Risk is everywhere, just make sure you're getting paid to take it

When it comes to investing, risk comes part and parcel with return. 

You cannot generate a return without taking on risk, but there are times when opportunities arise to achieve higher returns for lower risk than would typically be the case. 

Roy Keenan, Co-Head of Australian Fixed Income at Yarra Capital Management, believes that now is one of those times in the fixed income market. 

His mantra is "make sure you get paid for the risk you take" and one area he and the Yarra fixed income team are finding attractive is the subordinated debt market - i.e. Tier 2 securities in major banks or insurance companies. 

Keenan adds that investors "can generate a seven to seven-and-a-half percent return in that part of the marketplace, which, on a five or 10-year security looks extremely attractive" - particularly when compared to equities:

If I compare that to equities, over the last 10 years the ASX 200 has generated an average return of 7.1%. If I can get seven to seven and a half in investment-grade credit across that sort of landscape, it looks pretty attractive at the moment.

In this Expert Insights, Keenan shares his views on the trajectory for interest rates, how he and the team manage what are likely to be rising default rates, and exactly where he is seeing opportunity in the fixed income market right now. 

Edited Transcript

Chris Conway: Roy, thanks for chatting with Livewire Markets today. It's been a pretty wild journey over the last 22 months for fixed income. Can you just talk about how the landscape has changed over that period?

Roy Keenan:

It's great for a fixed income investor to finally have some yield or income. With the RBA some four and a bit percent higher than where it was 22 months ago, it has created an environment that offers a lot more income. 

I didn't expect cash rates to be this high, and I think that's partly a reflection of how the central bank was a bit slow in tightening interest rates when inflation was running at its peak.

What does it mean from here? Obviously, it's a great opportunity for us with rates so high and 10-year bonds approaching 5%. We believe that looking forward in the cycle, it's going to be a period where there's going to be a trade-off between inflation, employment, and how much central banks can ease interest rates.

If you believe that we’re in a “higher for longer” period, which is our base case, then it's going to be really challenging for central banks to actually cut rates as aggressively as what the economy and consumers are hoping for.

Chris Conway: Roy, are you concerned at all about default rates? And if you are, how do you manage that risk?

Roy Keenan: As a credit investor, you're always worried about default rates. 

I really find it difficult to imagine that we can have such an aggressive tightening cycle in the US and in Australia without defaults occurring. 

In some ways, the amount of income we have in fixed income offsets that a little bit, but I think it's inevitable that we'll see some sort of default cycle. In the US, that will probably be in specific areas, but at home there's no doubt the property market - particularly commercial property - is where people would point to as a likely source of stress.

Also, any business that's highly levered, whether its five or six times, higher rates and the impact of higher interest payments are quite significant, especially for companies where their business models haven't been tested through time.

So how are we thinking about that? We're probably running the highest credit quality in our portfolios today. 

If I think about where we stand from investment grade versus high yield credit, we're running the biggest amount of investment grade credit we ever have and the smallest amount of high yield. 

We don't need to take a lot of risk to generate quality returns today.

Chris Conway: Roy, just a follow-up question there; in a practical sense, what red flags do you look for when you're assessing credit? When something comes across your desk, what's the thing that stands out where you say, "Oh no, we're not going to touch that one"?

Roy Keenan: 

For us, the first thing is to get paid for risk. 

We're happy to take risk and we will assess it. So first is to get paid for it, because you don't want to take risk and not be getting paid fairly for it.

Secondly, sometimes people look to leverage but don’t always understand how much leverage is in the business. Leverage is fine sometimes, right? But it's your ability to generate cash flow to meet the company's commitments that matters. The moment you're not generating that cash flow, it starts to put stress onto the business.

Chris Conway: Roy, what are the biggest opportunities and risks in the fixed income market right now? What are some of the things that you're actually adding to the portfolio?

Roy Keenan: The good news is there's plenty of opportunities, which is very exciting.

When talking about getting paid for risk, we believe there are probably two areas. The Residential mortgage-backed securities (RMBS) market which we find attractive at the moment. Employment remains strong, and the expected rise in arrears hasn’t materialised. Property prices have held up tremendously well, even exceeding our expectations. So for us, that's one area.

The other part of the market I really do like is - and we're talking about being up the credit curve and higher quality - I like buying subordinated debt. That's Tier 2 securities in major bank or insurance companies.

You're looking at BBB+ type credit ratings, and you can generate a seven to seven-and-a-half percent return in that part of the marketplace. On a five or 10-year security, that looks extremely attractive.

If I compare that to equities, well, over the last 10 years the ASX 200 has generated an average return of 7.1%. If I can get seven-to-seven and-a-half in investment-grade credit across that sort of landscape, it looks pretty attractive at the moment.

Chris Conway: Roy, just one other follow-up question; are there any worries about concentration risk? Because if you're looking at the RMBS market as well as the banks, obviously the banks leverage heavily off lending to property investors and for property. How do you manage that concentration risk?

Roy Keenan: It's horses for courses in some ways.

We manage multiple funds. Where we're overweight RMBS is where we don't have a lot of exposure to the banking sector, and where we do have more exposure to the banking sector - and major banks and regionals in particular - we don't hold RMBS.

So you're right, the two are correlated and exposed to the same risk profile. That means you've got to be very mindful of not doubling up on your risk there.

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 via the Fund profile below, or by visiting Yarra Capital Management's website.

Managed Fund

Yarra Enhanced Income Fund

Australian Fixed Income

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