflation erodes the value of assets.
Where are the opportunities for yield in markets today?
So I think there are still lots of opportunities and let's not forget that if we're seeing higher rates going forward, that conversation on higher rates is predicated purely on really strong economic growth, very robust corporate balance sheets, a very healthy banking system. And so, it's not something we should shy away from. And it's something that we can look to get exposure to. So certainly protecting against the risk of long-dated yields backing up through shorter duration assets is one way. So for that safer portion of your portfolio, we think that it's worth just reigning in the duration risk a little bit, because we do expect to see a little bit of pain for long-dated assets. Buying inflation-protected securities, whilst the really, really strong period for that sub-asset class has we think passed, we still think there's a place in the portfolio for inflation-linked bonds.
And, then in the world of credit, short duration, good old fashioned industrials, and with a fair proportion of that in floating rate instruments, so coupons that pay a margin over liable, for example. So, it's about, I think, sheltering in that part of the yield curve and getting exposure to sectors that are still thriving in this very benign credit environment.
It's important that this is not about runaway inflation or a really hawkish central bank. This is a central bank that's saying, "Okay, we've had our foot on the accelerator for some time. What we're going to do now is we're going to just take our foot off the gas a little bit, and we're still a long way away from applying the brakes." So that is actually a very, very fertile environment for credit.
So, starting point with the inflation-linked bonds, that short duration, and then those high-quality industrial names with a cyclical bias, I think that's important. And then, there are other areas, more idiosyncratic areas.
In Europe, for example, we've got a new regime under Mario Draghi, and if ever there was a market-savvy political leader in the mix, Mario Draghi is the man and he is looking to make some big, big changes, and those are going to be very, very market-friendly changes. They'll be very, very good changes for the banking system. So we like exposure to the Italian banking sector, particularly at the more subordinated layer on the capital structure. We think that with a supportive policymaker backdrop, coupled with the ECB's lower for longer mindset, that's a very, very good place to extract carry effectively. So whilst capital appreciation is probably limited at these sort of levels because the market's rallied so hard, there's still a nice pickup to be made in the form of coupon carry.
If you're rotating towards Europe and European banks based on policy changes, where are the areas that you're rotating out of?
That's a good question. So, I think some areas that we liked up until recently, were a lot of the telecom names. So under a Biden administration, we felt that telecoms were a good place to be. He made very, very strong overtures to that sector in terms of not being too hawkish on a regulatory note. And so we thought that was a bit of a green light for telcos. That's getting on for 12 months ago now. So we feel that that trade has been more or less exhausted.
I think, some parts of emerging markets. We had a very, very benign environment for emerging markets under this lower for longer US dollar scenario. I think now the conversation has shifted with the US dollar, and we're starting to see the market positioning for this tapering, and ultimately that's translating into dollar strength. That is a headwind for EM, in particular, EM hard currency. So, we split emerging markets up into hard currency and local currency. If you're an EM borrower of US dollars, then a stronger dollar is going to hurt you, because you're earning revenues in local currency, and you've got outgoings in US dollars. So, that's probably another area where we've reduced exposure. And I think, on a more generic, index level, if you like, investment grade and high yield, to take index exposure there, is a tricky exercise.
What are some of the other risks that investors should be on the lookout for? Are there any pitfalls, or ways they can position themselves if they don't want to ride up that risk curve, but still achieve good yield?
Yeah, I think, in my conversations with clients, I always break it down into three areas really. If you want to extract yield from the market, you need to make a sacrifice in one of three areas. One is the duration piece. One is the credit risk piece. And then the final one is liquidity piece. And I think one risk that I'm very mindful of, and I think, that's echoing the view of the investment committee right now, is just purely reaching for numbers based on historical, what we've got in our mind as that hurdle that we need to reach to be happy with our fixed income portfolio, or our income piece of the fixed income portfolio. You're required to take too much of one of those three buckets of risk and liquidity is a classic. So, you can get paid significant spreads over BBSW for entering loans for example, but these loans don't necessarily have liquidity, because we're in a very, very changing, very fluid environment right now.
What we've seen happen in Australia in the last two months, it's been a pretty sizeable move and a shift in sentiment and expectations. So if you're tied up in an illiquid structure, granted that might be paying you 6, 7, 8, 9, 10%, but that's of little consolation when you want to get your cash out, if there's a big picture shift in the market. So I think being nimble is very important.
Staying defensive, so that aggressiveness on taking on duration risk just to get the extra yield. The yield curve is steep enough that you're getting much better compensated at the 20-year end of the curve than you are at the three-year end of the curve, which as we all know, is subject to yield curve control. So, we've talked a little bit about the credit risk, so those are the three areas that I think you just need to be very, very on top of your game.
Was there anything from your list that we didn't touch, on that you wanted to get across to investors?
When we get to this stage in the cycle, and with spreads very tight in the public markets, I think, one area that we like at Credit Suisse, that we think there's still some value, is in the private markets. And whilst I talked about the liquidity piece, if we can navigate that risk and manage that risk, I think there's some really interesting opportunities in the private markets.
Can you give us an example?
Yeah. I think with a good manager, looking at areas of the economy which are going to continue to thrive under a relatively loose credit environment, I think that's a really interesting place. A lot of the loans in the private credit market are floating rate in nature, so you've immediately removed any interest rate risk. If rates start to go up, then your income goes up as well. So I think, because of the high barriers to entry in private credit, it's an area which is still, not quite uncharted waters, but it's not been trampled over by the entire investment community. And so, there's still some margin to be had there. So I think there are some really good opportunities there.
You take a healthy economy, so from a top-down point of view, you take an economy like the US economy, and companies, they want to go to direct lenders. They don't necessarily want to issue high yield bonds. It's cheaper for them.
There's more certainty of capital at a given time, which companies might need if they've got deadlines. And added to that, a sophisticated lender may be able to offer IP in other areas and to add value to that business in other areas. So, we think that that's a really interesting space and one that still offers, relatively speaking some good value.
One other thing that you mentioned there is that in private markets, there are some areas of the economy that are thriving and benefiting in the current environment. Can you name some examples of that, either specific companies or even just sectors that people should look at?
Yeah. So, sector-wise, I think that the telecom sector is still doing very, very well. I think one area that's been really surprised to the upside in the last 12 to 18 months has been the logistics space. And there are lots of companies in that middle-market segment of the real economy, that need funding that have great deal pipelines, but they need a nimble lender who's going to help them and partner with them. And in many cases, a lot of these logistics names might also need access to real estate capabilities for warehouses and so forth. So, that's a really good example of a sector that's great to get exposure to right now, and is a good illustration of how the market is shifting.
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