4 potholes fixed income investors need to avoid

The secret to successful investing in the fixed income and credit markets is simply avoiding the issues or potholes. While we freely admit that 90% of the time, we are jumping at shadows (perceived risks) that turn out to be risks offset by other factors, we believe this approach remains prudent given how costly that 10% can be to our investors, particularly those looking to the asset class for income and capital stability.

In the following wire, I identify some of the key things fixed-income investors should watch out for. The first of these revolves around some mistakes I made early in my investment career, which have since sharpened my focus.

Pothole 1: No skin in the game

Alignment of incentives is crucial – put another way, be wary of those offering investment deals if they don’t have skin in the game. This is my top investment consideration, at least partly because this Principal-Agent problem was core to some of my investment blunders in my earlier years. 

In short, if a firm that offers me an opportunity has a strong reputation in the market, is incentivised primarily by how the investment performs (i.e. fees), and the person pitching it to me is personally invested in equivalent or more subordinated terms, I’m more inclined to listen.

On the other hand, I avoid those who don’t have much at stake by way of reputation, economics, or “hurt money”. A simple question, ‘Why is that person pitching me this investment?’ can lead to the most profound and informative insights.

Pothole 2: Large loans

We’ve spent decades managing multi-billion dollar loan books on behalf of Australian and international banks, having seen both the good and not-so-good times. But a common theme throughout is the avoidance of large loans, with loan size considered relative to the borrower's size, credit rating, financial position and other factors. However, it ranges anywhere from a consumer loan that exceeds $100,000 to a property-backed loan exceeding $10 million.

Large loans are riskier because they typically require a refinancing event, unlike smaller loans, which can often fully amortise down to $0. 

They also fit the credit appetite of an increasingly small group of lenders as they get larger (minimising the parties who will refinance them). In our experience, avoiding large loans and investing in a diversified portfolio can materially de-risk one's portfolio, maximising return potential.

Pothole 3: Highly leveraged counterparties/borrowers

Thanks to a higher RBA cash rate and credit spreads, the borrowing cost has almost doubled compared to two years ago. Despite this, we haven’t seen a material reduction in the use of debt funding. This begs the question - why?

Understanding why and, importantly, what forms of debt those counterparties and borrowers have becomes crucial to avoid adverse selection. That is, capital going to those with the most acute borrowing needs who are in the most acute predicament (aka, poor quality credits). For example, certain borrowers have high borrowing requirements given their sector, business model or funding (cheap) access that justifies higher leverage.

Others with a lower capital base, who can only access more expensive debt, are less justified and symbolic of the borrower’s financial position.

Alternatively, investors could avoid highly indebted counterparties and borrowers who use expensive unsecured or short-term borrowings to maximise the chance of positive selection/financing of the best credits.

Pothole 4: Duration isn’t a free lunch

Over the prior 18 months, investors commonly ask us whether we believe Australia’s cash rate has peaked. This is commonly used as a gauge of whether or not to add duration to a portfolio.

I believe actively managing duration can add alpha to portfolios, so it’s a worthy pursuit. But the additional risk this can add is often overlooked. Depending on the investor, this additional risk may be acceptable. But we commonly find that risk is being taken by a sleeve of one’s portfolio that is viewed as low risk, anchoring absolute returns, and offering diversification.

Adding duration over the prior three years has seen investors lose around 10% of their portfolio’s balance, a significant loss of capital. When adjusted for the opportunity cost, that money could have been invested in a short-duration portfolio (which has for the most part printed very healthy returns). Duration is no free lunch.

An important role to play

Using the above guide and asking salient questions can provide a rich sense of whether your holdings are well-positioned for 2024. Should investors avoid the issues, it’s hard to argue that credit/fixed income that can offer expected returns of up to 10% per annum doesn’t have an important role to play in 2024.