Smiling all the way: Equity-type returns in fixed income

I, for one, am getting pretty tired of the bearish themes in markets. 

Higher interest rates, slowing growth, recession, earnings peak, rising geopolitical tensions. Outside of the fabled Santa Rally, there's not a lot for the positively minded to cling to at the moment. 

Enter Roy Keenan who manages the Yarra Enhanced Income Fund. Whilst he's positive on fixed income, he's no noob - he's been looking after the fund for 21 years and he's mindful that we're coming off a pretty torrid period for fixed income. 

It's probably one of the better times to have fixed income in your portfolio because the amount of income provides defensiveness and fixed income didn't have its defensiveness two years ago. Today, it does.

Keenan is also liking the new issues that are coming into the fixed income market, as it gives him and his team the ability to improve the quality of the portfolio. 

The more deals, especially if they're new issuers, gives us the ability to diversify our portfolio... and you can do this rotational trade.

Whilst defensiveness and new issuance are making fixed income attractive, so too is the return profile, particularly when compared to equities. 

Keenan notes that corporate balance sheets are in great shape and adds that 'if we have good corporate balance sheets and we can generate returns in that seven-to-seven point a half percent return mark, that looks extremely attractive for us and we can lock that rate in for five to 10 years'. 

Now if you compare that to equities from a valuation or expected return perspective, over the last 10 years, the ASX 200 has generated an average return of 7.1%. 

So now you could argue that you are getting equity-type returns in fixed income today, which puts a smile on my face.

In the following Expert Insights, Keenan talks about what has been driving the Enhanced Income performance, the impact of new deal flow, the impact of volatility in equities, and what makes the Fund unique. 

Please note that this interview was filmed on 23 October, 2023

Edited Transcript

Chris Conway: Roy, thanks for sitting down with Livewire today. Spread tightening and carry have been driving a lot of the performance in the Yarra Enhanced Income Fund of late. Can you just briefly explain them and do you expect those factors to continue?

Roy Keenan: When you hear about carry, it’s essentially the income generation of the securities we have in the fund. Today, in the Yarra Enhanced Income Fund, the carry (or income) that we're generating is around six and a quarter per cent.

If I compare that to two years ago, it was at three per cent. So it's a great space for us to be in at the moment.

What does carry do? Carry protects you from things that can go wrong, whether that's credit spreads selling off or changes in interest rates.

That's why people say today it's probably one of the better times to have fixed income in your portfolio because the amount of income provides a level of defensiveness and that fixed income didn't have two years ago. Today, it has.

Spread tightening has been contributing to our fund. It's been about the sectors we have exposure to, such as bank and insurance tier two, which have been really solid performers for us. That is something I expect will continue.

Today, credit spreads are still trading above average, and corporate balance sheets are in robust shape, especially investment grade companies that primarily we're investing into. While I don’t anticipate a tremendous rally in the future, I do think they'll slowly grind on. 

Chris Conway: Roy, new deal flow that's been picking up of late. How does that impact the way that you're investing?

Roy Keenan: 

The more, the merrier from my perspective. 

First of all, we're all about getting paid for risk. Moreover, the more deals, and especially if they're new issuers, it gives us the ability to diversify our portfolio. Where we do like a new issue into the marketplace and we're getting paid for that risk, then what it does, especially if it's a little bit illiquid and you're getting paid an illiquidity premium for that security, then you can look across your portfolio and say, "Well, how does this stack up versus something else already in the portfolio?" And you can do this rotational trade. In some ways, new issuance always gives you that ability to improve the quality of your fund.

Chris Conway: Roy, how does equity market volatility impact the flow into fixed income? Are you seeing a lot of investors shunning equities because of the volatility and coming over to the fixed income side?

Roy Keenan: I think it's about volatility, but also price comparison and future return expectations. And I think you've got to be careful what you wish for in some ways. Excessive equity volatility can have flow-on impacts into the credit market.

I always look back to the pandemic and the amount of equity volatility we saw that naturally flowed into credit markets, which ultimately created one of the best credit investing opportunities in my career. From our perspective, a nice slow sell-off in equities is fantastic for credit markets.

Corporate balance sheets are in great shape, so it's really important to think with that context in mind. If we have good corporate balance sheets and we can generate returns in that seven-to-seven and a half percent return mark, that looks extremely attractive for us and we can lock that rate in for five to 10 years.

Comparatively, looking at equities from a valuation and expected return perspective, over the last 10 years, the ASX 200 has generated an average return of 7.1%. 

So you now would argue that you are getting equity-type returns in fixed income today, which puts a smile on my face.

Chris Conway: Does it put a smile on the face of all the equities guys here at Yarra as well, Roy?

Roy Keenan: Probably not.

Chris Conway: Fair enough. Just to finish up, Roy, what's unique about the Yarra Enhanced Income Fund?

Roy Keenan: It's funny you mentioned the equity team. One unique aspect of the Enhanced Income Fund, which I've been managing for 21 years now, is our experienced team.

It's a good question because it made me really think about what's unique about us, and it goes back to the Yarra Investment Team. I think we are pretty unique. We don’t view ourselves as separate fixed income and equity teams. 

We see ourselves as an investment team. We work together, we share research, we talk about companies, we share company and morning meetings together, every day. 

I think that's quite unique because normally fixed income and equity sit opposed to each other. We've got a really tight-knit group that work for each other, which I think leads to better investment decisions.

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's website.

Managed Fund

Yarra Enhanced Income Fund

Australian Fixed Income

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