Insights Series: Fixed Income – Smarter Income Opportunities

Hello, I'm Darren Connolly, CEO at Investment Markets, and I'd like to welcome you to the super six, six experts, six asset classes, and one outlook for your investment portfolio. Before we start, however, I need to remind you that this is all general advice and general information only, and nothing that you see or hear should be construed as an investment recommendation. You will need to decide what is right for you. With me today is our fixed income expert, Cameron Window, Executive Director at Income Asset Management. Welcome, Cameron.

Thank you, Darren. Glad to be here.

Excellent. Cameron, we're going to talk about income, fixed income in particular. My first question is what have been the main themes in this asset class over the last 12 months?

Over the last 12 months, we've really seen investors looking for safety. I think the biggest global factor has been Trump and that's brought with it a great amount of volatility. And because of that, people are looking for safety. People are not sure where to put their money into equity markets or really look fully priced. And so we're seeing quite a bit of money on the sidelines looking for alternatives and looking for ways that people can protect their capital and generate an income from it. So we've seen huge demand for primary issuance as it's come to market with banks and insurers taking advantage of that demand. Over the last 12 months, we've also seen a steady decline in yields as a function of the interest rate cuts.

And is that likely to continue, Cameron?

We believe so. I think we all thought the RBA would cut last month and surprised us by not cutting. It seems that they will cut next month and of course there are further cuts priced in and I think for investors who have recently enjoyed higher yields and been able to even get a decent return from cash, people are seeing those returns start to dwindle. Term deposits are maturing. The rates that investors are being offered are now significantly lower. And so people are being forced to look for alternatives to maintain their income. And so that's really where a lot of our fixed income products will come in. Because of that decline in both short-term interest rates and the forward-looking interest curve, We're seeing people wanting duration and by duration, I mean long dated fixed rate assets that are going to protect people's incomes. We've seen banks coming with 10 year bonds in the five and a half to six and a half percent range. And that's very attractive for investors to be able to lock in that return in what we know is going to be a declining interest rate environment.

That's a great rate to be able to achieve.

Unbelievable. We've seen the majors, Macquarie just in the last six months, 10 years, 6.15%. And investors, that was oversubscribed at least five times. We saw another deal from a foreign bank issuing into Australia at 6.56%. Again, oversubscribed nearly 10 times on that one. That was $3 billion worth of bids into a $300 million deal. So that tells us there's huge demand for that product. There's a lot of money sitting on the sidelines that doesn't that people don't know where to put it. And when they see it, an opportunity to protect their future incomes and also preserve capital, they're jumping all over it.

Is part of the challenge then the actual scarcity of suitable product?

Yes, it has been. I think in the last six months in particular, we have seen, as I said, every new issue that's come has been heavily oversubscribed. So we would love new product. We would love more product to be able to sell. What we've seen also is because of that, issuers have been able to tighten their margins a little. So over time, We're starting to see some of those headline rates come in a little because borrowers know that there is a lot of money out there looking for a home. I think we see a little bit of quietening off in issuance across the end of financial year and into reporting season. So whilst I think there's a backlog of money looking to be placed, and I think between August and Christmas, we're going to see a very active primary issuance market.

Cameron, what separates your approach to this asset class when compared to some of your other peers?

I think the main difference we offer is direct access. Many investors will see the easy way to gain access to fixed income as being via an ETF or via a fund, or some investors even use property trusts as a quasi fixed income product.

All very popular options.

They are because they're accessible. And our market and accessing direct bonds is a little trickier to find. You need a broker to access this wholesale bond market. 95% of the world's bonds trade in an over-the-counter professional market. And so what we do is make that available to private investors in smaller parcels. I think obviously if you're in funds, ETFs, trusts, you're paying fees, right? And you have diversification, you're not really sure what's in those products. So whereas our direct approach, if you like buying equities direct, then you may like to buy your fixed income direct as well. It also then allows you to assert your view on your investments. When you're in a diversified bond fund, again, you have no idea really what you're going to be holding. So if you believe that if you want greater duration, because you believe that interest rates are going to fall further than the market is anticipating, you can apply that view by buying fixed income products that match. Similarly, if you believe the reverse, that we're not going to get more cuts, inflation is going to peak again and we're going to go back the other way, you can apply that view too. You simply buy more floating rate products and inflation linked products. So we allow investors to apply their own knowledge, expertise and views and have direct exposure to particular issues. The other thing at IM that we do with fixed income is provide access to a syndicated loan market. So people think fixed income, they think bonds. And that is the large majority of our business. But over the last 18 to 24 months, we've also now started working within the syndicated loan space. And this is providing access, we're investing alongside institutional investors. So macro super funds, sovereigns, large investment banks, and we're now playing in these syndicated loan markets. So when you're investing, you're sitting alongside CBA, Macquarie, Nomura. Some of the biggest names in the market. Absolutely. And the due diligence that they do, obviously, before participating in these transactions gives you great comfort that that work has been done. If you're sitting in pari passu with those major investors who have hundreds of millions of dollars invested, and you're able to sit alongside them, that you know that you've been well covered in terms of the research that needs to have been done. So we're bringing syndicated loan opportunities that you won't see publicly, and they're offering a real niche for investors and value that you won't find elsewhere. If I could provide an example, one recent transaction was for Foxtel. And I see Foxtel and like most people, I think, oh, Foxtel, that's been around forever. And what is their business these days? You don't realize that Foxtel has really successfully transitioned into the digital platforms and has recently been taken over by global sports provider, DAZN. So here we have a senior secured syndicated loan from Foxtel now owned by DAZN, paying bank bill swap rate plus 5.25% for three years.

