How to follow a safer path to profit
Humans love a good story, and, in the vast majority of situations, that’s not a bad thing. But for investors, getting seduced by a good narrative can be a recipe for disaster. While narratives often drive the short-term direction of markets, they can change without notice. Andrew Papageorgiou from Realm Investment House says it’s important not to try to be too far-sighted in markets.
“You can pick the destination, and you can lose a lot of money.”
Instead, he advocates a measured, step-by-step approach. Manage your bets appropriately, stay conservative, keep your bias in check, and position yourself for a timeframe where you have useful information.
In this interview, he discusses the areas of the market where he’s finding the best opportunities today, what it means to be a contrarian credit investor, and why minimizing the cost of carrying cash could be the wrong approach.
Could you compare how a bond investor might think about investing compared to an equities investor?
The framing is a little bit different. Ultimately someone there with a fiduciary responsibility to deliver returns to unit-holders still has their objective of delivering returns versus competitors and the market front of mind. But the framing that's different within corporate bond markets is that the returns on offer are finite. You're going to get your coupon along the way. And if you're fortunate, you're going to get your money in the end. Now the framing and the way the market is priced also allows you a greater power of inference than what would normally be the case within equity markets. So for example, a coupon within corporate bonds expresses the risk associated with that company not being able to pay something back.
So the return has a lot more information attached to it than an equity price where people on any given day might be willing to pay 10 times earnings or 20 times earnings. So from that perspective, you are framed by the conservatism that's inherent within the asset class, where people don't want to lose the money they invest, and the finite nature of returns.
But within that, there is scope for relative value. There is scope for relative assessment that is not dissimilar in some way. Because at the end of the day, we're still taking views around certain sectors. We're still taking views around certain names. We're still looking for those names that are going to outperform based on the business profile improving or credit metrics rising. So in terms of the framework and context you look at those things through, they're not dissimilar, but for the fact that outcomes tend to be more finite.
What might drive a change in attitude when it comes to low yields?
One of the real dangers is having been too far-sighted within investment markets. You can pick the destination and you can lose a lot of money. A common mistake among retail investors is allowing their bias or their view to heavily impact how they act from day-to-day. The reality is what moves around the market price on any given day is more a function of the battle of narratives at work. You talked about concern around deflation. That's a narrative. That's exerting force that is driving rates lower.
At the same time there's another story out there, the story of the reflation trade, the threat of modern monetary theory becoming widespread and capacity utilisation all of a sudden popping up above levels we've previously seen. That theory or narrative is exerting a force. That's what's driving the price from day-to-day. That battle ebbs and flows. One thing becomes more dominant than the other.
I might have a view that over the medium to long term, deflationary drivers are structural. And as a consequence, the reality is that we battle against an environment where technology continues to drive capacity utilisation lower. That might be my view, but that battle in the narrative could change four or five times this year.
For me, the key focus is on managing your bets appropriately, being conservative, risk managing your positions, keeping your bias in check, and positioning within a timeframe where you have information, where you can actually execute. Because the reality is for us to take a view from an investment standpoint on a deflation trade, or a deflationary environment which manifests itself in 2026, from a probabilistic standpoint, there are so many things that have to lean in to get there. It's just nonsensical to be positioning a portfolio of assets from day-to-day based on that long-term view. That's a big wheel. It turns slowly. It does provide a constant gravitational pull, but in the medium term, there are other things going on that are more dominant.
From my perspective, what always worries me as a part-owner of a fixed income and credit house; rates going to zero and there being no credit premium around anywhere. I think that would scare most credit managers because that's existential at that stage. That might make me lie awake at night, but for very different reasons.
The other thing you've got to be careful about is how you assign probabilities around your view or another view because the reality is we're wrong all the time. The skill is minimising your drawdowns when you do inevitably get things wrong, and being able to maximise the utility where you're near enough getting it right. That generally requires an investor to be able to moderate their views, to be able to position themselves in a disciplined fashion, to account for all probabilities, those perceived, those that have their bias attached to them, and those that are seen by the investment manager themselves as being unlikely.
What does it mean to be a contrarian investor in bonds and credit?
Within credit specifically, contrarian just means you're selling when they're buying and you're buying when they're selling. Feed the ducks when they're quaking is an old fixed income broker term.
