How investors can tame the bond market rollercoaster

If you hold even a reasonably balanced investment portfolio, you’ve probably noticed your credit assets doing some weird things in the last couple of years.

“It’s been one of the worst 24 months on record for credit markets, ” says Dr Christian Baylis, CIO of Fortlake Asset Management.

So, how have the returns of his team’s Fortlake Real-Higher Income Fund – launched in the midst of the global pandemic – held up so well? That’s a question that Baylis addresses in the following interview, which is part of Livewire's Undiscovered Funds Series.

As Baylis emphasises when discussing Fortlake’s absolute return approach: 

“We’re Puritans in relation to our investment ideology. And if we have to go to the ends of the earth to eke out the right opportunity, we will.”

While he acknowledges the strategy's relatively short tenure, it already has two research ratings – which is rare for such a fresh fund. 

In the following video you’ll hear what Baylis thinks lies ahead for credit markets and some of the most interesting countries – some well off the beaten track – the fund is invested in.

You'll also hear his key takeaway from a recent South American research trip (he was in town for the faceoff between Bolsonaro and Lula).

He rounds out our chat by discussing a couple of countries in the region in which the fund invests, bringing home his point about going to the “ends of the earth” to deliver investment returns.

About the Fund

Name: Fortlake Real-Higher Income Fund
Asset Class: Short-term fixed income
Year listed and size: 18 December 2020.
Description of strategy: A fund that seeks to protect investors against inflation risk by using specialised techniques, the variety of return sources it employs is a point of difference. 
Investment objective: To provide an absolute return and capital growth over the long term and beat the prevailing RBA cash rate by between 4% and 5%

Transcript

Please note that the following transcript has been edited to highlight Baylis' key comments 

Can you tell us a bit about Fortlake Asset Management and your background?

Fortlake was founded probably in one of the worst periods coming out of the pandemic. We looked at our particular sphere of competence and thought, "Look, if you're going to start an asset management firm, try to solve a problem, don't come out and try to be a sausage factory and ultimately flog product."

Ultimately, we looked at the landscape and said, "Look, there are some really interesting things that can be done that aren't really being offered domestically."

The competency in the domestic market wasn't as deep here as, say, in the US and Europe. And so we looked at the asset class and said, "let's come out with a range of products that really hit the spot, based on some of the feedback that we've had just through talking to people". And that was really how we got started.

My background was working at UBS across a variety of roles, credit inflation derivatives and overlays, particularly in the insurance and the reinsurance space as well. Prior to that, I was at the Reserve Bank doing a range of different roles there as well. 

We owe it to our investors, with that remit, to go out and seek the best opportunities that are in the global fixed-income markets. And that's really what Fortlake is about. We're a pure, absolute return manager, unashamedly.

We'll go to any market and use any tool or instrument that we need to use in order to generate returns for the investor. That's really what the point of the firm was and the types of strategies that we run.

What led you to launch the fund when you did In the midst of a global pandemic?

We said, "Okay, well now is a great opportunity." At the point in time we started, we also were very much aware that it was a disinflationary environment and we wanted to bring the focus back to real returns because that was something that I think I noticed from my previous life when I was very focused on the inflation-linked asset class, was that there wasn't a high degree of inflation awareness. And we really wanted to bring that to the forefront of our products to say, "Look, you've got to start focusing on real returns."

Even though it's a disinflationary environment in an income-based asset class, you've really got to bring the focus to what you're achieving after inflation. That became one of the overarching themes across all of our products and basically, the firm is we wanted to take that inflation capability, try to eke out a decent return for investors above inflation, and I guess use our sphere of competence to do that. And that's really what the essence of what we created was about.

Inflation awareness

It's the real taxi driver topic now, and in the short space of probably 24 months, you've actually had a full economic cycle. You've gone from disinflation when we started to, obviously, a high inflation environment. You've had all the twists and turns in capital markets that come with those types of macro events as well.