Plus 5.2%, just to clarify.

Yes, over the swap rate. So we're talking nine, nine and a half percent, three years partially amortizing. So you're getting paid down along the way. So it de-risks effectively as it goes along and you've got billions of dollars in assets provided by DAZN as well as Foxtel. So we provide access to these sort of loans and opportunities that you just won't see in a public space.

And for the loans and also sort of alluding back to the parcels, what is the ticket size generally that investors need to meet to participate?

Sure. The minimum parcel size is $50,000 and then $10,000 increments thereafter.

Okay, that's pretty reasonable for any self-directed high net worth investor.

I think so. I think if you have a well-diversified super fund or trust, then allocating $50,000 as a minimum across a variety of investments within the fixed income space is certainly feasible for the majority of private investors.

Cameron, how should investors think about fixed income within the context of their investment portfolio?

It's definitely the defensive part of your portfolio and should take up a piece of the pie within your overall asset allocation. I always think about this. If we're looking at professional asset managers or industry super funds, there's a pie chart and you'll see a section for equities and you'll see a section for property and you'll see a section for cash and you'll see a section for fixed income. People don't realize fixed income is bonds. And so what a lot of private investors do, they go out there, buy their favorite equities, they'll buy some property, they'll have cash. And they often overlook that fixed income component, sometimes because they don't know how to find it or don't understand much about it. So in terms of allocation, in terms of our role there, it really is about providing a hedge against those other higher risk assets being property and equities and more volatile, providing liquidity through the stability of fixed income and also improving returns over what people are going to get from cash.

And we've seen sort of liquidity issues pop up quite frequently in the past, haven't we?

We have, absolutely. And this is why diversification is important. And you can look at bonds, in general, I would say a bad day for equities is a good day for bonds and vice versa. So you have something which really is counterbalancing your portfolio and potentially providing liquidity when you don't have it in other parts. I think in terms of the misconceptions that arise around fixed income, People think it's boring and I guess it sort of is. No, this is the point. Boring is good. When you're talking about large amounts of money and your retirement and your wealth, boring is good. And you certainly need that component within your portfolio. It becomes the ballast, which effectively gives you the freedom to take those risks within the rest of your portfolio. If you know I have X amount allocated where my capital is safe and it's generating me X amount of income per annum, I can go and have a punt on the other parts of my portfolio, knowing that I've got this secure. I think in terms of what we need to be aware of and people need to be aware of is the broad range within our fixed income universe. When you read things about bonds in the media, it's often really not relevant at all to what we do. media coverage will focus on government bonds, right? Because they make up 80% of the global fixed income market. But what is happening with government bonds may be totally irrelevant to what's happening with someone's fixed income portfolio. So I've seen some wonderful headlines over the years, Bond NATO, you know, to have bond bubbles, these things, which causes, you know, designed to create fear and uncertainty.

Sells newspapers.

A hundred percent. So, and it has that effect because people ring and will talk to me and ask, what does this mean? And is this going to be a problem for me? Those sorts of situations really relate to long dated government bonds. And this was particularly relevant, I guess, when we had a rising interest rate environment, where if you were stuck holding long dated fixed rate government bonds or corporate bonds for that matter, then yeah, that would be a problem. but, If you're actively managing your portfolio, which is obviously something that we do with our clients, then you're not in that situation. You've adjusted well beforehand, just as you would your equity portfolio, or you felt the property market was topping out. You're not going to continue to be buying property in that space. So we will constantly assess that, and there's a forward-looking curve, so we're rebalancing people's portfolios, moving them from fixed rate into floating rate, or as I've just discussed at the moment, with a declining yield environment going back the other way, we're looking for fixed, we're looking for duration. There are those misconceptions out there around that. And that's because I guess the bulk of media and coverage does relate to fixed rate bonds. But within our universe, we have fixed, floating, inflation linked, anything to match what's happening in the global environment.