When Robert Camilleri and I started this business 10 years ago, the reality was that for Realm to exist, it needed to have an edge. It needed to have a philosophy. It needed to have a way of doing things that wasn't par for the course. It had to actually go towards giving people what they wanted, which sounds like it's common sense, sounds like the type of thing every kind of fund manager investment manager would do. But, unfortunately in many big firms, they have scale to manage. They have business expectations to manage, which can often run contrary to actually delivering outcomes to clients. When we sat down with a blank sheet of paper, we realised that we needed to have the ability to operate within shallower pools. We needed to be able to buy a broad range of assets to deliver the returns that the market wanted, but we also needed to be very active.
When we looked at what being very active meant, it became clear very quickly that credit markets have certain characteristics. One is that, especially in the post-GFC period, they've become very pro-cyclical from a liquidity standpoint. That means that credit desks and banks are happy to facilitate the buying and selling of bonds in good markets. But when things turn, things tighten up really quickly.
That points to you being rewarded for being able to ration your capital and liquidity at appropriate times so you can take advantage of those dynamics. Now, being able to take advantage of those dynamics forces you in certain instances to be able to take money off the table when things are running hot. Because there's no way we can pick the bottom. But when we start to see that markets are implying levels of compensation that haven't historically compensated for the risk you're taking... For example, there's been a lot of talk about the US high yield market paying credit spreads below 4%, when in truth, the default rate for sub-investment grade companies in the United States is 4%. So essentially you're being paid less than the historic default probability. That gives you a sense that the gravitational pull in that market is technical. It is driven by the supply-demand dynamics, which is driven by a mania of sorts, but for a contrarian investor when you start seeing something like that, you're just looking at the numbers. The simple facts are that at that stage, you are being paid less than that kind of asset should be compensating you for the risk you are taking. Now, just because it's a little bit expensive right now, doesn't mean that it can't get more expensive six or 12 months from now.
For a manager like us in the current environment, the mindset turns from 'how do we take advantage of what occurred in March, April and May' to 'how far does this run?' And when do we start to step off so we are in a position to have capital spare, so the next time the market sells off, we can lean in? That's really been our skill over 10 years. That's what we've been able to demonstrate again and again is the ability to take the pain, to take reinvestment risks, to take the hits from sitting out and then having the liquidity available when we need to lean back in. So really, contrarian means contrarian in it's pure sense, it means genuinely looking to start to move in the opposite direction of the traffic.
But being a contrarian for contrarian's sake? There's no honour in that either. There's no honour in failure within markets and within funds management. So the reality is that timing is important in all of these things.
I spoke earlier about the gravitational pull exerted by different forces. We're in a market right now where the technical or the supply dynamics, the supply-demand dynamics are arguably different than they've been at any point in the post-GFC period, here in Australia in particular, where you have a term funding facility that is lending banks money at 0.1% p.a. so they don't need to come to the market and borrow money. Banks have a lot of extra money so they can lend to a lot of the companies which would generally issue corporate bonds. At the same time, Australian households have record amounts of money thrown at them from the government and savings rates are going through the roof.
So from early 2019, the major banks here have got $180 billion in deposits through their coffers. They've lent out maybe $20 billion. So there's $160 billion sloshing around out there. Then you add a term funding facility, which has thrown another $80 billion on top of that. That's a lot of liquidity.
So a question for us at the moment is, what does being a contrarian look like when you're facing that kind of wall of money? This is where you have to be pragmatic as well. So ultimately we have tended to act in a contrarian fashion. We believe that in general terms, being a contrarian rewards you within fixed income and credit markets.
Are there any interesting areas that appear to be notably out of favour?
The one market that probably hasn't pulled right in versus where it was a pre-COVID is the residential mortgage-backed securities (RMBS) market. The RMBS market in Australia is more or less pricing in line with its pre-COVID levels. On a relative basis, would you say it's rip rip-roaringly cheap given its entire history on a relative basis versus itself over five years? No, it looks like it's trading around in line. But in the context of the rest of the market, it does look quite attractive. The ability to buy triple-B RMBS at 3.5 to 3.6% for those mortgages that are conforming prime mortgages, 3.6% over the bank bill swap rate (BBSW) sounds okay in the context of investors happily taking 1.25% over BBSW to buy bank subordinated debt which has an equivalent credit rating. So the attractiveness of structured credit versus corporate credit starts to look attractive.
