With dividend income challenged from COVID-19 and a slowing economy, many investors are looking for a middle ground between low-yielding term deposits and the volatility of shares. Australian investors are notoriously underweight fixed interest investments but the Switzer Higher Yield Fund has been designed to deliver attractive yield with much lower risk than equities, by investing in a portfolio of fixed-income assets.
In this webinar, Peter Switzer and Ying Yi Ann Cheng, Portfolio Management Director of Coolabah Capital discuss: Coolabah’s view on the current economy; how the fixed income market works; the outlook for interest rates and asset prices in the year ahead; and where investors can find reliable income in a low-yield environment.
Peter Switzer (PS): Hello and welcome to this live webinar. I’m Peter Switzer. Today we’re talking about where investors can find income, in the current low-rate environment. To talk about what this means, I’m joined by Ying Yi Ann Cheng, of Coolabah Capital. Coolabah is a leading active credit manager, who manages over $5 billion worth of assets on behalf of the institutional and retail investors.
I’m excited to say that Coolabah has recently been appointed as the manager of the Switzer Higher Yield Fund, which has relaunched as a quoted vehicle and is currently traded on the Chi-X Exchange. A quoted vehicle basically means you can get it on the stock market. And it’s kind of like an ETF.
We start with some key questions with you, Ying Yi. Before we go into the new fund itself, Ying Yi, can you just tell us what you guys think is going to be the outlook for the Aussie economy in 2021?
Ying Yi Ann Cheng (YYC): Firstly, thank you for having me on, Peter. And to follow we’re quite bullish on in growth. We’ve seen a ton of fiscal stimulus and monetary stimulus continuing to be rolled out. As you would know, the RBA cut rates down to 0.1%, over the course of last year, they also announced QE. In November they announced that they would be buying a hundred billion dollars of Commonwealth and state government bonds. In February before the current QE program ends, they announced the second round of QE, starting after April. Our view is that they’ll continue rolling out this QE, because they really need to meet these inflation and employment objectives. Meanwhile, you can see that GDP is picking back up as well. And as the economy sort of normalized, particularly with the vaccine rollout, but also because Australia has had COVID-19 under control, we’ll see that economic activity really pick up and people start spending again.
PS: I think people listening to us have heard plenty about QE or quantitative easing. Just in a nutshell Ying Yi, what is quantitative easing mean? What is the reserve bank doing? And what’s its impact, particularly on interest rates?
YYC: The RBA has been forced to do QE or quantitative easing, because it’s taken rates to what it considers to be the terminal cash rate, which is 0.1%. So, while offshore central banks have moved to negative rates, the RBA or the Reserve Bank of Australia has been quite adamant about not moving to negative rates. Which kind of leaves RBA out of other policy options. What it can do though, is it can actually purchase securities in the market. What sort of securities or assets? Well, we’ve seen offshore, there’s been a plethora of different types of securities, but the most obvious one would be to buy government bonds.
Why government bonds? Well, firstly, with the private sector a bit impaired, so business spending is not necessarily sort of increasing, businesses are massive CapEx plans at the moment, right? There’s still a bit of uncertainty left. It’s kind of the role of the Government to be boosting the economy. However, they need to find that money from somewhere; and in order to do so, they need to issue more debt. The RBA is indirectly supporting that government debt that needs to be issued, because it has become a very large marginal buyer of this government debt or these government bonds.
PS: And when it buys those bonds, basically, it means money is less than the economy. And that really helps the economy and it also keeps interest rates down.
YYC: Well, it keeps interest rates down, but it keeps the cost of borrowing down, for the government, right? Which is incredibly important. There’s no point for the government who has to issue a very high rates of debt because they’re being forced to, right? If you have the central bank supporting them and being that large buyer, that keeps the costs of borrowing down and it keeps, yes, those expectations around interest rates anchored as well.
PS: Let’s go to interest rates. What is Coolabah’s outlook for interest rates and asset prices in the year ahead?
YYC: We think that the RBA definitely isn’t in any sort of a hurry, to hike rates, they’ve currently still got yield curve control. Which means that they’re keeping rates out from zero to three years, around 0.1%. They have been buying bonds out to the three-year mark, trying to keep that cost of borrowing down. And that’s to drive expectations around the fact that rates will be low for longer. We’re of the view that they’re going to announce QE three, when before the QE two program ends. Now the QE two program hasn’t even started yet but there’s no reason why they wouldn’t announce another a hundred billion. And a hundred billion is, a bit of an arbitrary sort of a number. We think that the RBA will be looking to sort of recalibrate that and it could be even more.