So there's a bit of a bit of complexity within the potential product suite, would that be fair?

There is. I mean, I find it quite simple, but you know, I've been in the industry and in this asset class for many, many years. So compared to the complexities, I think within equities, I think fixed income is really easy. Once you understand, it's a very mathematical, logical market. The yield determines the risk. The yield tells you everything you need to know about the risk that's implied with that particular product. The types of coupon, there are really only three. It is fixed, which as the name suggests, you're getting that same amount of income from a bond, rain, hail or shine, through the life of the bond. There's floating, which means it will pay a margin over and above the bank bill swap rate, which, which follows the cash rate. So I talked about Foxtel earlier, which is floating. It pays BBSW plus 5.25.

So we may see a drop.

So the income, a hundred percent. So the income could come down from that, would come down from that as rates fall. And then we have inflation linked products as well. And obviously we've seen periods of high inflation over recent years. And so you can have products that are pure hedges to inflation and will actually benefit from greater CPI growth.

Cameron, what should investors who have a more conservative risk profile do when thinking about this asset class?

Well, Darren, there's a very clear delineation within the fixed income space of what we would consider defensive versus aggressive. So if you're a conservative investor, you're purely looking for investment grade debt. And so an investment grade debt means it carries a credit rating of triple B minus or better. And this really what if we're talking about the institutional not-for-profit space and they have mandates around their investments, government bodies, et cetera, their mandates will dictate that they can only play an investment grade debt. And that's because once we go below that triple B minus line and into high yield or unrated paper, there's obviously a higher probability of there being an issue down the line.

Higher risk.

Correct. Yeah, higher risk, higher reward. But within the investment grade space, you're talking about large household names, with significant asset backing and plenty of coverage from research houses. Many times the equity is listed. So there's lots of coverage on the name and therefore your risk is negligible. So if we have investors that are wanting to stay purely in that investment grade space, then we're going to be offering returns of somewhere between one and a half and three percent over cash. So probably right now the average portfolio, which is purely investment grade, would be yielding five and a half to six and a half percent. Investment grade products do afford the ultimate in liquidity. This is probably the upside to this. So because we're talking about large issues, the NAB came out just last week and printed $1.5 billion of a 10 year fixed rate issue. So this is trading all day, every day in millions of dollars by multiple counter parties, not just in Australia, but around the world. So if you and an investor are holding that particular asset and you're earning your circa 6% and you decide you want to trade out of that, it's gone. Same day, money back two days later. So investment grade products probably afford you greater capital stability. and much better liquidity as well as significantly lower risk. You're playing in a really institutional space.

So less worry.

We always said it's a sleep at night type product. If you are an investor and I've spoken to many clients over the years who they're retired, they want to travel and they say, I don't want to be waking up in the morning on my cruise ship.

Looking at the stock market.

Exactly right. So this is the thing. When we said before, bonds are boring. If you want them to be boring, they can be. You could set up a portfolio of investment grade bonds with me today and not talk to me for a year and nothing would happen. You would receive your income, your capital would be safe. Now I will have opportunities and ideas as to how to maximize value from your portfolio within that timeframe. But you could just tell me, no, thank you. I'm going traveling for a year. I don't want to talk to you and everything would be totally fine.

That's getting on the boat and just disappearing for 12 months and coming back and everything's still good.

Yeah. Yeah. That's the dream, right? For a lot of people. And I think we definitely afford that to people is that ability to get on and live there. Everyone loves investing. If you're looking after your own money, you enjoy it. And so you want to be a little bit involved. But if you do want to take a step back and be able to enjoy those freedoms and those wonderful things about life, then you can do that by having a really defensive fixed income portfolio.

What should investors with a balanced risk appetite think about when investing in fixed income?

Well fixed income is traditionally a conservative asset class and so within that asset class we have investment grade bonds which would be more suitable for the conservative investor but we also have a broad range of high yield products where a more balanced investor can achieve some higher returns to boost their portfolio. So if we were comprising a portfolio for an investor with a balanced appetite, then we're going to have some high quality investment grade bonds. They'll help provide liquidity and good capital stability, but we'll also temper that with some high yield allocation. And so with high yield, we're looking at diversifying across industries. The conservative side of things is really governments, insurers and banks. They take up 90% of that investment grade space. So if we're looking for high yield to provide a more balanced approach, we need to look at other industries so we can look across mining, infrastructure, transport and logistics, retail, and these businesses will still often be household names but don't potentially have the size, scale or backing of large financial institutions.

