The best opportunity I’ve ever seen to generate alpha

Predicting the direction of interest rates has been a preoccupation of many in recent years.

The Federal Reserve recently surprised the market with a 50-basis point rate cut, signaling what is expected to be a steady easing of monetary policy. In contrast, the Reserve Bank of Australia held rates in September but is expected to follow suit in the near future.

So what does this mean for investors?

The market has been anticipating that central banks would start cutting rates by the end of this year or early 2025, in line with its global peers. However, we do not expect rates to return to the lows seen prior to the current rate-rising cycle. Investors will need to navigate a higher for longer landscape and manage their portfolios accordingly.

A lower risk income solution

The key question for investors is how to secure reliable, consistent income while managing risk in this environment. This is where investment-grade credit can add real value to a portfolio.

Many investors are focused on income, but also want to protect their capital and avoid unnecessary risk—particularly retirees. Investment grade credit offers high quality income with minimal risk of default.

Credit spreads are currently near their long-term averages. When combined with higher base rates, it creates an attractive proposition from an income perspective.

Investment-grade credit is particularly well-positioned for a higher for longer environment, as the underlying companies tend to maintain more manageable debt levels, exhibit greater flexibility in managing their cost base, and possess stronger pricing power for their products. These factors place them in a better position to navigate through the economic cycle.

Ultimately, it all comes down to risk versus reward. At the moment, high yield credit does not offer sufficient premium over investment grade to justify the additional risk for investors.

Understanding the opportunity

While investment grade credit is well-suited for a higher for longer environment, investors should also understand the nuances within the asset class.

In the current market, active versus passive management can make a significant difference. Over the past two years, managers with flexible mandates—who aren’t restricted by benchmarks—have outperformed. The ability to add alpha is better than I’ve ever seen it.

If you’re taking active bets, whether that be in interest rate duration or in investment selection, you’re likely to generate alpha.

Therefore, when selecting a fund, look for one with the flexibility to not only assess individual credit securities and how risky they are, but to navigate other factors like duration risk.

Volatility and liquidity are also key considerations for investors.

With some funds, the securities are highly visible and liquid on a daily basis. In contrast, other fixed income assets, like private credit, are less liquid but are less volatile because they are not marked-to-market the same way publicly traded securities are. However, it's important to note that while private credit might seem less volatile on the surface due to less frequent pricing, the underlying risk may still be present, particularly in times of financial stress. It’s important to understand the differences.

Finally, it’s important to assess risk versus income. Be cautious of opportunities that seem too good to be true, especially those offering unusually high yields in fixed income investments.

If you’re being offered a 14% yield, ask yourself why. There’s always a reason, and it comes down to risk. Navigating the next period successfully will involve focusing on stable parts of the market while carefully managing risks.

However, by identifying these stable segments, investors can secure reliable sources of income to help ride out the higher for longer environment.

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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