PS: So in a sense, what the RBA is saying to the bond market, as to the private aspect of the bond market, is that don’t mess with us. If you try to push rates up, we’re going to take you on.
YYC: Pretty much. They want to keep the cost of borrowing down. Obviously there’s been a lot of market forces, pushing rates higher, as people have been factoring in inflation, but the RBA is not alone in trying to fight this, right? Other central banks are doing this as well, and we need to do the same.
PS: So the implication then is that interest rates on bank deposits are really going to be low for a long time.
YYC: That’s right. The RBA has obviously lowered rates. Even the banks that have deposits with the RBA, these are called ES balances, they cut that rate to 0%. So even the banks earned 0% on deposits left with the RBA. They want to encourage activity and they want to encourage people to go out and spend it.
PS: Okay, Coolabah Capital plays in the bond market, the fund that you manage for us, is all about you playing the bond market as well as you can. So all of what you’ve said so far, what’s the outlook for the bond market in your opinion?
YYC: I think really it’s very important to distinguish within the bond market. So firstly, there are fixed-rate bonds and there are floating-rate bonds. You, a lot of the listeners and the participants in this webinar, may have read recently that there’s been an absolute bloodbath in the bond market. And that has been true. But that’s only the case for fixed-rate bonds. What this means is that, for example, when you buy a fixed rate bond, it’s almost like fixing your mortgage or fixing your term deposit, for example. You might think, okay, if I fixed my mortgage at, let’s just say 2% out to three years. If rates continue to, if rates rise, then you’ll benefit because you’ve fixed it at a low rate. But if rates fall, then you kind of lose out, because you could have fixed it at a lower rate. But instead you have to think about, as a bondholder, you’re actually the lender now. So as rates move higher, you’ve actually missed out on lending to someone at a higher rate, because you fixed it at a lower rate.
All of the shenanigans that have been taking place in February, with the bond market route, that’s really been around fixed-rate bonds. Because with all of this stimulus and in particular, this has been led by the US as well. US president, Biden, has announced a mammoth stimulus package. Obviously he needs to get all of this through the Senate, et cetera. However, all of the stimulus that’s going in, whether it’s fiscal policy, monetary policy globally, this is highly reflationary. This will create inflation down the track. What we’ve seen is fixed-rate bonds, out to 10 years, really push being pushed, well, their yields have been pushed higher. And therefore the prices have gone down.
Notwithstanding the fact that central banks have tried to keep shorthand or short-term rates, out to three years, very anchored, that long end has been pushed very higher. If I give you an example, the 10-year Aussie government bonds yield was about 0.7%, last year. In February, it got to 1.95%. It’s currently around 1.7%. That moves very aggressively. And by the way, not much has happened, but this market always moves ahead. And that’s caused a lot of havoc for fixed-rate portfolios or portfolios that have interest rate duration. That’s the distinction. The portfolios that we run and the Switzer Higher Yield Fund, is a zero-interest rate duration portfolio. There is no interest rate risk in that portfolio at all. If interest rates move higher and yields move higher, then that actually benefits us because we’re floating rate, the coupons that we’re generating from the bonds actually move higher as rates move higher. If rates move lower, we don’t get that tailwind though. So, even though a popular fixed-income benchmark for a lot of portfolios is the AusBond composite bond index, in February, that was down 3.6%. Okay, and that was the worst month that it had in 31 years. And I can tell you the Switzer Higher Yield portfolio, in the month of February was actually up 0.29%. In a month where equities and fixed-rate bonds were down.
PS: We would have really roused on you, if it was other way around, Ying Yi. Well done. What do you think someone needs to know to understand if you could describe fixed income 101?
YYC: A bit of a fixed income 101. There’s, like with any asset class, typically if you want more returns, managers in fixed income will give you more risk. And fixed income has traditionally been a more institutional market. It’s a wholesale market and there’s minimum investment sizes. It’s not as if you could go into your brokerage account and then access and buy bonds like you would with equities. It’s just not the case. Most of the securities that are traded, other than hybrids that are within the portfolio, within the Switzer Higher Yield portfolio, they’re all traded OTC, over the counter. Now just taking a step back. As I said, as with any asset class, if you want more return, people generally chase more risk. And in fixed income, the typical ways to drive more return would be what we call these types of risks, these are beta risks. I’ve already mentioned interest rate duration – that’s fixed-rate risk.
