It's "hard to see where it can go wrong" for these assets

"Cost" is a word that dominated earnings season – from the surging cost of financing debt, to the rising cost of raw materials and the rising cost of labour – which in turn was spurred on by a soaring cost of living. And as many companies have learned the hard way, investors don't like it when management teams cannot answer how they are tackling this pressing issue. 

This season, credit investors have also had to deal with the default question. Can companies that were born during the free-money era survive without it? And can investors avoid the landmines and stay away from companies that are at risk of defaulting or further losses? 

To answer all those questions and more, Roy Keenan of Yarra Capital Management joined me to give his verdict on the August reporting season, from the perspective of a credit investor.

The major themes of August reporting season

At the beginning of the reporting season, the three C's were in focus - China, costs, and consumers. While equity markets may have been caught off-guard by the rising cost of capital, Keenan admits that he wasn't surprised.

"For us, it was probably as expected," he said. "It was probably more a tale of two quarters. The first quarter was really strong and the second quarter was much softer. And the two together made it look like it was OK," he added.

Keenan said he will be taking two key themes moving forward.

"Some companies are no longer passing on price increases, which is good for inflation. We're seeing that moderate to slow," he said. 

"We also monitor offshore companies like James Hardie (ASX: JHX) and Reliance Worldwide (ASX: RWC) for which their import costs are falling and they've been the true indicators of inflation over the last two or three years," he added.

How are higher interest rates impacting the cost of capital?

This reporting season was also the first to seriously feature the impact of higher interest rates on the cost of capital. For the banks, he said that it was a game of bad debts, arrears, and NIMs. 

"In the financials sector, there was no doubt that NIMs declined right across the board," he said. 

"In some ways, the major banks were fine because they have so many funding sources but ADIs [authored deposit-taking institutions], which are pretty small and took on a lot of that term funding facility and cheap finance are now coming out the other side. That's starting to expire and their cost of finance is rising dramatically," he noted. 

While there is no doubt all three are moving in the wrong direction, there is argument on how much of that fear has manifested.

"Some people have been a bit alarmist about it. Bad debts are rising but they are only normalising to pre-COVID levels," he argued. "We were quite surprised about how well consumers are holding up and being able to adjust their lifestyle to keep up with debt repayments," he added.

Navigating a bifurcated market

The good news is that fixed income is once again serving its purpose - or as Keenan would say, "it's got its defensiveness back". The bad news is that fixed income returns have been all over the place so far in 2023. Government bond returns have been anaemic while different areas of corporate credit are delivering drastically different returns. 

But like clockwork, an interest rate hiking cycle also brings about a default cycle. And although the high yield/risky corporate credit market is much more developed overseas, Keenan is still watching with bated breath.

"What history tells you is that when interest rates go through a cycle like this, you get a default cycle. It's just a natural thing," he said. "I just find it really hard to believe that we won't see a default cycle."

In this environment, Keenan is doing what so many other fixed income investors are doing - moving up the quality spectrum. 

"Investment grade companies tend to do very well. They sail through the cycle because they have pricing power and they don't have as much debt," he said. 

As for the opposite end of the scale - or in the high yield market - Keenan says he has never been this underweight high yield in all the years he's been managing money.

Sectors of interest (and sectors worth avoiding)

Almost all of the top 10 holdings in the Yarra Enhanced Income Fund are financials and insurance business-centric. These include holdings in National Australia Bank (ASX: NAB), CBA (ASX: CBA), ANZ (ASX: ANZ), Bank of Queensland (ASX: BOQ), and even AMP (ASX: AMP). The fund also holds stakes in Challenger (ASX: CGF)'s life insurance arm as well as QBE Insurance (ASX: QBE). So what did Keenan make of these results? 

"The insurance results were really good," he noted. "This reporting season only validated the positions we have today."

"We really do like highly rated financials and insurance companies," he said. "We love that risk-reward opportunity. It's quite compelling," he added.

In contrast, Keenan finds it difficult to build an investment case for REITs.

"We still see valuation headwinds - and it doesn't matter if it's office or retail," he said. "The rise in interest rates has not been reflected in valuations. There's no doubt leverage is rising," he added.

And... the asset classes the fund is overweight and underweight

From a credit spectrum perspective, the fund is keenly eyeing several assets - all of which could be characterised as being in its Goldilocks zone. One of those is the corporate hybrid market - which has been out of favour for a long time. 

"It's the perfect environment for corporate hybrids or subordinated debt because if a company doesn't want to raise debt and put their credit rating at risk, they can raise subordinated debt or hybrids where they can protect their credit rating because they get an equity credit. I would not be surprised if in the next 12 to 18 months, we see a lot more corporates come back to that hybrid market," he noted. 

"It's been a long time since that's happened but it's very cycle-driven and for the last 5 to 10 years, balance sheets have been in great shape and there is no need for corporate hybrids. But we're moving into this environment where it will be cheaper to raise corporate sub-debt than to go back to equity markets," he added.

But there's one market Keenan is even more optimistic on than the hybrids market. 

"We think the RMBS [residential mortgage backed securities] market is probably offering the best risk-adjusted returns across the complex," he argued. 

"Not only are you getting paid for the risk you're taking, you're in an environment where unemployment is low and arrears have not risen to dramatic levels. But more importantly, we're now seeing property prices stabilise," he said. 

"It's hard to see where it can go wrong - especially when you're now getting paid," he added.

Access to regular, stable income

The Yarra Enhanced Income Fund seeks to deliver higher returns to investors than traditional cash management and fixed income investments. Learn more via the Fund profile below, or by visiting Yarra Capital's website.

Managed Fund

Yarra Enhanced Income Fund

Australian Fixed Income

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