Joye: Equities set for a "terrible" decade

When you're running north of $8 billion of investor capital in the bond market, you have a vested interest in highlighting the benefits of bonds over other asset classes.  

Coolabah's Christopher Joye makes no bones about promoting bonds over equities but he backs it up with evidence. 

That evidence comprises the S&P 500's current cyclically adjusted PE of 31x. Not only is that high when compared to the average since 1880 of 17x, but it also is a harbinger of tough times ahead. 

"When we research what happens to equity returns once the PEs pierce 30x we find that the future 10-year returns are absolutely terrible. So most of the time, inflation adjusted, equity returns are negative in the decade after the PE punches through 30x".

It's one thing to highlight problems, however it's another thing altogether to provide solutions. 

In this Expert Insights, Joye runs the ruler over his opportunity set and highlights not only which areas of the bond market he likes, but also those that he wouldn't currently go near. 

He also shares what sort of returns investors should be expecting and why liquidity is so critically important for Coolabah's investment style. 

Please note that this interview took place on 13 September, 2023

Edited Transcript 

LW: US equities appear expensive when compared to other inflationary periods. What does this mean for the outlook for equities over the next decade?

The S&P 500's cyclically adjusted PE is at 31x right now. Since 1880, it's averaged 17x. So equities look very dear. 

When we analyse the relationship between US core inflation and US equity PEs, they suggest that current PE should be around half their prevailing levels. So with a 4 to 5% core inflation rate, such as what we see today, we'd normally see PEs around 15x. 

The 31x PE we're observing, cyclically adjusted, really implies that the equity market thinks that core inflation is around 2%. So equity investors are clearly not worried about this inflation crisis. 

When we research what happens to equity returns once the PEs pierce 30x we find that the future 10-year returns are absolutely terrible. So most of the time, inflation adjusted, equity returns are negative in the decade after the PE punches through 30x.

LW: Which sectors of the bond market do you like right now?

• We like cash. You can get cash deposits at 5, 6%. 
• We like bank senior bonds, they're also paying 5 to 6%. 
• We like bank Tier 2, which is paying 6 to 7%, and we also like Aussie bonds in US dollars and euros, which are paying even better yields again. 

LW: Which sectors of the bond market are you worried about at present?

Our key concerns are really around risky debt and illiquid debt. If we look at the high-yield bond market, or the riskier part of the bond market - below investment grade - spreads in the US are actually more than a hundred basis points less than what you'd normally get through the cycle. 

Which makes no sense, given we're experiencing the worst default cycle since the GFC. 

So the high-yield market is very illiquid and we don't think spreads that are being reported are truly representative. A little bit like what you're seeing in commercial real estate and cap rates or yields.

We're also concerned about what we're seeing in the private credit markets. We're hearing a lot of problems with loans that are not being repaid, funds that are experiencing liquidity issues.

We've heard of 12 different funds going to family offices looking for emergency loans to give them liquidity because they've both got outflows combined with borrowers not repaying their loans. 

Obviously, I don't want to generalise. There are great non-bank lenders and great private credit investors. Historically, we've been very open in saying we really admire and respect groups like Liberty Financial and Metrics, but we remain concerned about the illiquid bond markets where spreads have not widened like we've seen in the liquid investment grade domains. 

We remain very worried about the impact of this very large default cycle on both high-yield debt and illiquid private credit, and we're generally avoiding the REIT sector. 

Obviously, commercial real estate is in crisis right now and we're also avoiding the corporate bond sector that tends to be far less liquid and more pro-cyclical.

Finally, we are very leery of subordinated ABS and RMBS issued by non-bank lenders that specialise in subprime home loan lending, here in Australia. So we are seeing a massive increase in the reported default rates or arrears rates on non-bank subprime home loans that have been securitized here in Australia, where the 30-day arrears rates have increased from circa 1 to 2% towards circa 3 to 4%. 

LW: What return should bond investors be expecting moving forward?

I think it's very simple, just look at the yields. 

So in cash deposits we're getting 5 to 6% interest rates. In government bonds, you're getting - incredibly - 4 to 5%. Aussie government bonds are paying you similar yields to what you're getting in commercial real estate. Cash is paying better yields. 

Indeed, if we look at the All Ordinaries Index, it's only giving you a yield, pushed up with franking credits, of about 5.7%. So you can get similar returns on some deposits today. And then if we look at the bank market. 

Bank senior ranking bonds are also paying interest rates of 5 to 6% per annum, and bank Tier 2 bonds are offering rates of 6 to 7%, even higher again, if you look at Aussie banks in US dollars and euros. 

And then if we shift to the hybrid market, we see All-In Yields franked on major bank hybrids that are around 7%. I would say that hybrid spreads, the extra margin you earn above cash, do look a little skinny at around 2.5% above the Bank Bill Swap Rate. Historically, that's quite small, relative to the yields that hybrids would pay, compared to Tier 2 bonds and senior bonds. Normally, the hybrid market gives us two times the spread that we'd get on higher ranking and safer major bank Tier 2 bonds. Today, hybrids are paying about 1.5 times the spread on Tier 2.

LW: Why does liquidity matter and how does that focus manifest in the portfolios that you are running?

Liquidity is really a condition precedent or a sine qua non for us. 

So our higher octane strategies are turning over between eight and 20 times a year. So to turn over the book that actively you can only invest in liquid assets. 

We were shorting Credit Suisse senior bonds last year and most of the rest of the market was chasing yield. In fact, many Australian investors had even loaded up on Credit Suisse hybrids that were wiped out. We had a blanket ban on long exposures to Credit Suisse, all the way back in May, 2021.

We're very good at identifying the bonds that will be liquid in all markets, and it's pretty simple. They've got to be very safe. 

Generally, you're talking about government bonds, or government guaranteed issuers, or implicitly guaranteed issuers, and that's what we tend to focus on. We're typically trading $300 to $400 million a day and since the start of last year, we've turned over about $132 billion of bonds. 

Crucially, we average negative transaction costs. What that means is, we're not chewing up returns through this active trading. Rather than paying away the bid-offer spread, Coolabah actually systematically earns the bid-offer spread, and there's no brokerage or commission in the OTC bond market.