To take on more fixed-rate risk, to drive more return, you can invest in longer-dated fixed-rate bonds. If you have a naturally upward sloping yield curve, you would know that a 15-year bond should pay you a higher rate of return than a 10 year bond, right? Or we might see managers punting around on, where interest rates are going to be. They might, what we call go underweight or overweight duration, but they’re just punting around on interest rate futures. The problem with that is that this is a very volatile market and it’s actually the largest source of volatility for fixed income portfolios. However, it’s a way to drive more return. So as rates move lower, then this will benefit. If rates move higher, this will sell off, which is what we saw last month, in February. The other way to drive more return, would be to take on more credit risk. So investing in higher yield bonds, which means more specifically sub-investment grade. So double B, B, triple C rated securities, or even unrated securities.
PS: So what you’re saying is, if government bonds are the safest and the best, if you move in, to say, corporate bonds, they’re not as safe. And if you go into more risky companies, well, they’re even riskier and therefore they’re sub-investment grade.
YYC: Exactly. So, for example, Virgin, was a double B plus rated airline. Obviously we know what happened with Virgin. So you’re taking on more credit default risk, in order to drive return. And very closely correlated with credit risk, is illiquidity risk. Investing illiquid loans, illiquid corporate bonds and other illiquid securities. The problem with this is that it conceals a lot of risk. When you invest in an illiquid security, you might not know about anything going wrong until it actually blows up. Let me give you an example. This week we’ve seen Greensill in the news.
Greensill is a financier. They issue illiquid loan products which produce high returns, but they’re illiquid loans. Credit Suisse had to freeze or get to $10 billion of its funds this week, because these funds had invested in these Greensill loans. It’s like, we never heard about this and then it blows up and we hear about it. These are the building blocks that fixed-income managers can use to drive more return. But again, they come with risk. However, what we’re trying to do, is very different. And what Coolabah is trying to do, and also within the Switzer Higher Yield Fund, is we’re trying to drive returns, not through any of these beta sort of risk. We run a zero-interest rate duration portfolio.
So the Switzer Higher Yield Fund is a zero interest rate duration portfolio. It has a high average credit rating, typically of between triple B, to A. It’s currently A. And it has also daily liquidity. In the sense that you can buy and sell this on an exchange, even within the day, if you like. You can buy it in the morning, sell it in the afternoon, I suppose, if you wanted to do that. It’s highly liquid, and at Coolabah we drive returns through a different source. We drive returns through alpha, not beta.
How do we find this alpha, or this excess return? Well, we do it by finding capital gains. How do we find capital gains in our asset class? We do this by finding mispriced bonds. What is a mispriced bond? Well, it’s a bond that is paying too much interest after you adjust for its risk factors. So, let’s just say, some of the risk factors were adjusting on average, for at least 20 to 30. But we’re adjusting for risk factors which could include, the credit rating of that bond, the liquidity of that bond, the term to maturity of that bond, where does it sit in the capital structure? The liquidity, I’m sure I said liquidity. The industry of the issuer. Is it a bank? Is it a supermarket? Is it an airline? And if that interest rate is higher than where we see fair value, i.e. it’s mispriced. Then as that traded interest rate then drops towards where our fair value or our predicted interest rates should be, so it dropped that yield then drops, then we get price appreciation in the bond, because there’s an inverse relationship between yield and price. And then we were able to sell that bond after we get that price appreciation for a capital gain. At Coolabah, we’re much like your active equities manager but in fixed income. This is why we’re very different to a lot of our peers. So, if I just zoom in one level, you’ll see. And what’s evident here is that we have a very large team.
Coolabah itself is actually running 5.7 billion in funds under management. Assets under management is about 8 billion. And obviously within our FUM is the Switzer Higher Yield Fund. But it is the same team across all 27 portfolios that we’re running. And you can see that we have 26 full-time execs. We’re actually in the process of hiring an additional two more execs. And we’re continuously growing the team. A lot of our peers tend to have, might have two or three portfolio managers or one or two analysts. At Coolabah, our investment team is made up of five portfolio managers and 13 analysts. And you can see, we’ve got a data science team, in addition to your more traditional credit research analyst. But the reason why we have such a large team, why we’re running also 30 to 40 different quantitative valuation models and doing an intense amount of due diligence, is because in order to find these capital gains or alpha, you need a very large team to do that. We’re also typically trading at least 70 times a day, and on average, $150 million a day.
