Performance-enhancing debt: The key to high returns in a rising rate environment

Throughout history, top performers have done whatever it takes to remain at the summit - however it is the experienced heads that play the game with distinction whose legacy remains the strongest. In the world of funds management, the importance of long-term performance matters more than any short term win - the compounding effect speaks for itself. 

Yarra Capital Management has demonstrated this immense consistency: Their Enhanced Income Fund has surpassed its target return every year for the past two decades. As Yarra's longest-serving employee, Roy Keenan - Yarra's Co-Head of Australian Fixed Income - has been an integral reason for this performance. 

With experience comes a degree of insight when markets experience turbulence. The RBA last raised interest rates nearly 12 years ago, meaning a significant portion of managers have never invested in these market conditions. Roy's team have been expecting this onset of inflation, and they are placed to make the most of the opportunities that will arise 

Every time the RBA starts to tighten policy, we get increased income and higher yield. If 3% cash rates is right in March 2023 next year, we're going to be having a running yield on this fund close to around 6%. In my eyes, it's been probably 10-12 years since we've seen that type of return in running yield across an investment-grade portfolio.

In this interview, we discussed the thinking behind the Enhanced Income Fund and what makes it unique, how the fund is positioned within the current macro environment and what role it can play within an investor's broader portfolio. We also explore a special type of PED (performance-enhancing debt) in floating rate securities, and their power within a rising rate environment. 

Transcript has been edited for clarity

What is the Enhanced Income Fund?

Some people call it a hybrid fund, but ultimately the Enhanced Income Fund is a credit fund. We invest in senior credit, bank hybrids, corporate hybrids, and subordinated debt. Now, from my point of view, all those securities have different risk parameters and therefore you need to actually have a very diversified portfolio. We currently have around 75 to 80 securities within our portfolio, historically somewhere between 60 to 100, but that's always dependent on the opportunities that present at any one time.

The uniqueness of the Enhanced Income Fund is also its floating rate allocation. We're very lucky in Australia that we actually have a market that provides floating rate securities. There's a lot of markets around the world that don't provide that, in particular regarding hybrids. Because banks tend to lend on the variable side of housing loans, companies issue floating-rate securities to match their assets and liabilities. 

One of the beauties of the Enhanced Income Fund is we actually invest into those floating rate securities. In a rising interest rate environment like we have today, there's probably no better place to invest.

What makes the Enhanced Income Fund unique?

This is not just about the Enhanced Income Fund but also about Yarra and the way we go about markets - we are a very research-driven business. We believe the more research we do, the better returns we'll get. If I bring it back to the Enhanced Income Fund, I think one of the key things for us is that we don't have a benchmark that we measure ourselves against - We try to give a cash-plus type target return, which we've done and exceeded for over 20 years.

One of the keys for us sometimes in credit is that it is not about what you own, it's about what you don't own. Having that flexibility to navigate markets is essential, particularly this year where it's going to be really important to be invested in the right sectors of the market. Research is the starting point of it all. 

Another point that's quite unique about the Enhanced Income Fund is that it is floating rate in nature. It tends to invest around 75% - 85% of its portfolio in floating-rate securities. Finally, our process has been evolving for 20 years and I have a very experienced team to help me with that research and understanding of the credit that we invest in.

What value do floating rate securities provide in a rising rate environment?

It's everything. You'll hear the word duration mentioned a lot, and one of the things about fixed income markets is that if you're buying government or semi-government bonds, they tend to come with a lot of what we call duration risk. All that means is that if interest rates rise, you potentially can lose money from that rising interest rate by investing in fixed rates securities.

By investing in floating rates securities, our interest rates are reset every 90 or 180 days. Given that rates are rising, and I used the example previously that at one point, the cash rate (or 90-day BBSW) was forecast to be 3%. That's our base rate and then we earn our credit margin above that. 

So, by being in floating rate, we don't experience any capital loss and that's really important in a rising interest rate environment.

How is the portfolio positioned in the context of rising rates?

There are a lot of people in the market today who have never seen interest rates rise. Because it has been a long time. I think the one thing that we've called as a house, in particular Tim Toohey, is the impact of pending inflation. We've been talking about inflation rising for a long period of time, so, we've been very well-positioned for that. We've been hedging out all our fixed-rate securities, hedging against the right part of the yield curve, which is really important as well. So, despite that rising interest rate that we are seeing, we don't expect to experience any capital loss in the Enhanced Income Fund - so we're actually getting an uplift in yield. 

Every time the RBA starts to tighten policy, we get increased income and higher yield. If 3% cash rates is right in March 2023 next year, we're going to be having a running yield on this fund close to around 6%. In my eyes, it's been probably 10-12 years since we've seen that type of return in running yield across an investment-grade portfolio. 

I find that exciting. I think investors will find that exciting. And as I said earlier, I think it's probably a good place for investors to be in the current environment.

What are the current security allocations across the fund?

The Enhanced Income Fund always tries to be investment grade on average, and we've done that for over 20 years but we do have the ability to go down into the higher yield with non-investment grade type credits. And it's really interesting today. The fund on average is around BBB at the security level (as opposed to the company level). For us, we're probably running the highest credit quality that we've had for 10 years now within our fund and that suits the time and environment where we're moving into. But today, we run around 75% investment-grade credit and around 25% which is rated non-investment grade and below, what we'd call high yield.

To bring that into context though given we invest in hybrids, I'll give you an example. Regional banks today - Their tier 1 paper is non-investment grade at BB+. I think it's really important that they're still quality companies at the senior level. It's just that that subordination in hybrid knocks it down to that high-yield level. 

We're moving into an environment that is a bit unknown with interest rates rising. We don't know the outlook for growth. So, it's imperative to stick to high-quality companies and in particular, companies and sectors that probably aren't exposed to discretionary spending, which is something that we're trying to avoid in our fund.

How do you offer enhanced income within the fund?

As you're taking risk, you should be compensated by a greater return. For us, we always think about, our rule of thumb: get paid for the risk you're taking. So, assigning a Yarra rating is our tool that tells us our starting point. Now, whether it's a senior credit or subordinated to that, we will notch for various risks within a security. The most important thing for us is we need to get an appropriate return for doing so. 

Adding that value by taking more risk is how we go about developing a portfolio that is ultimately investment grade on average, but is going to give us roughly a return of around 260 to 270 basis points in compensation. Now, you add your BBSW in 12 months' time where cash rates will be at roughly 3% - That's where we get to a 6% type total return that this fund will offer.

Where does your fund sit in an investor’s portfolio?

It's a good question because I've seen that evolve over the last 12 months. What a lot of clients have been doing is identifying that interest rates were rising. So, what they've been doing is instead of getting rid of their interest rate duration, they've been using the Enhanced Income Fund because we're floating rate with very little interest rate exposure. Bringing the two together enhanced their yield, but may have also halved their interest rate risk and exposure to rising interest rates. This has been quite interesting for me because I actually haven't seen clients do that in the past. 

Access to regular, stable income

The Yarra Enhanced Income Fund seeks to deliver higher returns to investors than traditional cash management and fixed income investments. Learn more by visiting Yarra Capital's website.