How to Find Alpha in Fixed Income | Ying Yi Ann Cheng, the Switzer Higher Yield Fund

During the recent Switzer Investor Strategy Day Ying Yi Ann Cheng, Portfolio and Management Director for the Switzer Higher Yield Fund (the Fund or Portfolio) presented on the fixed income market, how Coolabah Capital is investing and where investors can find income in the current low-yield environment.

Transcript of the presentation

Hi, I’m Ying Yi Ann Cheng, Portfolio and Management Director at Coolabah Capital. And today I’m going to be talking about fixed income.

In a low yielding world, how does one generate higher returns? In fixed income it’s typically no different to any other asset class in the sense that if you want more returns, people, investors or managers can typically chase more risk. In fixed income this could take the form of chasing on more interest rates duration risk, otherwise known as fixed rate risk. This would involve investing in longer-dated fixed rate bonds, which compensates you for losses on interest rate risk. An example of that would be investing in a 10-year bond as opposed to a five-year bond for example. It could also involve punting around by interest rate futures.

Another way to drive more return would be to chase more credit risk. So the risk of default or loss. Examples would include high yield bonds or loans, those that are in red BB, B or CCC, or even unrated securities. Or you could chase more illiquidity risk through illiquid loans, illiquid corporate bonds and illiquid ABS, or asset backed securities and illiquid residential mortgage backed securities. Those securities that you can’t trade in and out of very easily. In that respect, it’s very straightforward because you know that when you chase more risk you should get compensated with a higher rate of return.

What is harder is extracting alpha to generate higher returns. How do you find alpha in fixed income? Well, you do that by finding capital gains. How do you find capital gains? You do so in identifying mispriced bonds. What is a mispriced bond? Well, it’s a bond that is paying too much interest or spread after you adjust for its risk factors. And examples could include the credit rating, the term to maturity, the industry of the issuer, the liquidity of the bond, where it sits in the capital structure. And if that interest rate is higher than the fair value then one can look to buy that bond. And as that interest rate or yield drops towards fair value that lends itself to price appreciation because there is an inverse relationship between the bond price and the yield. And then you’re able to sell that bond for a capital gain. So it’s no different to you finding capital gains in equities, but you can also find capital gains in fixed income.

Something to also be aware of in fixed income portfolios is diversification. Here I really want to emphasize the paradox of fixed-income diversification. Many so-called active fixed income portfolios have anywhere between 200 to a thousand securities. However, most investors would not know 25% to 50% of the names in those portfolios.

Diversification is really a vehicle for taking much more credit risk or the risk of default or loss, which all converge in a crisis or a recession like we saw last year. During a recession all these businesses face the same risk. Therefore we see default correlation spike, liquidity risk also spike, and rather than reducing risk this form of fixed income diversification actually increases both credit risk and liquidity risk. And as I mentioned this explains the extreme illiquidity and poor performance amongst fixed income portfolios in 2020.

At Coolabah we prefer to focus on systematically important businesses that have little or zero inherent credit risk. And instead we focus on investing in securities that are issued by entities that have either implicit or explicit government guarantees, and that are either oligopolies or monopolies. And at Coolabah Capital we’re focused on capital gains rather than taking on more risks to drive return. In order to find these capital gains and to find these mispricings you need a very large team. Which is why we have built the largest team in Australian investment-grade fixed income. So we have 26 full time executives at Coolabah across four offices, two in Sydney one in Melbourne, one in London. And within the investment team we have five portfolio managers and 13 analysts, 10 quants, four PhDs, and two university medlists. And the reason we have such alliance team as I mentioned is we’re trying to look for these mispricings. They source alpha and capital gains.

Meanwhile, we also happen to be the most active trader of Aussie fixed income globally. So we’re typically trading 70 to a hundred times a day. And on average at least $150 million a day. If you look at our last 12 month returns to the end of March, you’ll notice that in the top row here is the gross return. Meanwhile, if you look at our capital gain, it’s quite substantial. And in fact, capital gains as a proportion of our gross returns is around 70%. In this strategy it’s actually 126.5%. You can say that way generate consistent alpha or capital gains across all bond sales since Jan 2020. And I know the writing is quite small, but you will notice that over more than 9,500 trade sales in total worth around a $14 billion, we have made money 98.5% of the time. That is our win ratio.

How often are we finding capital gains? Actually that’s 92.4% of the time. And that’s on average AA- credit rating. So we’re not reaching down the credit risk spectrum. We’re not taking extra default risk. Our median holding period is only 52 days. So we’re trading very actively. Since the start of 2020 we’ve sold close to $15 billion of bonds and bought almost $19 billion of bonds. So in total we’ve traded over $34 billion of bonds. You can see our trading activity, the aqua-bars are the sales and the red bars are our buys. We were particularly active pre COVID, during COVID, and also post COVID. You’ll notice that in January, 2020 when credit spreads were very tight people thought that equities was expensive. For example, we were actually dig risking our portfolios. That was our largest sale month in history. We sold $1.14 billion of bonds. In Feb and March when the market was throwing the baby out with the bath water, they were selling risky assets and even safe assets, and just switching into cash. We were actually contrarian. But what were we actually buying? We were buying, as I mentioned securities with little or zero inherent credit risk. So bonds issued by the major banks, for example.

In March, when a lot of our peers had issues with liquidity we actually bought $900 million and sold a $100 million dollars. We had no issues with liquidity. In April you can see that we started taking profits and in April a lot of our peers still had issues with liquidity. Where we started buying bonds again. In fact, we were buying state government bonds in August, and that was in anticipation of RBA-QE.

As you can see here, this is all about trade sales. Every single black dot is a trade sale since the start of 2012. So since Coolabah Capital’s inception you can see we’ve demonstrated persistent alpha and a 98% win ratio over more than 19,800 trade sales with a face value of more than 22.17 billion. You’ll notice that the average credit rating has been high throughout. It’s been A+. Our median holding period is only 63 days. And what you notice is that the coupon or the yield on each of these securities is actually quite low over the last 9.5 years. And that’s because we aren’t trying to drive returns through interest rates duration risk, or credit risk or illiquidity risk. Instead we’re focused on capital gains, which by the way are quite substantial. So the capital gains serve to augment the interest that we earn, and if you look at our IRR on these bond sales it’s actually close to 12%.

Rounding off, if you look at the Switzer Higher Yield Fund the target return is cash + 1.5%. The target rating is also very high. It’s in the A band. You have daily liquidity. And in terms of the target holding it’s 30 to 60 active alpha generating positions. And the top holdings are listed here. Names that you would recognize, but as mentioned securities that have very little intrinsic credit risk, because they are issued by oligopolies or monopolies for example, the banks and governments themselves. So new South Wales, Queensland, if you look at the interest rate duration there is zero interest rate duration. In terms of the investible assets you can invest in cash, investment-grade bonds and hybrid securities. Looking at the asset allocation you would notice that more than 24% of the portfolio is in government bonds and the rest are in bank securities.

On that note thank you for your time today, and I look forward to engaging with you in the future.