“Don’t panic” - yield opportunities are still out there, says Realm
Fixed-income investors have plenty of reasons for optimism despite credit assets’ historically high prices and stimulatory tailwinds that are almost blown out, says Realm Investment House’s Ken Liow.
A fiercely contrarian credit-focused fund manager, Realm combines quantitative, data-driven research with a focus on fundamentals to identify and exploit inefficiencies in the market. In a recent webinar hosted by financial planning firm Hamilton Wealth Partners, Realm co-founder and investment manager Andrew Papageorgiou joined strategy and risk committee chair Liow to discuss the outlook for credit markets.
Markets aren't always efficient
Liow started by describing the features of bank capital versus structured credit, pointing out that banks often keep the debt they sell to customers on their own books.
“But what they may have also done is sold that mortgage into a structured product known as a residential mortgage-backed security, which is issued to an entirely different set of holders," he says.
“That mortgage is the same risk, but just happens to be sold into different markets. And there are different people operating those markets, and sometimes those prices get out of alignment.”
Spotting these misalignments is a key job of Realm’s team, who compare the relative pricing of the debt assets and buy the cheaper for their clients. They also search for inefficiencies between pricing in domestic and offshore credit markets. Australian banks’ issuance of credit notes into global markets has been almost non-existent in the last year, given the large amounts of liquidity sloshing around.
But Westpac recently became the first Australian bank to tap international markets since the pandemic struck, raising US$2.75 billion from its sale of five and 10-year bonds in the US. And it’s widely expected this is just the start, as banks will soon lose access to the Reserve Bank of Australia’s Term Funding Facility, which will be cut off at the end of June.
“It’s obviously a much more challenging environment in which to generate returns than it was around a year ago, so what we need to think about right now is that unwinding of liquidity support and QE,” Liow says.
Certain areas of the credit space benefited hugely from the QE and other stimulatory measures introduced after the onset of COVID. Senior bank debt was one of the most affected, along with long-dated credit.
“So highly liquid long-dated credit that was highly-rated benefited the most from QE…but that tailwind is coming to an end so they’re the last places you now want to be,” Liow says.
Following this logic, investors should now target the areas of credit that benefited least from QE.
But don’t panic!
Liow emphasises that investors don’t need to get on the phone with their broker right away.
“Don’t panic too much, it’s not about to be unwound tomorrow - we’re talking about a very gentle unwinding over a period of several years,” he says, referring to the general level of monetary policy support.
“The first movements will possibly happen in July, with just the smallest movement, followed by perhaps a bit more in the middle of 2022.”
What looks good now?
Favouring Realm’s contrarian approach, Liow says the market is currently rewarding areas that are “just a little bit different.” These include:
- Hybrid securities
- Structured debt securities.
“To us, structured securities are less common and require a different kind of skillset,” Liow says. “The opportunities there remain very significant and they didn’t even compress much as a result of QE.”
Realm’s portfolio is shifting away from long-dated, more liquid assets into more of the above opportunities.
“Yes, spreads are lower now than they were before, but not by a terribly huge amount and there are still good returns to be had,” Liow says.
Further explaining Realm’s contrarian approach, he describes how plummeting bond yields during 2020 saw increasing concern among investors seeking yield. In many cases, they were shifting money into higher-risk parts of the debt market or even into equities.
“That’s not what we do, and it does force us to accept lower returns at times, and unashamedly, there are times within this portfolio where we are targeting numbers of below 3% over cash, because it’s the right thing to do,” Liow says. “If the market doesn’t want to give you 3% over the cash rate, the last thing you should be doing is forcing it out of your book.”
Moving into the COVID downturn, Realm was already positioned quite defensively. And by late February when the outbreak was declared a pandemic, it implemented further measures to “de-risk” portfolios.
Liow and Papageorgiou also discussed several of the major macro topics that currently confront markets. One of these is the prospect of a “hot war” between China and Taiwan. Aside from the obvious downside of armed conflict between two of Australia’s Asia-Pacific neighbours, it could create a shortage of semiconductors, which would have huge flow-on effects.
Microchips have already been in short supply because of supply-chain disruptions. Taiwan, which produces more than 80% of the world’s supply of advanced microchips, via multinational company Taiwan Semiconductor Manufacturing Company (TSMC), is critical to an ongoing economic recovery.
“Chips are in incredibly short supply right now, and it takes years to rebuild one of these advanced manufacturing factories,” says Liow.
But Realm regards the chance of a sustained hot war as a very low probability, largely because the Taiwanese people have little appetite for a conflict.
“War is talked about, there’ s a lot of sabre-rattling going on. But if it does occur, the possibility of prolonged kinetic warfare doesn’t seem very high.” Liow says. Recent battle simulations recently conducted by the US also showed they will lose their edge in the coming years. China can exercise patience.
The commodities supercycle
On the prolonged surge in iron ore prices that has lifted Australian miners to historic highs, Liow says these prices won’t be sustained. This is reflected in the Australian Government’s latest Budget, which factored in a long-term price of around US$55 a tonne versus the current level of more than $200.
Realm is quite positive on the outlook for LNG, given the importance of gas as a transition fuel as countries around the world gradually shift from coal to renewable energy.
“Australian LNG is perfectly positioned in having this really nice geological setup that allows us to get it to places like Korea and Japan, whose plans require contracts of around 20 years for LNG, so that’s looking really solid, from our perspective,” Liow says.
The fixed-income fund manager is also quite constructive on the outlook for copper along with other metals used in producing electric batteries.
“Prices of copper have got to rise quite a bit more to encourage others to get that more difficult to extract copper,” Liow says.
“It’s part of a wider picture of electrification…you can’t get to a low-carbon future without electrification of a lot of different things. And this means that demand for lithium, nickel and assets like that, which are used in transmitting and storing energy, are in a supercycle.”
In summary: How Realm is positioned
To recap, Liow calls out hybrid securities and structured debt securities among Realm's preferred positions currently. He also says residential mortgage-backed securities are attractive. But he emphasises they're not about to buy more risk to target a level of yield, just when the market is most expensive, "because it just doesn’t make sense".
"If anything, you want to do the opposite. It’s very important not to be benchmark aware, not to be constrained or have your freedom of choice and of action constrained."
As Papageorgiou explains, bank-issued credit remains attractive for a few key reasons.
"Credit is as expensive as it’s been in a very long time…but we do know that the economy is in pretty good shape.
"The banks are fine and a lot of the concerns around the defaults and arrears in residential mortgages have largely dissipated, we’ve got a very robust property market despite challenges around migration.
“There are sectors that will fare better and still others where there are lingering risks, and it’s important that we keep our wits about us and don’t materially discount the prospect of things going wrong. Because a lot of these businesses are carrying a lot more debt now than they were pre-COVID.”
RMBS and bank debt securities are how Realm has exposure to property: "There are things we’re concerned about, such as a property crash and problems in debt serviceability for households," says Papageorgiou, but they aren't currently part of his base-case scenario.
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Glenn Freeman is a content editor at Livewire Markets. He has almost 20 years’ experience in financial services writing and editing. Glenn’s journalistic experience also spans energy and automotive, in both Australia and abroad – including the...