PS: So Ying Yi the Switzer Higher Yield Fund can be accessed via the exchange, using the ticker code SHYF. It’s listed on the Chi-X exchange and you can easily access it by your share trading account, either online or physically with a stockbroker. The fund manager is Chris Joye’s Coolabah Capital, as we already pointed out. And is supervised by, well, I think he’s a really smart, Ying Yi Ann Cheng, who I’ve just been talking to.
The fund invests in government bonds, including state-issued ones, hybrids and top-quality corporate bonds. The goal is to get returns of 1.5% to 3% of the RBA’s cash rate, which is 0.1%. And the fund could do better or worse, but Coolabah has an above-average return history. That’s why I’m happy to work with the guys. The fund aims to provide investors a quarterly income, which is paid quarterly. And this is not a government guarantee deposit but currently, term deposits are paying around 0.5% for lock up your money for a year. And because this is listed on the stock market, you can get in and out whenever you please, as Ying Yi, pointed out.
Let’s go into the questions that we’ve got here. You’ve written in your recent portfolio update about bond spreads. Can you explain what that means?
YYC: Yeah, sure. The bond spread is where it is traded at. When you look at equities, they’re traded at a price level but for bonds, you could have different sort of bonds. You could have different maturities. Some could be below par, above par. The standard when trading bonds is to look at the interest rate. The interest rate is made up of the benchmark plus that bond spread. And that benchmark tends to be BBSW, the Bank Bill Swap Rate. So, senior bonds, subordinated bonds and hybrids trade at a credit spread or a bond spread over that BBSW.
PS: Okay, let’s go to the next one. What are the risks of investing in a fund like this?
YYC: There’s always risks to investing in anything other than cash, but I can tell you that anything under 250,000, within a bank deposit, that’s government guaranteed. So that’s as good as it gets, it’s triple A. Even when you invest in government bonds that have AAA-rated, those have market risks because they’re traded. They will have what we call mark-to-market volatility. Because all the assets that we’re trading within this portfolio, other than obviously the cash that we hold are traded securities, they have market risk attached to them.
As you can see, the Average Credit Rating is quite high, it’s investment grade. Currently it’s A. You have very little liquidity risk because the underlying securities that we’re trading are super liquid. Obviously these vary in terms of liquidity but we’re talking about a very liquid portfolio as well, and there’s no interest rate duration risk, as I mentioned. All I would say is that there is market risk and there’s volatility in the market but overall, we’re talking about a very safe portfolio.
PS: A question is coming here. How does that market recite compare to something like an equities portfolio? That’s a good question.
YYC: Let’s just take March this year, as an example. Equities were down anywhere between 20 to 30% in terms of drawdown, I believe. That was probably one of the worst months since, like for a while.
So the was down about 21% in March, and obviously we didn’t have the Switzer Higher Yield Fund, it wasn’t up and running at the time. But if I looked at some like a sort of a benchmark or a barometer for that, some of the other Coolabah strategies that we run, we’re down 1.5%, in the month of March,
PS: That’s a big difference.
YYC: Versus Aussie equities, so much lower volatility. If you look at the volatility on equities, it depends on what sort of time period we’re talking about. We’re typically talking about anywhere between 10% or 20% volatility as a measure of risk. If you look at the portfolios for the Switzer Higher Yield Fund, were talking about volatility of around 1 to 1.5%. So substantially again, lower vol.
The upside that you capture from equities is you were presumed to be higher than in say these products. These products shouldn’t be compared with equities. It’s just a different risk-return profile, at the end of the day. By the way, equities are subordinated to all the debt holders so when you invest in equities, you’re at the bottom of the capital structure. Everyone else gets paid out before you do. All the securities that the Switzer Higher Yield Fund invests in, including government bonds. Depending on your view of whether, the Commonwealth government or the State government will default on their debt. If you take a look at the non-government holdings, which is mainly bank securities, well, bank senior bond holders, bank subordinated bond holders and bank hybrid bond holders. Well, I should say, just bank hybrid security holders, all get paid out before shareholders get anything. So just different risks.
The bottom line is this that we all would love to be in 5% government-guaranteed term deposits, but they don’t exist anymore. What we’re trying to do is go up the risk curve but try and keep it as safe as we can.
PS: Right, Ying Yi, thanks for joining us in the program.
YYC: Thank you, Peter.
PS: Okay, so If you have any questions, please contact us by phone or email at [email protected] The phone number is 1300 052 054. A reminder, please read the PDS carefully before investing. Thanks for joining us.