Last week, we held our inaugural High Yield Bond Conference in Sydney to a packed house, there was standing room only with practically all guests attending and praising the event. Guests included: institutional investors and issuers, financial advisors and media, including an international contingent and private clients
Findings from Corporate Bond Market Report - John O’Mahony
Partner, Deloitte Access Economics
John presented the key findings of the Deloitte Access Economics “The Corporate Bond Report 2018 – Australia’s growing appetite for corporate bonds” commissioned by FIIG Securities. The report shines a spotlight on how the corporate bond market performed and the potential it offered to Australian investors. Click here to read our announcement and summary of the report.
Megatrends shaping the future of Australian prosperity - Bernard Salt
Managing Director, Demographics Group
Bernard Salt believes that while there’s “no shortage of entrepreneurial energy” in Australia, our attitudes towards high income earners and business needs a readjustment. He is concerned about the “anti-business, anti-entrepreneurial sentiment in Australia”, and that our awareness as investors and the economy as a whole needs to be more “ethically rich”.
“The problem we have is that everyone who is a high income earner is lumped into the same bucket and I think we need to be more nuanced than this,” Salt said.
“There are some uncomfortable discussions the Australian people need to have. One is around allegiance, one is about our future, one is about entrepreneurship and one is about who actually delivers the tax, no issues paying it and a full and fair and open way.”
He also emphasised that China will continue to benefit our country thanks to our proximity. We should be among the most prosperous nations for the next century at least, Salt said. However, there needs to be a “shift in the heartland” towards recognising the role of business.
“Why is it that we have not appointed an Australian of the Year from the business community in two generations for their ability to create wealth and prosperity for the Australian people?” Salt asked.
“If this is because there is no one worthy from the business community then I say that is a damning indictment of the business community, but I actually think that there is,” he continued, pointing to the founder of Ramsay Healthcare Paul Ramsay. “That person was never identified as an Australian of the Year candidate. We need to shift the way we think,” Salt said.
Assessment of returns, trends and outlook - Mark Bayley
Head of Credit Strategy and Research, FIIG Securities
On how the Australian high yield market market has performed in comparison to the global market
Mark Bayley made several interesting points to note:
- The Australian high yield market averages a return around 8.6% per annum and a coupon return around 7.8%. Ellipse 1 shows Qantas joining the index then leaving the index when it became investment grade
- Overseas, Ellipse 4 shows the period in which the global high yield market was hit by lower oil prices, dragging the energy/oil sector in the States considerably lower in terms returns, and also the capital prices of bonds
- Ellipse 5 shows a significant fall in the investment grade space associated with the increase in yields at that time. It clearly shows a difference between the two markets - investment grade bonds depreciated while high yield bonds didn’t
The outlook for the next six to 12 months
“One of the key drivers that I see for future spread movements and future defaults is the access that corporates have to capital,” Bayley said. As long as corporates have access to capital they are very unlikely to go into bankruptcy.
He highlighted that over the last couple of years, global trends show that it’s easier for corporates to get access to capital, indicating that global credit markets are positioned against a “robust backdrop”.
Bayley also raised default rates as another key factor for outlook noting that S&P expects default rates to continue to fall.
"In our opinion, asset values are priced to perfection. It is true that global credit fundamentals are expected to be stable but technicals will remain volatile."
The biggest concern and recurring theme throughout the conference, is that we are very much in the latter stages of the credit cycle with the second half of 2018 characterised by marginally wider credit spreads.
Bayley’s recommendation is towards a more defensive or cautiously positioned portfolio by migrating to more highly rated and shorter dated corporate bonds. For investors searching for even more yield, he recommends moving into shorter dated, lower rated corporate bonds rather than longer dated but more highly rated bonds.
Principles of fixed income portfolio construction
Moderated by Jon Sheridan, NSW/ACT State Manager, FIIG Securities
Nick Bishop, Aberdeen Standard Investments
Stuart Gray, Schroders Investment Group
Kieran Quaine, FIIG Securities
Bob Sahota, Revolution Asset Management
Jon Sheridan presented a brief overview of portfolio construction – is it an art or science? Overall, he admits to being an “absolute return” investor rather than looking for a benchmark return. Absolute return seeks to provide a smoother investment ride than traditional long only strategies.