So they could still be brands that we know or see on a day-to-day basis?

Absolutely. I think there's a couple, if I could provide some examples, and I'll reference mining again, Newcastle Coal. Now we've had numerous issues for Newcastle Coal over the years. There's one right now paying 12.5%. Now that's a fixed rate of return, and that's been in the market a long time. That will actually mature. somewhere between 2027 and 2031 but mining providers have been really active in our space and therefore as a private investor you can look across that spectrum and often achieve double digit returns. Similarly within the financials if we go outside the banks and we look at the non-bank lenders businesses like Liberty Financial, MoneyMe, Pioneer Credit are all smaller organizations, in some cases APRA regulated still, and they're offering a higher return than what you'll see from the banks. So when we're looking at a balanced portfolio, what I like to do is have some core good quality positions because they will provide good stability, good liquidity, and we will maybe take larger allocations in each of those individual credits. So if I'm looking at a portfolio, say of 500,000 and I want a balanced approach, I might say, okay, let's take three investment grade positions of $100,000 each. Alright, and that's the core part of my portfolio. I'm not really going to do much with that. But maybe I'm using that last $200,000 to have four lots of $50,000 in lower quality credits that are going to boost my returns and give me a higher bang for my buck on that money.

Cameron, what is the outlook for the asset class? What does the next 12 months look like? What should investors be thinking about?

I get quite excited about the next 12 months actually, because I know we have interest rates coming. And even though this is considered a boring space, it's about as exciting as it gets in fixed income markets, because interest rates falling and yields falling means bond prices rising. So we've been positioning clients well and continue to position new investors well for this opportunity. We're looking to add fixed rate duration, We're talking about assets that will hold the same income, the same coupon for the next 10 years. So there are some longer, but let's say 10 years. These types of assets will not only protect incomes for investors, but they'll also appreciate in value. I can provide an example of a bank which recently issued a 10-year bond at 6.5%, which traded from $100, which is its notional face value when it's issued, to over $104 within seven weeks of issue. So we have investors here who are making, in that case, 6.5, 6% per annum, and have also made an additional $4 plus inside six weeks time. So when we see this, it gives us the ability to trade. So I can talk with investors who bought that particular issue about selling it at a premium, taking some profit and looking to do the same in a different asset within the same sort of class. So that's really quite exciting from my point of view, because you can stay in high quality investment grade bonds and e-cat double digit returns if you are wanting to be involved in an active management, active trading side of fixed income. Uh, I think the other thing, which is really big for our asset class the next 12 months is the phasing out of the listed hybrids. So APRA has come out and pretty much killed that listed hybrid market, which was enormous.

There was a lot of money into hybrids.

Billions upon billions of dollars. And it's, it's about time too, because. And we've been saying this for years, the value in that, there was no value in that space. Banks were laughing all the way to the bank, shall I say, but banks were laughing. This was a cheap, cheap source of funding for them that was being proliferated far and wide across the country to private investors. When we're looking at it from our fixed income over the counter space saying there's far better value over here in what we do, but we just don't have that exposure or distribution. So, and the reality is that investors were buying things that they had no idea what they were actually buying. And that's not to say that investors should have done further research. We're talking about 60 plus page documents for people to try and decipher where every hybrid had different rules and APRA had the ability to come in and simply determine that hybrids should be converted to equity or that distributions needed to be suspended and not made up. All these complications, which again, were quite unique.

To each product

Yeah. Just how could anyone keep up with them? So it's great to see that getting phased out. It's really exciting for us because we're already seeing...

The money's got to go somewhere.

It's got to go somewhere. And we're getting inquiries now, how do I replace that within my portfolio? And so we're really well positioned for that money, which is going to be looking for a home. And as I've said before, there's better value and opportunity in the products that we offer now.

So boring is better.

Boring is better. And as I said, the next 12 months is going to be anything but boring. It's a really fun, exciting time. Uh, I love RBA meeting day because we get to, you know, look at what's going to happen to our screens and bond prices. And, uh, I think while that's been relatively benign for a period to now have live RBA meetings, if you like, that can alter the impact of products and prices within our asset class is really quite exciting. And I think if you're well positioned here, then you can make the returns from bonds a lot more than boring 6% and we can help you with that.

Excellent. Thank you very much for your time and insights today, Cameron.

Pleasure. It's been fun. Thank you, Darren.

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