After a market wobbles, sometimes comes the investment opportunity of a lifetime. Phil Strano (Senior Portfolio Manager, Yarra Higher Income Fund) sits down with Chris Conway (Livewire Markets) to discuss whether such an opportunity is now being presented in fixed income.
There were moments during the GFC, after markets had tumbled 30-40% (the drawdown topped out at 48% on the S&P 500), when panic set in and people began to seriously question the viability of the global financial system.
Some people couldn’t stomach being invested through the uncertainty and volatility, and ultimately sold their portfolios at the lows, only to miss out on one of the best bull markets of all time.
As much as we’ve all read maxims like buy “when there is blood in the streets” and “be greedy when others are fearful”, it’s not easy to hold your nerve during or after extreme market events.
And whilst fixed income didn’t suffer the same percentage drawdowns at the start of last year as equities did during the GFC, the ~15% wipeout was the worst on record.
So, after a shocker for fixed income in 2022, could some investors be missing out again, too burned and too scarred to realise that there is a Goldilocks opportunity occurring in credit markets right now?
That is the opinion of Yarra Capital Management’s Phil Strano, who is a senior portfolio manager focused on credit, within the fixed income department which runs 10-strong and manages around $4.5 billion.
“It’s a great time to be in credit because we’ve actually got yield to play with. We’ve got an environment where we don’t have to swing the bat too hard.
“Looking at our performance, the fund that I manage in particular, has got an average credit rating of BBB-flat, so that’s investment grade across the whole portfolio. The portfolio has generated 8.2% over the 12 months to July. So that just shows you’re able to stay in pretty high quality and generate just fantastic returns”, says Strano.
I recently sat down with Strano to help investors better understand credit markets and the compelling opportunities therein.
Credit markets are hard to understand for most investors. Give us the 30-second elevator pitch.
We’re here to lend money to issuers, the issuers that we perceive to be of a minimal risk, or carry minimal impairment or credit risk, with the objective of earning a premium over risk-free, i.e., government bonds. We do that in a diversified environment from a portfolio perspective to generate defensive, dependable income, and minimise any kind of drawdowns.
What’s in the portfolio?
We manage roughly $4.5 billion of assets across everything from government and corporate bonds, through to loans and private debt-style assets.
We do a lot of credit work. Of the 10 in the Yarra team, seven of us have credit responsibilities in terms of analysing credit risk, quantifying that risk, and focusing on the relative value to ensure returns are commensurate with the risk that we’re taking, and sizing the investment accordingly.
All the assets contribute to the portfolio carry. None of them are over-weighted from the perspective that they could detract significantly if something were to go wrong. So it actually adds a lot of defence. Looking at our credit portfolios, the average number of securities in there is 75-100, so there’s a lot of diversity.
What does credit do that other asset classes don’t and why is it important in the current environment?
When thinking about credit, it comes back to the return over the risk-free rate and doing it in a way that gives you dependability of income.
Most of our portfolios are floating rate and we’ve done particularly well at navigating away from duration, which have affected the returns for a lot of traditional fixed income managers.
“Credit brings a supercharged income because we’re seeing much higher yields now in our portfolios, which are investment grade quality, around ~7% – materially higher than where we were just two years ago.”
Having that kind of yield actually not only provides really good offence in terms of strong yields, but also provides really good defence from any kind of spread widening.
From our perspective, the prospect of seeing a negative return right now is just infinitesimally small. It’s very hard to see how it can happen because you’re looking at portfolios with an average spread duration of around three years and you’ve got yields around 7%. This means we’ll need to see credit spreads widen by a very improbable 250bps over a 12-month period to record a negative return.
What is your view on the current interest rate cycle? Where are we at and what happens next?
Right now, it’s a pretty interesting market.
From our perspective, we think the RBA is on hold and will be so for a while before potentially cutting rates modestly in mid to late 2024.
“It feels like we’re going to be at or around these levels for quite a while.”
What is your view on the economy? The RBA revealed recession modelling as high as 80% – do you factor this into your investing?
We don’t think that we are going to go into recession with expected growth at about 1.25% this year, then re-accelerating to about 2.5% next year. We may though have a per capita recession, with the biggest growth impetus coming from immigration. With circa 700,000 people coming in, this year and next boosting GDP, it then becomes a question on whether we grow on a per capita basis.
“We know that there’s a slowing growth environment coming and we’ve certainly positioned the portfolios to deal with that.”
This cycle is playing out very similar to most cycles as occur in Australia where you’ve got households under pressure, and what do they do? They tighten their belts, but they prioritise their mortgage payments.
From a portfolio context, we are acutely aware of anything that’s reliant on discretionary cash flow. So anything that’s relying on discretionary consumer expenditure, we don’t have much of that in the portfolios at all.
We’re also very discerning in that private debt space. When I think about levered loans right now, there are quite a few that are exposed to the consumer who will be challenged from an earnings perspective, but they’ll also have debt funding costs that have actually doubled, given they carry a lot of debt. They’re credit quality is likely to be challenged.
Yarra covers almost all segments of the fixed income market (a rarity in Australia). What are you seeing when you look across the space and where are the best opportunities?
We like the Residential Mortgage-Backed Security (RMBS) space. RMBS continues to come to the market and provide fantastic opportunities for high, risk-adjusted returns because we don’t see the impetus for wholesale impaired structures in that space, because households are generally doing the right thing by meeting their mortgage repayments.
Especially on anything below AAA, you’re getting paid yields of sevens, eights, even nine percent in some cases for investment-grade tranches, which require impairments akin to one and a half to two times what we saw during the GFC in the US. And that was accompanied by a 25% decline in house prices in the US. In Australia, house prices have been going up for the last five months.
“It’s really remarkable. With house prices roughly where they are, you could arguably have a hundred percent defaults, not that we’re going to have that, and you still wouldn’t lose a dime.”
The tier two space also looks incredibly attractive and we think that the REIT space, the REIT bonds in particular, will potentially look interesting. We think that REIT issuers will eventually be forced to come to the market, and it’s likely to reset their curves in terms of pricing, and that would be an opportune time for us to allocate more capital to that space.
You’ve been on record saying that you expect defaults to rise. What do investors need to be on the lookout for?
I’m expecting the consumer-related sectors would be probably more challenged, and that would be across sectors.
So whether it be levered loans that have business models that rely on discretionary expenditure, they’re likely to be challenged. We’re starting to see a couple of those that are having some residual issues now, and it’s probably likely to get worse before it gets better, and some of those asset-backed structures will also potentially be challenged.
Aside from that, the commercial property space, which is something that people are acutely aware of, the private debt area, the mezzanine property lending that’s gone on over the last five to 10 years, I think some of those structures will invariably become impaired.
This article originally appeared here and is re-produced with the express permission of Livewire Markets.