Absolute return – seeking a smoother investment ride
Source: BNY Mellon
Here are his key considerations for portfolio construction:
- Credit risk
- Position sizing
- Foreign exchange
Nick Bishop, Head of Australian Fixed Income, Aberdeen Standard Investments
On pricing risk given low spreads and investors’ ongoing hunt for yield
Nick Bishop offered a positive view on Australia’s less liquid bond market quoting this as a benefit as “there are fewer players in the market”. He observes that “since buyers overseas can enter and exit with ease, they don’t build in an extra premium needed to be compensated for lacking liquidity. This is not the case in Australia.
“It’s about minimising your drawdown in this part of the cycle,” says Bishop. “A lot of investments right now are not really priced for the risk of accidents, but it’s more pronounced in more liquid markets”. He emphasised that in Australia, you can still get “fantastic compensations for arguably very low risks”, and listing secured loans, short dated, non rated bonds and asset securities. “You’re still getting 6, 7 or 8% returns – that looks fantastic compared to the rest of the globe”.
Interestingly, Bishop believes the US market will be heading into a recession “in late 2019, early 2020”. The Fed will react and that’s when credit markets will be properly tested.
Stuart Gray, Fund Manager and Head of Credit Research, Schroders Investment Group
On key considerations when constructing a portfolio
“The starting point is: what am I trying to achieve in the portfolio? Fixed income is very diverse and very different to equities so it can construct very different risk characteristics just by what you put into it. So, it’s normally a combination of some form of defensive, equity and income,” Stuart Gray said.
“The key thing we do look at is having the broadest opportunity set as possible for the portfolio, so I can get my diversification. Next thing we look at is valuation cycle and liquidity. So within that invested universe, where are my valuations? What’s expensive, what’s cheap? Then more importantly, where in the cycle are we?”
Kieran Quaine, Head of Managed Income Portfolio Services, FIIG Securities
On key considerations when constructing a fixed income portfolio comprised of corporate debt
“In the last few years, credit margins have traded somewhat tighter than they have been for a long period of time. The additional yield, or spread, offered by high yield and unrated corporate assets over corporate investment grade assets has compressed markedly, giving us a difficult equation to solve,” Kieran Quaine stated.
He manages this by “varying the percentage exposure between investment grade and non-investment assets constantly … and recently that is, reducing high yield and unrated exposure in favour of investment grade exposure.” This strategy may be deployed across multiple or singular issues.
“Singular issues can present yield opportunities that will out-perform the general average. Within our portfolio, we can, and often do, take defensive stances in the short term awaiting spread margin deterioration, or increased yield opportunities, before deploying back into the high yield sector.”
On managing those fixed income portfolios in a rising yield environment
Although “the easy answer is to shorten the portfolio duration, including a large exposure to floating rate notes, it’s often not as simple as that,” Quaine said. “The universe of asset opportunities, including high yield, doesn’t necessarily always come in both short dated fixed and floating rate form from the target diversified range of corporate issuers of interest”.
“That’s where the art comes in - you’ve got to make a combined credit and duration decision. You’ve got to decide where you want to be on the interest curve as an average term to maturity, and select the best assets available at that point in time, whether they be investment or non-investment grade, whether fixed or floating. Importantly, investors need to understand the factors that will influence a bond’s price change and therefore the performance change for that investment. If the expected rise in interest rates, and subsequent price fall, offsets any high accrual benefit derived from investing in higher yielding fixed rate assets, then the investor would have been better off parking the money very short, protecting capital, before deploying at a later time at a more advantageous yield.”
Bob Sahota, Managing Director/Chief Investment Officer, Revolution Asset Management
On building a portfolio from scratch with a billion dollars and an unconstrained investment mandate
Bob Sahota also echoes that we are in the late stage cycle and that "we need to be defensive; we need to think about things in the sense of ‘what could go wrong,’ rather than ‘how much money we can make?"
“Diversification works wonderfully well and portfolio theory works great when you’ve got liquid deep markets like the US. In the Australian context that is a high yield but illiquid market – you need to make high conviction trades and avoid the ones that won’t pay you back.”
His key trends, particularly in this late cycle phase are:
- Security, to minimise any loss in a big spike in default
- Covenants, such as interest rate coverage ratio, debt service coverage ratio and leverage covenants to enforce your security and get your money back if things go wrong
- Timely information on how your particular investment is performing is important
On pricing risk given low spreads and investors’ ongoing hunt for yield
Sahota compares the bond market to the equity market that depends heavily on entry and exit points and the concern that the holding period will make a return.
“If you’re a hold to maturity investor, which you should be in a high yield market in Australia, it doesn’t matter if the market price goes up or down. If you pick the right investments and you recover at maturity … you get that coupon that’s contracted for the whole period.”
