Fund Manager Q&A

Unless we get more RBA QE, Aussie dollar could go to parity with US dollar

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Exploiting inefficiencies and finding real alpha in bond markets during an era of low yields is possible says Ying Yi Ann Cheng, Portfolio Management Director at Coolabah Capital Investments, it just requires a sustained intellectual edge.

The $4.8 billion fund manager Coolabah is focused on leveraging its 25 person team, including 13 analysts and 5 portfolio managers, to identify mispriced bonds that can generate capital gains (alpha) that are greater than the yield on these securities.

They are also maniacally focussed on predicting macro themes that influence asset pricing. In 2020, the team couldn't miss, correctly calling the timelines for COVID-19 waves, vaccine developments, house prices, unemployment, and RBA decisions months in advance.

Now, Cheng identifies several current investment opportunities, including major bank hybrids, select Tier 2 bonds, and state government bonds. While Coolabah believes that the RBA will expand its QE program next year, the team thinks the end-game will be an inflation cycle over the next decade as a function of the unprecedented fiscal and monetary policy stimulus.

In the following wire, Cheng reveals key trends for the future and where Coolabah sees value right now.

What are some of the trends that you have spent time researching in 2020?

Innovative quantitative research is incredibly important to us. Of the 25 full-time executives, we have 10 quants, five data scientists, four PhDs, and two University Medallists. We're doing an extraordinary amount of deep statistical and mathematical modelling in addition to software engineering to develop methods to predict the future, including those that harness artificial intelligence.

Some of the issues we've investigated this year have been: when would the first and second COVID-19 waves peak; when effective vaccines were going to arrive; how far the unemployment rate would increase; how far and fast house prices were going to fall and then start climbing again; and on a more qualitative basis, whether or not the RBA would launch quantitative easing (QE).

We find it odd that the funds management industry flips from one fashionable idea to the next without actually divining the future. The same investors who were warning of 20% house price declines only a few months ago are now calling 10% to 15% house price increases.

Yet we’ve had a consistent view throughout: in March 2020 we advised our investors that national house prices would only fall by a tiny 0% to 5% over 6 months, dismissing calls for prices to plummet 10%, 20% or 30%, following which we said they would starting climbing again in September with total capital gains of at least 10% to 20%.

What did you and the team uncover from that research?

During the first COVID-19 wave, we were one of the first groups in the world to predict that it would peak in Europe, the US, and Australia in early April—many months ahead of what epidemiologists were forecasting—using our dynamic, data science-based forecasting models, which we publicly released via an academic research paper.

Leveraging off some of the best immunologists in the world, in March we developed the view that an effective vaccine would be found this year, and that production, approval and distribution would also commence this year, when almost all experts were saying that vaccines would not come for at least 18 months.

On housing, we were the only investor to accurately forecast the circa 2% correction over just six months, and to predict that house prices would start increasing robustly again in September, as they have done. It seems like every other analyst wildly mis-forecast the housing market, which is a big problem when you are talking about the single greatest source of household wealth. If you cannot get housing right, you have little hope of anticipating the overall economy’s behaviour.

Back in March we projected that the unemployment rate would promptly settle between 6% to 7% compared to the much more dire consensus forecast of 10% to 12%. Again, almost all analysts, including the RBA, really struggled to accurately foretell Australia’s unemployment—and hence overall economic—dynamics.

Finally, on the RBA’s inaugural $100 billion 5 to 10 year bond purchasing program (QE), we have been advising clients since August that Martin Place would be compelled to start longer-dated asset purchases, and they delivered that in November. We think the RBA will extend QE further next year.

Where are you finding value right now?

Our investment universe spans from federal and state government bonds, senior bonds issued by financials and corporates, subordinated bonds, hybrids, ABS (asset-backed securities) and RMBS (residential mortgage-backed securities). Typically, we focus on highly liquid, A to AA rated assets, that have little intrinsic credit risk because they're issued by entities that are either implicitly or explicitly government guaranteed.

Some of the securities we invest in include federal and state government bonds and bonds issued by strong oligopolists, such as the major banks, Woolworths, Coles, and Optus.

