Fixed Income with 2025 Vision

Our next speaker is Scott Rondell, Chief Investment Officer at Mutual Limited.

Scott has over 25 years of financial markets experience, specializing in fixed income investment strategy, portfolio management, fundamental credit analysis, and relative value analysis.

Today, he will be talking about fixed income with 2025 vision.

Welcome to this presentation, Scott.

Thanks, Angelina.

Thank you all for the opportunity to talk.

Today I'm just going to sort of touch on some very high level macro data points and then how we think the economy's going, interest rates are going and inflation going forward.

The slide in front of you, you'll see some numbers around CPI, cash rate and GDP.

Obviously CPI has risen quite significantly in the last year or two following the COVID pandemic.

And as we came out the other side, a lot of resurging spending and also accommodated monetary policy leading into that period.

So as a result, CPI has risen.

It's currently running at 4.1%, which is well outside the RBA's target range of two to 3%.

and at this stage isn't really forecast to get back to within target range until sort of 2025 as per these numbers here.

So within that environment, what are some of the investment opportunities for investors?

And one of the key areas we focus on is fixed income or bonds.

And in front of you is just a very basic snapshot of what a bank's capital stack might look like.

So obviously the way the banks fund themselves, we see a large component of deposits.

And then below that, there's senior debt, subordinated debt and obviously preference shares or hybrid and equity down below.

Your average investor will understand deposits because they have money with the banks and a lot of Australian investors invest in equities and hybrids.

What a lot of investors don't really know or seem to ignore is the belly of the capital stack.

And that's the two blue components, which is debt or bonds, which are readily issued in the Australian market.

And as a professional investor, that's what we do.

We invest in these products to allow investors to invest in them, because typically they are a wholesale product.

They're not available to retail investors.

And a bond is no different to a mortgage in the sense that you lend the bank, the bank lends you money and you pay interest on it.

In this instance, you lend the bank money and they pay interest on it.

And there's just a schematic there detailing that.

Now, there's two very broad types of bonds.

There's senior and subordinated, which is reflected there.

And over and above that, there are also fixed and floating rate bonds.

And this is a slightly more stylised

schematic of what CBA's balance sheet looks like in deposits to the top there some 750 billion debt in the middle roughly around 250 billion and we can see senior floating senior fixed and then sub debt which is typically floating rate in an order of in the pecking order of the bonds the senior bond ranks first so they get paid first and then second to that is subordinated bonds

but importantly for bondholders and bond investors is they are contractual obligations.

They have to pay first before any bank pays a distribution on the hybrid or pays any dividends on an equity piece.

And just on this table here, I was showing you some specifics around the yields available on the various different products.

So we see senior floating rate, typically a five-year bond at the moment would yield 5.3% for the floating rate.

The fixed rate's a little bit different because the coupon flow, and I'll talk to that in a minute as to how they differ, that's around 4.8%.

So on the surface, a bit different, but there are reasons for that, and I'll touch on those in a moment.

And then there's the subordinated debt, which is ranked a little bit lower, but does pay you a higher return because of the perceived higher credit risk, although we would argue there is very little in that regard.

And we're seeing five-year callable bank spreads, or sorry, bank subordinated debt at around 6.3% yield.

Here's an example of a fixed rate bond versus a floating rate bond.

And this example is actually an ANZ bond that's due to mature in August later this year.

And I'll touch on the bottom left hand table first, and it shows you the fixed component.

And when this was launched in 2019, the fixed rate bond was paying a coupon of 1.55%.

That bond played the same coupon through the entire five year period.

But the floating rate bond or floating rate note,

The coupon is determined by a margin above the bank bill swap rate and that's the black columns on the left here.

You can see through time as the RBA increased interest rates to deal with inflation, so did the BBSW rate increase and we saw an improvement in the coupon from as low as 0.85% up to 5.16%, 1.2% at the current level.

And then on the chart at the table on the right, or this chart on the right, you see the actual income streams.

So if you had invested a million dollars in these two bonds at the start and simplifying the reinvestment process, you would have received coupons on the floating rate note of $110,000, whereas the fixed rate coupon would have only generated you about $69,000.

So in this environment, in a rising interest rate environment,

floating rate bonds have generated a greater return than fixed rate bonds, which has been a very attractive offer for a lot of investors over the last few years.

This is another way of looking at the same two bonds.

The blue line is the capital price.

This is the price you can trade this bond at in the secondary market.

And when a bond is issued at first issued, it's issued at a price of $100.

In this particular case, the blue line represents the floating rate note and the white line represents the fixed rate bond.

And you can see these bonds are exactly the same in all that facets except for the coupon.

One's fixed, one's floating.

And you can see the volatility in capital price through that cycle.

And obviously we can see the COVID dip in the middle there or towards the start there in 2020.

The range of price in this instance for the fixed rate bond was somewhere between $92 up to $104, so a $12 range.

Whereas for the floating rate note, the range was only 98 to 102, so only a $4 range.

And that's the key difference between these two securities is that a fixed rate bond has greater potential for upside, but also greater potential for downside.

Whereas the floating rate note gives you more capital stability, but at the same time, generating a strong and stable income stream, which is important for investors at the later stage of their lives who prefer a bit of stability in their investments rather than a bit of volatility that we see often with equity markets.

This is a schematic that helps to explain that on the left fixed rate bonds and on the bottom axis you see interest rates increasing as interest rates increase the benefit to or the impact if you will on fixed rate bonds is a falling market value and I touched on that a moment ago but the income stays flat quite vice versa when interest rates fall the capital price improves so you make a capital gain if you will

On the right hand side, the floating rate notes benefit from a rising interest rate environment, whereas the market value stays relatively flat and vice versa.

