Inflation is coming: Trilogy

With interest rates, inflation, and credit spreads still sitting close to record lows, the most important question for fixed income investors is how this could change over the years ahead. Henry Elgood, Head of Investments for Fixed Income at Trilogy Funds, says this is an issue they’re intensely focused on today, modelling multiple scenarios to ensure they’re prepared for whatever happens from here.

“It’s not just what expectations are, but what they’re coming from. We’re at an historically low base in terms of inflation expectations and we’re at a historically low base in terms of interest rates. It won’t just be where inflation is going to get to, but how quickly we get there.”

In this video, Henry discusses where he’s seeing the best opportunities in fixed income today. 

Edited transcript

What are the biggest opportunities you are seeing in the fixed income space?

One thing we saw over the last year has been the real compression in spreads across credit exposure and also the big issuance we're seeing on the government debt exposure, not just domestically, but also internationally. We've seen opportunities across the government debt issuance space, both at the federal level but also at a state level in terms of being able to maximise returns for investors above and beyond traditional periods. While doing that we want to maintain exposure to companies that have strong balance sheets and strong capital management positions with good tailwinds in the economy. Our exposure to the major Australian banks has been positive for our portfolio. It's something that has held us in good stead over the COVID-19 period and coming out of it. We think that'll be a key part of our portfolio moving forward. Therefore, we're cautiously optimistic on the returns offered by senior and subordinated bank debt, not just Australian majors, but also non-majors locally.

How does the fund use a mix of economic, monetary and fiscal indicators in decision making?

So, a number of those indicators we use in terms of our assumptions in the models that we build to assess the returns, but also the impact should there be a drawdown on the returns for the fund. In terms of the economic indicators, we look at what that will drive where we look to allocate on a very high level between maybe credit or between government and also undertaking, and then, the relevant due diligence on the managers within those sectors that we may want to be exposed to but also our existing exposure. 

If there was a significant shift up in interest rates, or there was a significant shift in inflation expectations, how would each part of our portfolio be impacted? And, to what degree on a theoretical basis, according to our models, would that look like? How would our return exposure shift? And, what we can do to mitigate that, what can we do to prevent that as best as we can is always front of mind through assessing and regularly reviewing those models and assumptions.

What are these indicators telling you at the moment?

Right now, I think one thing we see is the inflation expectations is building within the market. But one thing that people should be cognisant of in our eyes is that it's not just what the inflation expectations are but what they're coming from. So, we are at a historically low base in terms of inflation expectations. We're at a historically low base in terms of interest rates. 

So, it won't just be where the inflation is going to get to but how quickly, and also with interest rates, I know that there's been indications by the RBA that there'll be a number of years before we see interest rates starting to rise. 

But another question will be well if they do that sooner, how quickly will interest rates rise? Not just what will they get to. 

That's something we're really conscious of, and we're in constant dialogue and making our own re-evaluation and assessment at regular intervals as to what they are, what that may look like in the future.

How does Trilogy go about obtaining competitive returns in a low-interest-rate environment?

Well, within our Trilogy Monthly Income Trust, which is our flagship mortgage fund, we have a number of loans that we're exposed to across the Eastern seaboard. We currently have over 90 loans within the portfolio. What we look to do there is diversify amongst the type of borrower we have but also the industry and the state and the sub-sector they're exposed to. 

It could be an industrial construction deal, for example, or it could be a completed residential stock deal.

 So, we'll have different pricing metrics that we look at there. That pricing metric will then flow through to the return for investors. So, we've been very strong in terms of being able to support those developers. And we look to provide a competitive return from that pricing that we offer those developers. 

That then is combined with the cash position within the fund at any one time, which we look to optimise via our exposure to our fixed income managers. So, we're not sitting there with cash earning very little, and then, interest book at one point in time, earning interest with this thing combined, we're trying to blend a race that's optimised by maximising returns on both the cash and the mortgage book at any one time.

Are you actively moving around within the cash book too?

So, we're actively moving at the moment into more structured, fixed interest, and credit exposure. It's somewhere where we see opportunities still. We're still very much exposed to major and non-major Australian bank paper directly and indirectly. 

And, we see new issuances coming up across the year where we could certainly generate some alpha there, but certainly looking to make sure that we are exposed to the sub-sectors within the fixed interest sector on our cash that we want to be exposed to at any point in time, given our return expectations we're looking for out of that portfolio.

Find out more

To find out more about fixed income and property funds such as mortgage trusts and whether they may be a suitable investment option for you, visit their website.