Why this credit investor sees returns of up to 8% from here

Chris Conway: Can you please briefly explain the fund that you look after? What part of the fixed income market do you invest in?

Phil Strano: The fund I manage is the Yarra Higher Income Fund.

It's a multi-sector credit fund that invests in Australian credit. We aim to select the best opportunities in the market, focusing on high, risk-adjusted returns. Our approach involves creating a blend of assets that optimises the risk/return liquidity paradigm and effectively focuses on generating alpha to deliver superior performance for our investors.

Chris Conway: The fund recently celebrated its five-year anniversary. The past 22 months have been very volatile. Can you just talk to us a little bit about the journey over those periods?

Phil Strano: The last 22 months has been a positive environment for the Fund. In 2021, we hit a low point in terms of yields. When we talk to investors today, we're talking about yields because they're so attractive. This is in contrast to the focus on spreads around 2021 when things became expensive from a yield perspective.

It's certainly a lot more fun managing portfolios in this environment. Yields are attractive, but it's also a case that it's also providing a lot more defence.

When you're talking about investment grade portfolios with potential positive returns of 7% to 8%, the chances of delivering a negative return becomes infinitesimally small. I believe investors are starting to understand that, and that's the real attraction of investment grade rated portfolios.

Chris Conway: Before we talk about fixed income more specifically, can I get your take on the Australian economy and interest rates?

Phil Strano: Our senior economist, Tim Toohey, believes that there could be another rate rise on Melbourne Cup Day. He's expecting a rise of 15 basis points to return to that quarter increment. It looks like the rate cuts that the market was factoring in for next year, will likely be pushed out towards the latter part of 2024.

So, higher for longer. 

Governments are spending up big, economies are proving to be a lot more robust because of that government spending, and that's just going to mean that interest rates are going to be a fair bit higher than what we've been used to.

Chris Conway: How has the volatility that we've had over the past couple of years shaped the current market? Has there been a flood of new issues? How are things being priced?

Phil Strano: I think people have understood duration. From a traditional fixed income perspective, fixed income has had to adapt as it had no other choice.

Certain parts of the market, such as listed assets tied to duration and commercial property have adjusted.

In the unlisted side of the market, you're likely to still see that adjustment come through.

But overall, I go back to thinking about investment grade right now, and from an investment grade credit perspective, it's its time in the sun.

Chris Conway: There's a lot of talk about a massive wall of government debt that's going to flood the market. If that happens, what impact would it have on corporate funding rates?

Phil Strano: It's going to keep yields elevated. However, it’s important to note that investment grade credit doesn't have an impairment risk profile, so it doesn't get impaired.

If you're a credit investor and you're looking at elevated yields, when you consider that investment grade credit doesn’t have an impairment risk profile, you're quite happy to not worry too much about the spread compared to government bonds.

What we're seeing is that credit spreads are performing really strongly at the moment, and that's because of the attractiveness of the outright yields, and the comfort that people have with those investment grade corporates and issuers.

And I think that's a thematic that's likely to continue.

That is resulting in strong primary market support, robust secondary market issues trading well and we are reaping the benefits from a performance perspective.

Chris Conway: Let's talk about where the rubber meets the road, and the portfolio and how you're constructing it across the factors, quality, duration, what does it look like right now? What is the portfolio made up of?

Phil Strano: It's made up of our best ideas across a wide opportunity set. When you look at multi-sector Australian credit. It's something akin to the size of the ASX.

It’s really about being nimble and focusing on where we're getting paid for risk, because that is the ultimate mantra that we have.

Right now, bank issued hybrid capital, particularly in tier two securities, are priced attractively and that will continue to provide performance.

I also believe that RMBS is still a fantastic sector to be in because what we're seeing is that households are prioritising their mortgage payments over other aspects of the economy.

Consumers are cutting back on discretionary spending to prioritise their mortgage payments. House prices have essentially returned to previous levels, which has come as somewhat of a surprise.

This means that the attractive RMBS spreads that we've seen - 7%, 8%, 9% - for investment grade tranches, are poised for strong performance, not just from an income perspective, but also capital appreciation as spreads normalise when the market gains confidence that a housing price crash is unlikely.

Chris Conway: Phil, how long do you think this period of not having to reach for yield is going to last?

Phil Strano: I believe we're in a different era, and that this era will persist for an extended period.

The current global environment, with its geopolitical tensions, the reversal of globalisation, the United States’ efforts to decouple from China, are all high cost options.

Governments are focusing on sustainability and sovereign capability. These priorities come at a higher cost and the decisions being made are not purely based on cost economics.

That means that inflation is likely to be higher, interest rates will be higher, and it would just mean that the cost of debt capital is just going to naturally be higher for an elevated period.

As a credit manager, provided we can manage any kind of impairment risk, which I think we can if we stick to the investment grade quality sector, we're going to offer investors some really good risk-adjusted returns.

Chris Conway: Phil, the million-dollar question. What sort of return should investors expect over the next 12-24 months?

Phil Strano: If I look at the running yield forecast from the Fund at the moment, it's in excess of 7%. If you factor in capital growth on top of that. 

I think something in the order of 7-8% is quite achievable on investment grade credit quality.

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The Yarra Higher Income Fund seeks to earn higher returns than traditional fixed income investments, with regular and stable income.

Managed Fund

Yarra Higher Income Fund

Australian Fixed Income

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