A lot of people, when you start out say, "Oh look, we'd like to see you over a full economic cycle." And that's typically the feedback that you get from a lot of people. And you go, "Well, wait up."

You have literally seen every twist and turn that you can think of going from near zero inflation to upwards of double-digit inflation across some of the developed economies.

And as I said, you've had all of the bouts of volatility that come with a full economic cycle condensed into a short space of time. And for an asset class like ours, which is income-sensitive, that makes it particularly challenging. So you've had literally everything thrown at you, which has been good because what it does is it creates a point of difference. It creates disparity among managers.

I always say that it's a bit like a bike race. When everyone's riding in a tailwind, the pack seems to be quite condensed and together, but as you move into a headwind, it starts to create, I guess a bit of stress, and you start to see strategies for what they are. And that's ultimately a good thing as, I guess, a new-ish type of manager.

What role does it play within a retail investor's portfolio?

We seek to use the asset class as a non-correlated return source. So we are not trying to be a standard fixed-income manager. We are ultimately using the asset class as a conduit to provide non-correlated returns.

When you look at our return profile over the 30-odd months that we've been operating, we tend to have our better months in the more volatile periods, and we tend to get our better flows in those periods as well.

That's very atypical of what a standard fixed-income manager would see. We've had one of the worst 12 to 24 months on record in our little universe.

Typically what you'd find in that type of world is that you would have outflows and there'd be a lot of stress in the environment that you operate operating within. But because we've tried to keep those correlations low, we've found that the flows and therefore the return sources have actually been pretty decent for us over that period as well.

How do you select the credit assets to go into this fund?

This goes back to one of the earlier questions. When we started, we really wanted to have a meritocracy framework across the investment process as well, we didn't want to be tied to a benchmark.

We ultimately wanted to be real Puritans in relation to our investment philosophy and ideology. And that is really about putting best-in-class investments into the portfolio.

When you think about the process to do that and the quantitative process that we use, it's really about identifying ex-ante risk-adjusted prospects out in the global markets and making sure that we get the right concentration and the right balance. And we call that a trade meritocracy framework. And ultimately what that means is we're not putting in benchmark-aware types of investments.

We are a pure absolute return manager. 

That means that if we have to go to the ends of the earth in order to find the right investment to eke out the stated objectives of the fund, we will do that.

We're currently invested across 26 different countries. We have around 500 to 600 different positions in the fund, highly diverse. And that really is just an accumulation of all of these quantitative filters building up over time, and ultimately littering the portfolio with a range of opportunities.

We often say that our process is more like a glacier, you won't see large directional shifts in the portfolios, but over time, if you looked at the portfolios over a six-month period, you'd say, "Wow, that's quite a change that's happened there."

And ultimately that change tends to be more pronounced in more volatile environments. The less volatile, the less change, or the less reshaping.

And really, the quantitative process for us is about seeking those out, finding meritocracy in the global investment universe for us.

Which part of your process would you highlight as a key driver of performance?

Definitely the absolute return ideology - the foundation of the actual funds is absolutely critical.

What that means is to every investment that you approach, you're ultimately saying "Is this accretive to the risk-adjusted return of the portfolio as it sits today?"

If we add one incremental investment to the portfolio, what does it actually do to our risk-adjusted return on an ex-ante basis? What that means is if that is what shapes you, and that's what your ideals are, ultimately, your modeling process and your quantitative process have to work backwards from that.

What's your outlook for bond yields for the rest of 2023 and into next year?

I think really where the market might be a bit caught out is just the stickiness of the inflation, particularly the services inflation here and more and more broadly.

We do need to get into that restrictive territory, and ultimately it's going to be a combination of the cash rate having to go higher, but also inflation coming off in a more linear type of way. Because I think when you look at what's happening with the cash rate in inflation a lot of sale side analysts have this sort of perfect relationship or a Phillips curve relationship where interest rates go up and inflation comes down almost one-for-one, this beautiful type of linear relationship. And that just hasn't been the experience that we've seen, going into the pandemic, even.