In a falling interest rate environment, the income stream does decline, whereas the capital value stays reasonably consistent.

In this particular chart, I want to show you the top light chart that shows you the history of interest rates over the last sort of 20, 24 years.

showing the relationship to CPR inflation.

You can see in most instances the interest rate spectrum including cash rate and 10 year government bond yields as well above the inflation rate.

And then obviously in the last five, six years that relationship has sort of broken down.

A lot of that is a function of the monetary policy that we've seen post COVID.

Obviously a lot of central bank stimulus into the economy to prevent the economy slowing and to help households survive a pretty disruptive period.

But as we see, as time goes by, we expect that relationship to normalise and we expect interest rates to remain above the CPI inflation level.

which is reflected in the forecast inflation dropping to sort of mid to high sorry mid to high twos by 2025-2026 with the cash rate sort of mid threes to fours above that.

And the chart down below just shows you similar sort of relationship that shows that red little component there is the the markets forecast on which way the cash rate will go

So that environment we are expecting to see a fall in interest rates over the next 12 months.

Our house view is about 50 basis points, so from 4.35 to around 3.85.

over that period, but we don't think it's going to happen imminently.

We think there's going to be a bit of a lag because inflation still is running well ahead of the RBA's target.

So there's no rush to run out and switch from floating rate to fixed rate.

We think this period or this apex in the cycle will take a good three to six, possibly 12 months to facilitate.

And there's a lot of doubt around when that timing will take place.

So within that environment it's not a time to rush out and buy fixed yet.

We think there is potential volatility in interest rates and when you have volatility in interest rates you have volatility in the capital price.

Moving on to an alternative asset class that we haven't touched on and that is RMBS.

In slide 10 here you see a snapshot.

Now RMBS stands for residential mortgage backed security and this chart here, this table if you will, shows you an RMBS structure on the left and now on the right hand side shows you a stylised bank balance sheet.

And RMBS is basically a way of marketing or securitising mortgages and then selling those mortgages to investors such as ourselves.

It's an important funding tool for banks and non-bank originators.

So you may be familiar with the likes of Liberty and Pepper Home Loans.

These firms use RMBS markets to fund their lending.

And as professional investors with 25 plus years experience in these products, we invest in them quite heavily.

They're very good performing securities, very strong.

Historically, we've never seen one of these securities default, which can't be said for the US market.

And a lot of people would be familiar with the US market in this regard because there has been a lot of volatility there.

And that was witnessed during the GFC back in 2008.

Now, the Australian markets held up very well.

It's a very core part of the market.

There's over one hundred and fifty billion dollars of R&B products out there.

And if we look at this particular example, we see that a triple B rated

RBS Tranche, which is the bit in the middle there, is paying around 300 basis points over or giving you or invest a 7.3% yield coupon flow, which is very attractive when you consider a triple B bank security using the tier two or the subordinated bonds is playing, paying around 100 to 200 basis points less than that.

Yet the risk is very similar.

The underlying sort of collateral in this case is housing and mortgages.

And historically they've held up very, very well.

And in that regard, I'll point to this next slide on slide 11, shows you the arrears, which is the percentage of RMS securities in the market that's in arrears, or at least 30 days behind schedule.

And we can see, which is the red line, how the number has stayed very, very low.

in the recent years.

It has increased, as expected, with interest rates going up and unemployment ticking up slowly, but still very, very low, very well below average.

And we expect these securities to perform very, very well.

They're not a retail product.

They are wholesale products.

But we do use them in our funds and they are very, very good performing securities and something that I think investors should consider at this point in the cycle.

And with that, I'll throw it back to you, Angelina.

Thank you for your presentation, Scott.

Do you have time for a few questions?

Certainly.

First question for you, Scott.

How do your funds perform in a rising rate environment versus a falling interest rate environment?

As I touched on a moment ago, in a rising interest rate environment, our funds are designed to generate income for our investors.

And we had a lot of investors who are at the latter stage of their lives wanting income stability and security rather than volatility.

So within that environment, floating rate notes still generate strong income flow, but they just don't have the same capital volatility as we see with fixed rate bonds.

And that's because of the different dynamics around what's called duration risk.

Fixed rate bonds perform very well in falling interest rate environments from a capital perspective.

The income is very much the same or similar, but the capital price improves.

because of the relationship between price and underlying yield.

So theoretically, fixed income bonds perform better in a falling interest rate environment.

But if our outlook period is, say, 12 months, we think that there's a degree of indifference over that period because of we think it's going to be quite a flat apex of the cycle.

And we won't see a really aggressive interest rate cut cycle until sort of next year.

So we perform well because we generate income.

We don't see a lot of volatility in our capital prices reflected in our historical performance.

What are the advantages of your funds like this over, say, a bank-turned-deposit?

A bank-turned-deposit, once you lock away your money, you know, 90 days, 180 days, whatever the case may be, you can't access the money.

With our funds, they are mark-to-market.

There is T-plus-two-day liquidity, so you put your redemption in within two days, you receive your money back.

So we provide liquidity.

as and when it's required.

And it's something that we focus on quite a lot in our management of our funds, so that if an investor does need their money for whatever the purpose is, often we have four funds.

One is designed for, you know, if you need the money next month, and then there's the very end of the spectrum is if you need the money in two years time, you put the money there.

So depending on where your spending profile is, you would allocate your money accordingly, but what we offer over at TD is liquidity.

Thank you, Scott.

Thank you very much.

Appreciate this opportunity.