Right now, we're seeing a few opportunities. The first is in state government bonds, which we think will benefit from ongoing RBA asset purchases or QE. Another opportunity is in the ASX listed hybrids markets. We saw five-year major bank hybrid spreads blow-out from 307 basis points over the quarterly bank bill swap rate to around 340 basis points as a result of five new primary market hybrid transactions.

Prior to COVID-19, five-year major bank hybrid spreads were trading around 260 basis points. This implies significant potential upside capital gains north of 300 basis points (in addition to the underlying income paid on these securities) if they revert back to pre-COVID spread levels.

Finally, we think there is a place in portfolios for the more highly rated and liquid Tier 2 bonds, which will benefit from the search for yield notwithstanding an expectation of further primary supply in 2021. There has certainly been a surge of Tier 2 supply of late with 15 issuers tapping the Aussie dollar market or Aussie companies issuing in US dollars. Despite the wave of issuance, Tier 2 has performed well, which will think we continue in the first quarter of 2021.

Have you had to adjust your return expectations this year given the interest rates have been falling?

Coolabah’s portfolios are not dependent on yield, and we do not chase interest rate risk, credit default risk, and/or liquidity risk to boost our yields. We prefer instead to generate liquid alpha, or capital gains, by finding mispriced bonds paying excess credit spreads after controlling for their risks, which will appreciate in price in the future as their spreads normalise.

Our 25 person team has been very active in 2020, trading over $24 billion of bonds, which has helped us generate some of our best returns on record notwithstanding the March 2020 COVID-19 shock and the decline of both short-term and long-term yields.

In the 12 months to 30 November, our zero duration, AA minus rated Long Short Credit Fund, has delivered 5.5% after fees or 7.9% before fees.

Another one of our strategies, the long-duration, AA minus rated Active Composite Strategy, has returned 6.6% before fees. This is an insto-only product with confidential fee terms.

Please note that past performance does not assure future returns. Investors should read the product PDS and seek independent financial advice on their choices.

What are some of the scenarios that you're looking at for how policy will play out in 2021?

Since August we've had the view that the RBA would need to launch QE in the form of purchases of 5 to 10 year federal and state government bonds to ensure the Australian economy is not artificially disadvantaged vis-a-vis the rest of the world.

What we've seen from global central banks is that they've aggressively expanded their balance sheets and lowered the cost of borrowing for their public and private sectors, which has resulted in downward pressure on their currencies.

Australia has lagged in this respect: our 10-year federal and state government bond yields are higher than every other AAA and AA country in the world.

If you look at the Aussie dollar, back in March it was around 55 cents. Today, it's at 75 cents, which hurts our exporters and import-competing businesses. And we think the Aussie dollar could head towards parity with the US dollar unless the RBA does more.

To put Australia on a level-playing field, we have argued since August that Martin Place would have to expand its balance-sheet via QE in a manner that is broadly pari-passu with other global central banks.

By buying our government bonds, the RBA puts downward pressure on their yields. This makes these assets less attractive to foreign investors, which ameliorates the bid-side demand for the Aussie dollar, throwing sand in the wheels of its ascent.

And that's what the RBA has delivered. In November they announced a $100 billion bond purchasing programme running through to mid 2021. We feel the RBA is open to expanding these purchases in 2021, and project that they will extend the program with another $100 billion for a further six months by the end of June 2021.

While we are very bullish on economic growth in 2021, we think that it will not be enough to crush the jobless rate down the to “4-point-something” level that is going to give the RBA the 3% to 4% wages growth required to lift inflation back into its 2% to 3% per annum target band.

So the RBA definitely has more work to do. And since buying 5 to 10 year federal and state government bonds has little-to-no impact on house prices, financial stability risks are not a concern right now. Especially when you consider that house prices today are below their early 2017 levels.

Learn more about Coolabah Capital Investments

Coolabah Capital Investments (CCI) is a leading active fixed income manager, specialising in liquid, high grade credit. The large investment team covering Sydney, Melbourne, and London is equipped with deep quantitative credit research capabilities.

Click here for more information about Coolabah’s income generating investment strategies.



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