The fixed income manager that returned more than most equities managers in 2022
Rising interest rates and the spectre of inflation have struck fear into the hearts of investors since last year. But not every asset manager has been rushing for the exits.
Christian Baylis, CIO of the Fortlake Real-Higher Income Fund - an absolute return fixed-income fund – says this environment has played to the strengths of his team. That’s primarily because they’re not restricted to any individual style of fixed-income asset management. Baylis calls out inflation, volatility, and the emergence of default risk as the big themes of 2022, which created some of the most challenging market conditions on record.
“But these conditions have also provided significant opportunities given the right toolset,” he says.
“Specific investments can include but are not limited to floating rate notes, fixed-rate bonds, money market securities, inflation-linked securities, and generally anything that sits above equity on the capital structure.”
In a recent interview, Baylis contrasted Fortlake’s approach with the “individual silos” of traditional fixed-income managers. As he explains, when inflation started rising last year, many managers had little concept of what it would mean. Nor were they equipped to shift their credit asset selection appropriately.
“Only two years ago, if you asked a credit analyst what inflation was, they’d have pointed to a Swiss ball. Now, inflation is the number one thing wrecking their default models,” he says.
In the following Q&A, Baylis details the nuances of Fortlake’s approach to global fixed-income investing and discusses some of his largest positions. He also digs into some of the lessons learned last year and points out the most poignant market signals on the horizon currently.
What investments fall under the definition of "short-term fixed income"?
Short-term fixed income encompasses a very broad cross-section of public market global bonds. We aren’t really limited by the term of an investment, as everything can be reduced or deconstructed in our asset class. For example, if an investment is “long-term” we can reshape an investment by “swapping down” its duration to give it the characteristics of a “short-term” investment.
As an absolute return manager, this gives us a much larger opportunity set and doesn’t preclude us from opportunities due to market microstructure. But we still have the market beta (the volatility) of something that is short-term. Put simply, people should expect our asset profile to be somewhere between zero- and four-years duration, depending on the cycle.
Specific investments can include but are not limited to floating-rate notes, fixed-rate bonds, money market securities, inflation-linked securities, and generally anything that sits above equity on the capital structure.
Please pick three elements of your investment process/philosophy and explain how they contribute to the fund's investment performance.
The investment philosophy's three key elements are:
- Multi-faceted approach;
- Anchoring on managing risk then returns.
Fixed income has many areas where risk can be managed and returns derived. The number of dimensions is enormous, and they are all interconnected.
Traditional fixed income tends to look at each area as individual silos. However, this past year we've had so many crosscurrents, i.e. inflation started stepping up, and we saw credit markets react aggressively. It was only two years ago that if you asked your in-house credit analyst what inflation was, they would have pointed to a Swiss ball. Now inflation is the number one thing wrecking their default models. Taking a multi-faceted view across a variety of silos and focusing on the connectivity of these silos provides many more areas to manage risk and derive value, especially when markets are challenged.
A good analogy is a builder coming to a building site with only a hammer to realise they require many more tools for the unforeseen issues that have come about on the building site. If that builder doesn’t know how to use a hammer drill or some other tools that vary from their base knowledge, they will typically overlook simple solutions to ”market” problems.
Which investments have made the most meaningful contribution to your performance over the past year and do you still own them?
There are no prizes for identifying inflation, volatility and the emergence of default risk (particularly in Europe) as big themes in 2022, and we were certainly very active across these categories.
Emerging markets were also a welcomed yet smaller contributor for us as emerging economies became the “emerged economies” on monetary policy with their more responsible actions over the last two decades on base money and fiscal, bearing fruit in 2022.
As 2023 unfolds, many of these same themes will be with us but will require a more nuanced approach. So, we do hold and expect to hold many of the investments that we held in 2022, but the way we manage those will be more risk-based and interactive as we expect the environment to morph because of monetary policy and tighter fiscal settings.
It’s also worth noting that these themes have created some of the most challenging market conditions on record, leading to some dreadful performances across the board. But these conditions have also provided significant opportunities given the right toolset.
At the start of the year, the RBA was kicking tyres on raising rates, and the Fed responded aggressively. In Europe, the market simply couldn’t accept that Europe wasn’t Japan and that inflation had its rightful place there as much as any other economy.
We certainly liked Europe from the perspective of rates, inflation and therefore the default perspective. In sum, the significant volatility in the global rates market begets a more nuanced credit view, one where defaults are a consideration. Ultimately, appreciating the various attachment points of these big global thematics is what shaped our performance.
Is there a chart/graph that has caught your eye recently?