“If you bear the liquidity, you can actually earn an outside return; that’s come into Australia in my firm opinion,” Sahota said. With the Australian banks starting to feel the real bite of regulatory changes, he believes the high yield market is offering a very interesting opportunity for investors and the money market industry to enter.
Macroeconomic and policy influences on credit markets - Stephen Koukoulas
Managing Director, Market Economics
On global and domestic economic growth
Stephen Koukoulas notes that statistics show global growth but “we’re not getting that runaway sort of boom that is going to fuel a big pickup in inflation risks”.
“Three per cent for a US Treasury bond … that’s remarkably low, we’re still in a very low interest rate structure economy,” says Koukoulas.
He observes Australia’s “mediocre” economic performance as “a mild school report”, listing a high unemployment rate, low wages and inflation that is still below the RBA target.
“Unemployment and underemployment is still too high ... There’s more slack in the Aussie labour market today than when the GFC hit us."
To get the “bottom line GDP growth above three per cent”, Koukoulas says unemployment needs to fall, which will in turn see wages go up, and in turn boost inflation back to target range. The key ingredient is evidence of stronger investment in the Australian economy.
On the upcoming election
Koukoulas made it a point that this time, the politics have important implications for investment management and for portfolios, depending on who wins. This will also see “the dynamics change on the non government bond market in Australia”.
“Whichever side wins will determine how you will probably be revisiting your investment strategy … Two of the really important basic investment strategies over the last 15 years, are probably going to change.”
If the Coalition wins, business will run as usual. On the other hand, Labour is advocating tax reform and proposing a range of tax measures that are going to yield more revenue but also reduce government debt.
If Labour win, Koukoulas notes this will affect two traditional and “potentially, former tax effective” investment strategies:
- Negative gearing
- Dividend imputation cash refund
Post election, if these changes get through the Senate and become law, these investment strategies will become very different to what it is today.
“Bottom line is … we’re not heading for a boom nor are we not heading for a recession. Any rate rises will be pushed well into the future.”
The emergence of the Australian unrated bond market - John Ricciotti
Head of Debt Capital Markets, FIIG Securities
John Ricciotti turned the conversation to an issuer’s perspective.
- The Australian bond market is worth $2.4 trillion and it’s all over the counter
- Provides an important source of financing for the Australian economy
- The corporate bond market has room to grow
Source: FIIG Securities
The bond market is the ideal funding platform with a variety of participants from financial institutions, funds, professional and wholesale investors. “These investors are also accustomed to wanting to access different types of debt … they have an appetite for diversity. They’re not homogeneous like the banking sector,” Ricciotti said.
Issuance in the unrated bond market is growing, delivering diversity and providing issuers with a lot of choice. The slide from his presentation below sums up the main features of the unrated bond market.
“Probably the most important thing that the bond market is doing for issuers is that it’s supporting growth … delivering really positive outcomes.”
Source: FIIG Securities
“There are a lot of private companies out there with strong capital positions. The fact that they don’t have a listing means they’re quite limited to the amount of equity capital they can access,” says John. “The unrated bond market is absolutely accepting of those companies. It’s a good opportunity for the investor to get exposure to different parts of the economy”.
Finally, two concurrent panels:
1. Investing in the high yield market:
A discussion between portfolio managers and credit analysts sharing their knowledge of investing in high yield/unrated credits. The discussion covered why investing in the high yield/unrated market is different to investment grade and how investment mandates have changed in the last few years. The panellists consisted of:
- Anne Moal, Senior High Yield Analyst, Perpetual Investments
- Matthew Macreadie, Senior Investment Manager, Fixed Income, Aberdeen Standard Investments
- Adrian David, Senior Credit Analyst, Macquarie Investment Management
- Ky Van Tang, Senior Credit Manager, Colonial First State Asset Management
2. Issuing in the unrated bond market, an issuer's perspective
John Ricciotti moderated this panel with corporate issuers sharing their experience of raising funds in the Australian unrated bond market. The discussion provided insights into the decision making process to access the bond market as well as how bonds performed as a source of funding. The panellists included:
- Patricia Reid, CEO & Managing Director, CF Asia Pacific
- Paul Siviour, Chief Operating Officer, Elanor Investors Group
- Sebastian Paphitis, Partner - Capital & Debt Advisory, Ernst & Young
- Philip Harvey, Partner, King & Wood Mallesons