Flight to safety - where to find value in defensive assets

Glenn Freeman

Livewire Markets

Caution rules the day in our current macro environment. And of course, investing in fixed income is lower risk than stocks, particularly if you’re getting nearer to retirement or can’t afford equity risk. But some parts of the credit universe are a better idea than others – depending on your individual circumstances.

But where, and how, can you weigh the alternatives open to you? You could park your hard-earned in the money market (well, the Aussie dollar is doing okay, so maybe that’s not too bad an option).

Surely not in long-duration government bonds (guvvies)? Who’d want to lock in at today’s still-record low rates when US rates could be 1.5% higher – give or take – by this time next year?

A panel of fixed income fund portfolio managers assembled for the Fidante Partners Forum, a webinar that brought together the following portfolio managers, discussed these questions and more.

The need to exercise caution when chasing credit opportunities – especially in private debt, and especially in global markets – was a key theme. This was a point made by CIPAM’s Rodriguez. He said investors need to be careful when weighing up semi-liquid credit assets.

Macro - What's happening?

Commenting on the broader macro environment more generally, and fixed income specifically, Ardea’s Stanley expects to see further dislocations in the already widening credit spreads (the price between what you pay versus what you get in return) for corporate bonds.

“All major CBs have started tightening cycles or are planning to in the future. It’s not hard to look at the world and see it’s going to be a difficult risk-reward balance for those heavy duration strategies,” said Stanley.

What does that mean? You probably don’t want to be in bonds of 10, 20 or 30-years’ duration.

Are we going to see any major credit defaults around the world? Put simply, will many large companies – or indeed countries – renege on their debts in the next couple of years?

Happily, no is the answer from Ares’s Benveniste. That’s because consumers around the world are looking quite strong, largely because unemployment is low in many places. It is also because corporate fundamentals are more than reasonable despite the difficult last couple of years. “I don’t think we’re going to be in an environment of broad-based defaults, but higher inflation and rates will create dispersions,” Benveniste says.

He emphasises that every class of credit is different and believes fixed-rate assets (echoing the point above about longer duration) will struggle more. That’s why the Ares team prefers floating rate exposures.

“You have to be able to look at the broad universe of credit and ask ‘where can I get the best relative value,’” says Benveniste.

For example, in fixed-rate bonds investment graded bonds have underperformed high yield. Why? The latter has around half the interest rate duration of the former, IG with about eight years’ duration, on average, versus 4 years for high yield bonds.

Finding lower-risks, outside of RMBS

CIPAM’s Rodriguez spoke about private debt, which is his firm’s niche. He considered the susceptibility of households to rising interest rates. Particularly in Australia and New Zealand, where residential mortgages are exposed to the prospect of rate rises, this is a risk. But providing non-bank lending to unlisted corporations enables his firm to find those parts of the residential market that are less vulnerable.

In another way, Ardea’s Stanley says his firm’s “relative value” approach allows it to benefit from the interest rate volatility.

A gamechanger: The supply-demand imbalance

Among the higher liquidity credit assets favoured by Kapstream, some parts of the market have issued bonds at, for example, $100 nominal values. “They’re still paying coupons, but are trading at a discount. So, you can buy them at $95, clip the coupon and get $100 back at maturity,” says Ares’s Benveniste.

And in the more illiquid side of his portfolio, he finds opportunities because of the volatility in liquid markets.

“Because large companies that would normally go into liquid markets to fund themselves will instead partner with us, who can write a $1 billion cheque to one company and ‘de-risk’ their funding. Volatility creates those sorts of opportunities on the illiquid side.”

And as risk ratchets up, some lenders that have over-reached in their borrowing provide an additional opportunity. Paraphrasing the famous Warren Buffett line, “When the tide goes out, we see who’s wearing shorts. When that happens, we’re able to provide rescue capital,” says Benveniste.

What does all this mean for your fixed-income portfolio?

The diversification benefits of fixed income, whose correlation with equity markets at various times in the last decade-plus have raised eyebrows (when it was historically uncorrelated), are alive and well, says Kapstream’s Dan Siluk.

“It’s all in how you structure your portfolio to produce the correlation opportunities,” he says. In the case of Kapstream, their global approach, which opens up a huge universe of investable credit assets, is part of its competitive edge.

Liquidity – or rather, the premium you pay for the privilege of having faster access to money you invest in shorter duration bonds versus longer – was also discussed.

Defining it, CIPAM’s Rodriguez says the illiquidity premium is the extra yield you get in excess of what you would receive in more liquid markets.

“When you invest in public market debt, someone else has already originated that loan – a bank has written the loan, a credit rating agency has issued a rating,” he says.

“But as a loan originator in private lending, we’re manufacturing the deal and we earn an upfront fee, which we pass on entirely to our clients as part of that added return."
“And it’s a much less competitive market, at least in Australia. Compared to public markets, it’s the lowest common denominator. We often do bilateral deals, often only in competition with one other lender, which is why that additional return is available,” Rodriguez says.

Another of his key points related to the importance, in terms of portfolio construction, of ensuring you don’t only invest in fixed income from your cash book. “You also need to take from the growth side of your portfolio too,” he says.

What yields should investors expect in the years ahead?

Ares’s Benveniste says his liquid fund, the credit income fund, currently throws off yields of around 5% and current income of a little over 4%. And on average, credit duration is around three years.

“We feel pretty comfortable…but it won’t be the same as last year when we had almost no volatility. There’s a lot more fear of insolvency ahead with credit spreads potentially widening further. But if we can avoid defaults, the income generation will be there.”

"The future looks bright"

Kapstream's Daniel Siluk refers to the objectives of his fund, which will maintain its stated aim to achieve a return in excess of inflation over the medium term.

“We don’t know what’s ahead for interest rates or with credit spread volatility, but there is an agreement to keep duration risk low, that’s what we’ve done," he says.

“And as rates have risen, we’ve protected client portfolios, without suffering those capital losses, which is really important. The future looks bright given this structure.”

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Glenn Freeman
Content Editor
Livewire Markets

Glenn Freeman is a content editor at Livewire Markets. He has around 10 years’ experience in financial services writing and editing, most recently with Morningstar Australia. Glenn’s journalistic experience also spans broader areas of business...

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