We had huge amounts of disinflation. Everyone said the Phillips curve was broken, everyone said interest rates weren't working, so central banks went out and printed money.

And ultimately all of a sudden everyone seems to have forgotten that conversation, and all of a sudden we're back to the races with Phillips curves working, cash rates going up and inflation miraculously coming down, that just might not be the case.

It might happen, but we have to be open-minded to the distribution of possible outcomes and coming out of a pandemic, that's not a world that people have a lot of experience with, coming out of a pandemic, inflation doubled in terms of the distribution of possible outcomes.

And that's another error that central banks made was they started to give things like forward guidance and tried to shore up the investment community and the general population's views on interest rates. And that's not what you do when you're coming out of a one-in-100-year pandemic.

You think about it, if a company director was going through a very volatile period and came out and gave guidance on profitability in the most uncertain environment he'd probably have, or she would probably have class actions for the next two to three years.

So I think that's really something that's become evidence. You don't double down on a surety in an uncertain world. You communicate to people that the distribution of possible outcomes is very wide and you basically forewarn people.

In this sort of environment, how are you currently positioned across the floating rate, fixed rate, inflation-linked and different types of assets you hold?

We've just come out of an unprecedented level of volatility in interest rate markets. And I think that's what that's really quite bipolar about the markets at the moment.

On the one hand, you've got credit spreads and credit volatility at really condensed levels, not that far really from where you saw during the pre-GFC days almost in terms of credit volatility.

And then on the other hand, you've got interest rate volatility near all-time highs. I mean the US two-year bond, or treasury, or that part of the curve is literally at historical highs. I've almost never seen that level before. And yet on the other hand, you've got credit sitting in a totally different world, and then you've got equities vault sitting at very complacent levels as well.

And so that really shapes the way that we invest and what that means, going back to what I was talking about before about ex-ante risk-adjusted returns, that just leads you to say, "Well, now in government bond markets, what you actually find is that ex-ante risk is being well-priced and we're actually starting to get compensated for holding government bonds."

And now central banks have stepped out of the party. They're letting markets make up their own mind about these prices and these yields. And not only that, they're selling into these markets by not renewing issuance.

Some are selling into the market as well. And the buy-side community or the asset manager, ultimately, is now the determinant of market prices. And that's a very different world to what we've experienced over the last 15 years.

All of a sudden, you've got free markets actually determining prices and you've got commercially sensitive people like us ultimately having to say, "Is that the right level of return given the inflation risks and given the other risks that are out there in the economy?"

So that for us means that we're going to be more heavily skewed towards government bond markets, more heavily skewed towards lower default risk type markets because that's where the volatility is. And it also means on the other hand, is we're not going to be as aggressively allocated to credit in these sorts of areas, because the volatility's not there.

And one last final point: we also haven't had any corporate deaths in three to four years. We've had literally the worst parts of the credit markets, the high-yield markets in Europe and the US have had a handful of defaults.

In Europe, you've basically had none over the last few years. You get the odd one or the odd idiosyncratic one in the US in the high yield indices over there.

These corporates have all been living off the magical face cream of financial repression, negative real interest rates and fiscal largess. And that world's coming to a rapid halt. And that really reshapes the way you've got to form your portfolios.

And so, we see really good opportunities in passing the benefits of defaults through to investors. And that actually means you can prosper from defaults. It doesn't mean you have to just avoid it. And that's your way of effectively capturing the alpha.

Are you expecting a hard landing in the US?

The way I would typically look at that, we're obviously talking about GDP when we're talking about hard landing, and the sensitivity between interest rates and, I guess, domestic activity or global activity. And so what are the key inputs there?

Ultimately, let's talk about Australia as a starting point. As we look out to December of this year, we're expecting GDP of about 1.6%, probably maybe even a fraction lower.

