Love income? How much risk are you taking to get it?

At the ASX Investor Day in Sydney last weekend, once I had completed my presenting duties, I listened to a handful of the breakout sessions, one of which was delivered by Macquarie Asset Management’s Blair Hannon. 

The session was titled “A world without hybrids”, referring to APRA’s phase-out of the circa $40 billion AT1 hybrid market by 2027. 

The session also touched on the value of having fixed income in a portfolio and understanding the risk-reward trade-off.

It was a timely session, particularly given we're in the midst of a rate-cutting cycle and investors might be tempted to move up the risk curve to get the yield they desire - but at what cost?

Below is a summary of the highlights of the session.

Income vs growth: understanding the risk-reward trade-off

Hannon opened his ASX Investor Day presentation by drawing a clear distinction between growth and income investing. 

While much of the market talk focuses on where to find growth, whether through shares, property, or more speculative options like bitcoin, Hannon's session zeroed in on income.

He warned investors not to chase high yields without understanding the risks. “You look at this list [referring to advertisements in the image below] and you see 8%, 7.5%, 16%, 12.6%. The question you’ve got to ask yourself is: how much risk am I taking on to get 12.68%?” 

One key risk he highlighted is the “liquidity premium”, where investors lock their money away for a period in exchange for a higher return.

Fixed income: a complex but powerful tool

Hannon explained the often-misunderstood world of fixed income, primarily bonds, and why it’s crucial for investors seeking income and portfolio stability. 

“What actually is fixed income? Bonds. Not overly exciting,” he admitted, but noted that they serve a vital function in portfolio construction.

Unlike equities, bonds are harder to access directly.

“Let’s say you wanted to buy a CBA bond. Which one do you buy? The one year? Two year? Fixed or floating rate?” he asked rhetorically, demonstrating the complexity retail investors face.

He noted that the bond market is huge but inaccessible for most, with high minimum investment thresholds. “Whether it’s $100,000, even as high as half a million… we know diversification is key, and this is kind of the opposite.”

This, he explained, is where fund managers like Macquarie come in, providing diversification and access to these markets through managed funds or ETFs.

Defence and diversification in tough times

Hannon stressed the defensive qualities of bonds, especially during equity market downturns. “In environments where the market falls... what happened in the bond market during that time? It went up or stayed flat”, he noted, referring to the slide below. 

He likened bonds to a form of insurance:

‘“You cannot buy insurance for your car after the fact... You have to buy insurance before you get in trouble.”

Fixed income, he said, helps buffer against major equity drawdowns, citing the GFC and COVID-19 as key examples. 

Although 2022 saw both equities and bonds fall – “an anomaly” - he believes the traditional negative correlation between the two asset classes has since resumed.

Hannon also touched on the challenge of cash drag, noting that investors should treat cash differently from working capital and make sure their cash holdings are pulling their weight in the portfolio.

“If you’ve got a bunch of money sitting there in that portfolio, just cash, what is that doing for you?” he asked.

Ultimately, Hannon’s message was clear: “Fixed income is inherently more complex than equity investing,” but its role in delivering regular income and protecting portfolios during downturns makes it a critical component for long-term investors.

He pointed to July 2022 when inflation surged and real returns on cash dropped to -4%, saying, “It turns out [inflation] wasn’t transitory, which means it was here to stay. The cash rate did not move in unison... to push that down quick enough.”

He warned that a return to negative real returns on cash is on the cards:

“This is not to say that you shouldn't have money in cash... but understanding that cash as an investment per se may not be the best place to go.”

Hannon then turned to hybrid securities, “particularly the banks' hybrids”, which were once popular for their franking credits and income potential. 

But with regulatory changes phasing these out by 2027, investors need a new home:

“This $40 billion market... has to go somewhere. If you're in this audience as a hybrid investor, you need to make a decision.”

Why subordinated debt deserves a look

The product stepping into the void is subordinated debt.

“You're getting compensated more than you would in a hybrid,” Hannon explained, “but you're not getting the franking credits.”

Still, he said, “6% is a reasonably good chunk above what you would get in a bank deposit.”

He emphasised the relative strength of subordinated debt from institutions like CBA: “CBA never stops paying on the shares,” he said. “So that sounds great – low capital risk and high yield.”

However, this isn’t something you should DIY. “There are a couple of ways you can buy subordinated debt… but essentially, you have to come to a fund manager to do it.”

He advocated for active management over passive in fixed income: “In a bond index, the highest weighting holdings are the ones that issued the most debt. That doesn't make a whole amount of sense.” 

He contrasted this with equities, where market cap weightings align with business success.

“The difference between equities and fixed income investing,” Hannon said, “is like rugby and league - they look similar from the outside, but they’re not.”

He concluded with a practical checklist for assessing active managers: longevity, experience through market cycles, performance during drawdowns, and clarity around the level of risk being taken to generate returns.

Macquarie, he reminded the audience, is “the largest fixed income manager in Australia” and has launched a new fund – the Macquarie Subordinated Debt Active ETF (ASX: MQSD) – in the space:

“We think we can do active at the same price as passive… and we’ve seen really strong support from advisors and investors looking for a compelling yield.”