Plots on the expected loss of European high-yield bonds tell a thousand words. These indices track various segments of the debt markets across different regions, are highly liquid and used by all types of investors through to central banks and regulators as pseudo measures of risk.
iTraxx XOVER spreads over 12 months
There has been a structural shift in the credit markets – with the baseline of risk sitting higher as the economies grapple with geopolitics, higher inflation etc. Looking at the CDS Index in Europe, for example, the iTraxx XOVER spreads started the year at a low of 229 basis points, then hit a high (almost 2020 pandemic highs) of 670bp in September and finished the year at 474bp.
We have effectively experienced a full economic cycle, from a risk perspective, in the condensed period of 12 months. That is very painful for an asset class that can use running yield to drown out its sorrow…as yields just haven’t had the time to overrun capital losses. The above graph shows elements of the index reaching an expected loss of close to 90%, which is significant.
Could you talk through some of the largest positions in the fund and why they deserve a place in your portfolio in 2023?
Firstly, you won’t see us doing a slick PowerPoint presentation on why we bought a particular bond and why it was such a success as much as you won’t see the Chief Credit officer of the National Australia Bank (ASX: NAB) explaining why they are so bullish on an oversized exposure to ABC Learning Centres, on their balance sheet. If a fixed-income manager is doing this, I would suggest running a mile…We are not an asset class that gets rewarded for picking winners, we only have limited upside to many of our exposures and then we get our money back. Therefore unlike equity managers who get significantly rewarded by picking 10 baggers and the blue sky that comes with that, we live in a miserable parallel universe that lives and dies by the downside.
Therefore our process has to be about closing down risk, reducing forecast errors and mitigating “success stories”. There are no superstars in our portfolios. Our biggest success is the interplay of all our different exposures and that is the PowerPoint presentation that I am happy to front.
With these points in mind, we gravitate towards investment themes based on risk selection, and some of these were the themes that I mentioned previously. At this stage I don’t see a new calendar year as a basis for changing tact, we still see merit, albeit nuanced, in staying with these themes in the short to medium term. But we do put a lot of thought into how we build out a theme and this is where change will occur over 2023, much of this is quantitative but the rubber really hits the road on the practitioner overlay.
It’s an important closing point that good ideas in our asset class can turn bad by the way in which you execute them and vice versa. So, I would phrase it like this, “Execution” was our best position in 2022 and it will certainly be a big feature in our 2023 ex-post attribution. While I know this is mundane for the reader, it is going to be far more important in our asset class than picking five or so winners at the security level.
Which investments worked against you in 2022 and what have you done with those?
We’re always “expecting loss” and always anticipate making losses in the future. Missed shots, in our game, are a way of life, and it really comes down to how you view it and deal with it. We are managing the degree of loss/forecast error, which is a unique part of our process.
We accept fallibility, know it will occur, and spend our working hours thinking, planning and mapping out exit points. Forecast error is a certainty in the world we live in and to say otherwise is grossly misleading. Selling a narrative of ‘we know better” is not the guiding light that sits behind our process. So, in short, knowing that we don’t know actually guides our process more so.
To the second part of your question about what we do with our losses - we either optimise other parts of the portfolio which dilute losses or we mitigate them contemporaneously so as to give a similar effect. The analogy I would give here is that some rubbish has second-order benefits; think compost or rubber bitumen. You might find second-order benefits, from a risk perspective, by including a theme or a building block that naturally doesn’t have a strong foothold in your portfolio. Obviously, these decisions require a fact-sensitive analysis, each situation is unique.
People often look to fixed-income markets for a signal of the health and outlook of the economy. What signals are you seeing right now?
The yield curve (the gap between the long-term and short-term government borrowing rates) is the obvious thing tourists look at in our market. From my perspective, the curve has been playing out like dominoes. Each day you see another part of the curve invert and fall below the spot rate - we now have basically no carry and roll down outside the immediate front end. This means the market is daring you into “roll-up” short trades – this is where you get paid for going short bonds on particular parts of the curve. I would be careful here, being drawn into the devil’s lair – you will probably come out with fewer limbs. When events actually happen, the market tends to respond on top of the anticipation that’s already in the market.
The more remarkable story in our markets is the default cycle, or the lack thereof. Financial repression has played its part, and thanks to that, you really need to have been “talented” to default over the last three years in a world of fiscal and monetary largesse. I often refer to this phenomenon from an actuarial perspective – if you as an actuary had modelled the mortality risk of people dying at the age of 80 and over and told your CFO that there is no chance over a three-year period this would occur – the CFO would think you’re nuts.
Perversely, this is what has happened in credit markets – we now have basically three years of a near-zero corporate death rate. So, my take on this is that this statistical gold nugget will have to pay out at some point, and you want exposure to it when it does.
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