The thing to look at there is that we've also got GDP volatility at around 175 basis points, annualised. So you've got 1.6% and then you've got volatility of 175. So, the margin for error for the economy is actually pretty much razor-thin. And then if that comes down and we've got downside risks to the GDP forecast, IE, we have a fall-off in coal prices, we have a fall-off in iron ore prices and we're a commodity sensitive based economy, that margin for error gets ever and ever smaller.

The potential for us to actually go into a recession is higher than what people think, based purely on GDP volatility. And the fact that we've actually brought forward 30 years of future expenditure, punched it all into literally 18 to 24 months to get ourselves over the pandemic hurdle. And so we've spent future years of financial resources and the buffers that we would typically have, they've been spent. And so what that means is the slack and the buffers that we have going into the outer years just aren't there anymore. And it's a bit like someone spending on a credit card. That's exactly what we've done. And we used to always talk about keeping the budget strong for a rainy day.

Those conversations haven't been had for a very long time. And I think that's really what the issue is.

What are some of the markets that are appealing in that environment? 

We've had the world turned on its head and the developed markets have acted like emerging markets... there's, there's a huge level of complacency, I think particularly on the political side, and equally on the central banking side.

What do I mean by that? Developed and particularly the G7 economies and more broadly the G20 economies, we thought we could spend money hand over fist. And to some extent that was justified because we went through a pandemic. We've been printing money for literally 15, 18 years. These sorts of policies in this type of fiscal response typically used to be the remit of the emerging world. And everyone used to think the Latin American economies and these sorts of places were the basket cases of the world because that's what they used to do.

Now when you look at it, it's actually the polar opposite is that the emerging markets we're actually reasonably fiscally conservative. I mean, Brazil has a debt-to-GDP ratio of 60% compared to the US, which is well North of 100%. And a lot of these places didn't do QE.

A lot of these emerging economies acted fiscally responsibly. Why? Because they learnt the lessons of the Asian financial crisis when they had a crisis, they really reshaped or rethought the way that they needed to operate their economies.

There wasn't one set of rules for emerging markets and another set of rules for developed economies. We all live and die by the same economic principles. And so what you've actually found is that the emerging markets actually have less volatility than some of the developed markets now. 

And guess what? The inflation rates in the developed economies are actually on par with some of these, what we call basket-case economies like Brazil and some of the other Southern American economies.

And what you find now is that as we've progressed through time, places like China actually have a lot lower volatility in their interest rate and their term structure. And guess what? Interest rates in China are actually lower than treasuries now. So which one is, I guess, the riskier economy? And so ultimately what this shows us is that if you act in a particular way fiscally or in a monetary way, that's going to reshape the way that you have it have to invest.

That means allocations to places like emerging markets might not be as risky as they once seemed. I mean, when you look at the equity indices in Mexico, Brazil, some of these places, when the S&P was down 40%, the Mexbol was up, the Bovespa was up.

So these are high-risk equity markets and that's not the sort of place you would typically go for defensive portfolio characteristics. But that's what you're starting to see is that you're getting really high yields also in the bond markets.

A lot of these bond markets say in Brazil now have local currency and US dollar currency so that if they need to, they can print money in their own currencies as well, but the volatility's reasonable, and the yields are higher. So you've got to open your mind up to some of these new economies as an investment destination.

And you have to be much more cynical and sceptical about the developed economies, because this has Hotel California characteristics, in my view, very easy to come in, very, very hard to get out with a lot of these policies, particularly fiscally and from a monetary perspective.

I think people really need to make sure that, you know, don't want to go head-long into emerging markets. Still, there's nothing wrong with having a reasonable allocation into some of these markets because of the risk-adjusted returns that you're getting there.

Find out more

Fortlake Asset Management, as an experienced fixed-income manager, offers institutional expertise in a specialised setting, focusing on generating returns above inflation.

Visit our website for more information.