The best of two worlds in this defensive investment combo

Amid persistent uncertainty about the outlook for interest rates and inflation, income-focused investors are better served by spreading their risk across fixed income assets. That’s the view shared by Teiki Benveniste, Head of Ares Australia Management. He believes a combination of sovereign bonds and corporate credit is the best way to maximise yield while minimising the risk linked with interest rate volatility.

In the following interview, part of Livewire’s Income Series 2024, Benveniste discusses the pros and cons of both parts of the fixed income universe. He explains how his team finds the most compelling opportunities within investment-grade credit and bonds, their current positioning, and explores some of the most commonly misunderstood aspects of the asset class.

Why is a combination of bonds and loans the best way to maximise an investor’s income opportunity in credit?

If you look at bonds first, the impact of higher rates has driven lower prices, and a small increase in current income. Because bonds are fixed rate assets, the cash interest paid by previously issued bonds has not increased. Bonds carry interest rate duration risk, which means their price changes in the opposite direction of movements in interest rates. Therefore, buying bonds today can be attractive form a price discount perspective as they carry the potential for their price to pull back to par as they come closer to maturity.

Bonds have a nominal value and a maturity date – if they do not default investors get the nominal value of the bond back even if they only paid 90% of that nominal value to acquire the bond. However, bonds are less attractive from a current yield standpoint. To put that into perspective, the Barclays Global Agg index has an average current yield of 2.9%, which is well below cash rates.

On the other hand…

Conversely, loans are floating rate instruments. The interest paid adjusts with the higher base rate. They carry very little interest duration risk as their price doesn’t have to adjust to moves in interest rates, rather their coupon or interest payment does. This has resulted in current yields in loans increasing to approximately 8-9%.

In summary, Bonds can have both interest rate risk and credit risk while the main risk you are taking with loans is mostly credit risk – their prices move with market sentiment on the risk of defaults, not interest rate risk.

So, we believe, combining loans and bonds can help deliver both the opportunity for higher current income as well as potential capital gains from buying discounted fixed income instruments, while keeping duration risk relatively low.

What is the one attribute that distinguishes the Ares Global Credit Income Fund from others in the space?

We believe the Ares Global Credit Income Fund is differentiated as it is a pure play on global credit, with little interest rate risk, combined with no exposure to the lowest credit quality bands of our markets. We believe these features make it a predictable fund as the main risk is credit risk, which we are keenly focused on managing.

As such, the fund can serve to enhance yield and current income, with around 8% current yield* for one year of interest rate duration, delivered with no to little exposure to risks that are often already present in Australian investors’ portfolios, such as the Australian economy, real estate or banks.

What is your process for identifying the highest returning fixed income assets - and how closely do you hug your benchmark?

While the strategy is predictable from a risk management perspective, it should behave as you’d expect a low duration global credit allocation to – we take a very tactical approach and are benchmark unaware.

We go where we see the best relative value on offer between the credit asset classes that we invest in.

Importantly, we are not investing through a siloed approach between asset classes. For example, our allocation to loans does not need to be a benchmark aware allocation. We pick the parts of the loan market we like. We evaluate, for example, Triple-B-rated credit instruments across bonds, loans, and alternative credit, and invest where we see the best risk-adjusted return opportunities.

At the moment, we favour asset-based credit instruments (e.g. CLO debt) for that Triple-B exposure as we are able to generate 4.5% of current yield* premiums over similarly rated bonds.

What are your current high-level macro views and how is this reflected in the fund positioning?

There has been a lot of volatility in the rates markets, and we believe rates will remain volatile and potentially higher for longer as central banks combat sticky inflation and a robust but slowing economy. This observation has been a key driver of our positioning in multi-asset credit strategies where we focus on the relative value between credit asset classes.

In short, we are not taking directional bets on rates, as we are not a duration manager – we are focused on managing credit. For Ares, more uncertainty around rates implies more volatility for fixed rate credit instruments.

At the end of last year when the market was pricing in more than six rate cuts for 2024, we remained cautious around adding fixed rate credit instruments. That’s because we felt the risk of a hawkish surprise made bonds relatively less attractive versus high quality floating rate loans that were generating significantly higher current income.

Now, as bouts of volatility hit fixed rate corporate bonds, we have added selectively to discounted bonds that could have a catalyst to be repaid early, while still keeping interest rate duration low.

A little over six months ago, you predicted that corporate defaults would tick up but wouldn’t hit worrying levels. Has this played out and where do you see default levels for the next 6-12 months?

Yes, 12 months ago, we felt that credit markets were likely to see higher default rates as marginal credits were likely to struggle in a higher rate environment. Our view was that defaults were likely to go back to historical averages rather than extreme levels such as the GFC or COVID crisis, and in fact there was less of an uptick than we had predicted as corporates continued to see on average increased EBITDA and limited walls of maturity on their debt.

So, looking ahead, we still see the case for dispersion between good and bad credit with risks for outsized increase in defaults.

From an overall risk positioning standpoint, despite the fundamental picture remaining somewhat supportive, we are cautious in our positioning as there are many exogenous factors that could upset the apple cart and lead to volatility.

How are you currently positioned across fixed rate versus floating rate, and how does this compare to your benchmark?

We are overweight floating rate assets given the attractive current yield available in loans and CLOs [collateralised loan obligations] at around 7-9% currently.

We also have +/- 20% of the portfolio invested in discounted fixed-rate bonds, to add optionality with bonds being repaid early or trading back towards their nominal value.

What is the one area you believe less experienced fixed income investors most commonly misunderstand (and what do they need to know?)

Credit is a separate asset class with a $6 trillion opportunity set, ranging from liquid to illiquid asset classes. We believe transparency is important for investors seeking to better understand this opportunity set. We also believe that looking beyond headline numbers can be beneficial as various parts of the credit market will show value at different points in time. This could lead to missing out on potentially great opportunities to enhance current yield and provide much needed diversification in Australian investors’ portfolios.

Where does this fund typically sit in an investor’s portfolio?

The fund is a higher yielding fixed income strategy, so we generally see allocations from traditional fixed income but also from growth assets.

The credit asset classes we have invested in over the last 15 years have generated returns in line with growth assets but with 40% of the volatility. So, investors looking to take some risk off the table without leaving too much potential return behind are generally interested in this strategy.

Then the fact that we do not invest in the lower credit quality bands of our markets means the strategy is quite defensive and should experience lower volatility and default risk than higher beta credit markets. With its low duration focus and high level of current income, we believe this makes it a compelling strategy for investors looking to reduce duration risk and increase income generation within their fixed income allocation.

Consistent income throughout market cycles

To learn more about how Ares Australia Management navigates inefficiencies in the market to generate attractive, income producing portfolios please visit their website.

Managed Fund

Ares Global Credit Income Fund

Global Fixed Income

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