And that's another tether. That's another thing that's just next train station out so to speak. Because it's an asset class that is a little bit esoteric, is more specialised. It's an asset class that has motivated popular culture to the point where you've seen two or three movies written about it. The acronyms still put a shiver down people's spine. So all of those factors create a differential, which we think is very attractive right now, because the ability to maintain that bias in the face of you not being able to fund your cost of living as a retiree, you're going to find in that fight, you're going to let go of your bias first.
One of our financial advisors told me an anecdote the other day. He said to me, "do you realise to match the age pension using the current one year TD rate, you need something like $11.5 million to generate an income which would equate to a couple on the Age Pension?" Which is, thirty-odd thousand dollars.
So that starts to give you a sense of the fact that income's hard to come by, and you just can't sit on the sidelines. So people will find a way to deal with it, deal with their bias to certain assets.
The other market that looks attractive to us right now are private assets. So that's an area where we've developed a real skill and have become market leaders of sorts over the last two to three years. There are a lot of opportunities and possibilities that revolve around the wholesale banking market, which essentially involves partnering with major banks and financiers for the purpose of assisting them with providing finance both for home loans and other products too.
So that's an area where we've been putting a bit of effort into, because essentially I think we recognised early that if we are in an environment where the forces are going to be deflationary and credit spreads get tighter and tighter, delivering outcomes to real Australians is going to become more difficult. So, what do you do at that stage? How do you go out and deliver returns? And what's going to be your approach, and as a firm, where do we want to be positioned? So that's where we've really focused on those structured credit markets as being an area of opportunity over the medium term.
Is there anything you can do to minimize the cost of carrying large amounts of cash?
That's where we're at right now. Answering that question is where we've all gotten to, because yes you can, but at what cost and with what risk?
A lot of what's in place right now, such as central bank assistance in the US, the Fed Reserve targeting rates and buying credit, the term funding facility here in Australia. Two to three years from now, there's potentially a cliff effect. This support and this liquidity that's being funnelled towards banking and credit markets is not a constant for now and forever.
Just to complicate that question a little bit further, you have to be aware that you've also got the risk that a year and a half to two years from now, the music stops, and forces people into a position where they're going to need that liquidity again.
So when you frame it from that perspective, the question you have as an investor is, is it worth soaking up all of your liquidity right now for the purpose of making up that difference? Is it worth being corralled into taking more risk to be able to meet your lifestyle goals, or is the right thing to do to take a more measured approach with how you manage that?
What that means for us, it means that we want to pick our fights. We're a lot more relative value-conscious than we would be normally. We feel that we don't necessarily want bulk credit risk. That means we don't necessarily want to own the index because it's not clear to us that the broad credit indices are going to tighten a lot from here.
However, there are a number of relative value trades that could deliver a reasonable return over the next 12 months that allow us to meet our target. So for us what it means is we pick our fights, but not to the point where we overextend. We still feel like we want to hold onto a little bit of liquidity here and if this market continues to run, we'd be more inclined to take more off the table as it lengthens and reposition the portfolio in such a way where we start to expose our clients to a lower risk of capital loss or capital underperformance.
So we're almost at the point now where the two discussions are evenly weighted. We're not sitting there right now feeling like, "Jeepers, what do we need to do to get more yield?" Because frankly, that's classic late-cycle behaviour, isn't it? So you're more so wanting to sit back in a pocket right now and really be careful about what you do.
A bigger, more difficult question is what it means for clients. I think for us it's always really important to understand that we're here to serve. Sometimes you can get really stuck in the relativities when you're managing funds. You've got a close eye on your competitors. You're looking at your numbers versus the next guy. But the reality is at the end of the chain are real people that are trying to live their lives and pay for their cost of living and take the grandkids to the zoo and stuff like that, that is why we exist.
So what do they do? That's an interesting question as well. I think the idea that you could run the good old-fashioned Aussie barbell, where you run a bucket load of cash at a reasonable TD rate, and you pump the equity market with the other half, it feels like that's really changing. It feels like that's over, and that might not be a bad thing. I think what that points to is the fact that people are needing to think a lot more about how they manage their asset allocation, how they ration their capital. There is a very large amount of lazy money sitting out there on the logic that you'll be able to crunch it out of the park in equities or growth asset classes, I think that's gone now.
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