"Don't start here" - why investing in these times is no joke

There’s an old joke about a lost tourist in Ireland who asks one of the locals for directions back to Dublin: the local responds, “Well sir, if I were you, I wouldn’t start from here.” Bentham Asset Management’s Richard Quin drops the punchline when asked about the investment outlook for bond investors. Quin muses, “Bond investing is like that now; anyone hoping to achieve real returns going forward ideally wouldn’t start from here.”

Richard Quin, Managing Director and Lead Portfolio Manager

Bentham’s ability to move actively within fixed income markets between government bonds and corporate credit differentiates the fund manager from many of its peers. Given Quin’s concerns about the current risk/return profile of government bonds, he’s able to instead focus his multi-sector funds on floating rate credit (in particular global syndicated loans and ABS), which offer a real yield to investors, and are less exposed to interest rate increases. Quin has even been known to short government bonds opportunistically.

During lockdown last year global government bonds rallied to all-time highs while credit swooned to lows not seen since the GFC. Fast forward a year and the situation is much different with economic tailwinds spurring a rotation out of government bonds and into floating-rate credit.

In the following interview, Quin discusses the so-called liquidity crunch last March; his team’s four-step process; and why corporate credit is this fundie’s prime focus versus sovereign bonds. He also lays out the biggest risks, explains how credit investors can mitigate this and reveals his picks for weathering the storm ahead.

What’s the biggest risk for fixed income investors right now?

“The biggest risk now is that with rates so low and so much government stimulus, the economy is likely to be turned on like a light switch,” says Quin, CIO and principal Sydney based Bentham Asset Management.

“As a result, there’s quite a lot of inflation risk and potential economic demand that might surprise markets. This could see interest rate curves globally shift higher – hurting fixed rate government bonds but translating into higher coupons for floating rate credit.”

What happened in credit markets last March?

When the first Coronavirus cases were recorded outside of China and markets sold-off – with some investors aggressively moving to cash – it wasn’t strictly a “liquidity event,” says Quin.

The most common misconception that I hear about global high yield credit markets is that they were illiquid when risk premiums sold off in March last year. In fact, average trading volumes in those markets actually rose by 30%. This is because different investor groups (i.e. yield focused investors) become opportunistic and actively involved in different market conditions.

How does Bentham assess the various global credit markets – what’s your process?

We have a four-step process:

1. A global theme, such as the pandemic

2. Forecast sector returns for the medium term

3. Make individual investments for each sector

4. Active portfolio management.

First, we spend time identifying global economic and investment market themes.

Second, we translate these themes into underlying assumptions that we use to forecast returns for each credit sector. We use these forecasts in our credit sector allocation process.

Third, to populate each credit sector with securities we filter the market to create a suitably diversified portfolio to achieve our return targets and investment limits. In our multi-sector funds we have north of 400 individual names on a look-through basis. Every name will have a credit write up that will go through our credit process and go through a credit committee.

The last component is the ongoing active portfolio management. We ensure that individual securities continue to earn their place in the portfolio on a relative value basis, identify new opportunities and manage overall portfolio risks such as liquidity, overall market exposure, interest rate exposure and currency exposure.

In the past year, credit derivatives have been very important in allowing us to efficiently manage the overall credit exposure in our funds. We also have the ability to take short positions, and importantly for our unitholders, we made some money by doing this last year. Sometimes when you want to keep holding your physical bonds, but you want to express a view such as protecting against a fall in markets it's cheaper to use derivatives because of lower transaction costs. For example, we added equity puts on the European STOXX Bank Index as Covid initially spread to Europe in the early days of the crisis.

For interest-rate risk exposure we have been concerned that markets have been too complacent on the risk of rising bond yields. Right now, we've increased our position in bought put options on US 10-year interest rates, which will benefit the portfolio on rising rates. That's been quite helpful for us over the last quarter because the US 10-year interest rate has gone up by 70 basis points. Traditional fixed interest strategies have had one of their worst quarters, but we've actually had a very strong quarter in terms of performance.

Do you invest in both sovereign and corporate debt? And if so, how is your allocation currently split?

Most of our funds are designed to produce income for our investors, so we are more focused on investing in credit assets that deliver an income or a yield above cash. So we tend not to invest too much in government bonds with yields where they are now.

Over the past four decades, sovereign bonds have benefitted from falling cash rates and falling inflation. Historically, sovereign bonds have also been a great portfolio diversifier in months of market weakness because it is a favoured safe-haven asset. But given current low sovereign yields, the strategic tailwinds for having exposure seem to be over. If anything, the risk is that sovereign now underperforms cash or has poor risk-adjusted-performance. Lower government bond yields also mean the benefit of holding them as insurance for an equities sell-off is now much less than historically.

Fortunately, our core focus is on investing in global credit markets because these markets have historically generated favourable risk-adjusted returns. The credit securities that we buy can have either floating or fixed rate coupons, we are more interested in the credit spread above the yield curve and manage the interest rate risk exposure holistically at a portfolio level.

From AAA+ to BBB- and everything else: what do these ratings mean, and which are reflected in your portfolio right now?

A credit rating is an independent, forward-looking opinion of a credit issuer’s creditworthiness, of its ability to meet its financial obligations. Credit ratings are a feature in corporate debt markets, asset-backed securities and for bonds issued by state governments and sovereign governments.

If you want to issue debt into public fixed income markets, which is by far the biggest market in the world, you need a credit rating. The three major rating houses are Moody's, S&P and Fitch. Some investors will calculate their own credit metrics to generate internal ratings for unrated bonds, but ultimately unrated bonds will have less liquidity and less market oversight to identify problems.

The useful thing about a rating is it allows you to have a handle on risk that you can measure relative to the potential credit risk you get paid. If you're getting paid a very low credit margin, the investment had better have a very high credit quality.

There are two main ways you can get hurt by investing in credit – the company you invest in goes down in credit quality, or the company defaults (stops interest payments).

The key risk for investment-grade credit is that an issuer is downgraded to non-investment grade, resulting in the risk premium increasing and a fall in the market price of the bond or loan.

The bigger risk is having an issuer defaulting on its credit obligations. Credit defaults aren’t as frequent as people think, but it is a risk that can be mitigated by having very nuanced security selection and a very diversified portfolio (less concentration). That's where an active credit manager comes in – Bentham completes fundamental credit analysis on each investment and usually takes quite small position sizes in a large range of different issuers.

What are your favourite areas of global credit markets right now?

We like assets that we think will benefit from rising interest rates and rising inflation such as floating-rate securities.

So, we really like floating rate syndicated loans. You're basically getting paid 4.5% above cash with that floating-rate exposure. If interest rates go up, it increases the yield that you get paid. And the senior debt is secured. And we're also likely to see credit rating upgrades as we go through this cycle, as we go into this recovery mode with higher growth. The credit rating agencies aggressively downgraded companies during COVID, but I think they were too aggressive. Since then, companies have done much better than initially expected and we've seen default rates forecasts decreasing rapidly.

We strongly believe that active management is going to be rewarded. It has been rewarded recently and this will continue because these are very unusual times. The nature of fixed income indices have become riskier and you can't just buy an index exposure and think you're going to be okay - it's not that sort of environment. And I know a lot of people do that in the equity space right now, but fixed income and credit investing require more nuance.

For more information, please visit www.benthamam.com.au.

Be sure to tune in to Bentham's upcoming Quarterly Webinar Titled ‘When (Bond) Doves Cry’ with Richard Quin  on Thursday the 6^th of May at 11am. Click here to register.”