Generating Income for Retirement – Risks and Opportunities Amid Rising Interest Rates

Our next speaker is Adam Scully, Senior Portfolio Manager from Alexander Funds.

His presentation topic is generating income for retirement risks and opportunities amid rising interest rates.

Alexander funds provide investors with access to opportunities in a fixed income credit markets that they wouldn't otherwise be able to achieve through larger institutional funds.

The Alexander Credit Opportunities Fund is a weekly price fixed income credit fund.

The Alexander Credit Income Fund is a more conservatively diversified portfolio of Australian fixed income credit assets with daily pricing.

Adam has more than 15 years of portfolio management experience, with 10 of those as a senior portfolio manager within the credit markets.

Previously, he acted as a senior portfolio manager at the Victorian Funds Management Corporation.

Welcome to the presentation, Adam.

Thanks, Angelina.

Appreciate it.

Looking forward to having a chat with everybody.

Today, I wanted to cover off on a couple of things.

First, just give you a brief introduction to who we are, and then going to talk to our perspectives on the Australian economy and how we're thinking about the world as it pertains to the Australian economic environment.

And then we'll move on to just talking a little bit about how

Credit can perform a useful role in investor portfolios and what its advantages are and sort of how it fits in.

So just to give you a brief introduction to Alexander Funds, we're a credit focused asset manager.

We've been around since 2009, approaching 750 million under management.

We have two products, the Credit Income Fund and the Credit Opportunity Fund.

The investment philosophy supporting both funds is exactly the same.

They just come in slightly different shells with the

The credit income fund having slightly more restrictions around how it could invest and therefore a slightly lower return profile, but everything we do in terms of constructing those portfolios is exactly the same.

So moving on to how we're thinking about markets and how we're thinking about particularly the Australian economy, I think it's worth just having a look at what's happened over the last few years.

And I think what will come

as no surprise to most of the participants on this webinar is that the biggest influence on markets over the last few years has been the sustained rise in inflation and the resulting monetary response that's required to be implemented in order to combat that inflation.

And why does that occur?

Well, if you think about what the prior sort of 30 years it looked like before 2021, we'd really been in an environment of sustained disinflation as globalisation and a few other secular trends help support lower and lower inflation over a very, very long period of time.

And then COVID occurred and economic lockdowns came as a result of combating COVID.

And as we came out of those lockdowns, you know, some of those longer term secular trends changed.

So we went from, you know, an environment of globalisation to one of deglobalisation, in addition to just a huge surge in demand as people across the world, including in Australia, sort of let out of the house and able to begin spending again.

And as a result, we saw inflation began to tick up and began to tick up quite substantially.

Now, as a result,

there a monetary response was required in order to combat that inflation.

And what you can see here on this chart is we're just looking at the Australian CPI, which is the top line and the RBA cash rate, which is the bottom line over the last three years.

And you can see there that, you know, inflation started to rise in the middle of 2021 and central banks globally, including the RBA were a little bit tidy to respond with initially classifying

the initial rise in inflation is cyclical.

And what that meant is that they've had to raise rates significantly in a relatively short period of time in order to combat inflation.

And the RBA has been very direct around their core objective, and that is getting inflation under control because if it becomes entrenched, it becomes harder to solve down the track and it hurts the people in the economy that can afford it the least.

So they've been quite clear on what their objective is.

And as a result, we've seen one of the most significant tightenings in interest rates for many generations.

And that's important for a number of reasons, particularly within the Australian market, given the Australian mortgage market is generally a floating rate market and Australian consumers are generally over levered.

And if you think about the core trend driving that, well, Australian house prices relative to income

that ratio has grown over a 30 to 40 year period.

And as a result, Australian consumers have had to borrow more and more money in order to buy more and more expensive houses.

And in an environment where you have mortgages that are generally issued on floating rate, any change in interest rates flows immediately into consumer balance sheets and P&Ls.

And just to put some numbers around that,

All we've got here is a piece of research commissioned by the RBA last year and they're looking at the impact to the Australian mortgage market from a 300 basis point or 3% increase in interest rates.

Now bearing in mind that we've got blown through 3%, we're already at 4% with potentially more to come.

But just looking at the RBA's research, when they looked at a 300 basis point rise in interest rates,

for 30% of mortgage holders, so roughly a third of mortgage holders, that resulted in a more than 40% increase in their monthly mortgage costs.

So that is a huge amount of money that was being spent in the economy that now has to come out of it in order to be able to service a mortgage.

And as I said, that's at 300 basis points, and we're actually at 400 basis points, so it's actually more acute than what this chart would suggest.

However, one of the unique elements to the current cycle is that

During COVID, one of the programs that the RBA launched in order to help support the economy, the Term Funding Facility, effectively provided near zero-cost funding to the banks for three years.

And the banks then used that to on-lend into the economy.

And that was the nexus of the sub-2% three-year fixed-rate mortgage that most banks were offering over 2020 and 2021.

Now, quite rightly and quite rationally, Australian consumers gorge themselves on this product to take advantage of

mortgage rights that were probably unlikely to ever see, you know, certainly in this generation.

And it changed the dynamic and the structure of the Australian mortgage market from one that was predominantly floating rate to one that had a large fixed rate component.

However, those fixed rate loans were only for three years and they've been rolling off over the course of 2023 with the biggest cohort of those loans, as you can see from this chart here, rolling off between the 1st of July this year and 31 December.

And this means that the RBA has effectively been forced to make monetary policy decisions based on data that doesn't fully reflect the impact of rate rises made today.

And so for that reason, we made really cautious on the Australian economy.

Consumers proved resilient to date, but we think that some of those delays to the impact of monetary policy will make the next six to 12 months quite difficult.

Credit can play a role in investors' portfolio.

I think it's an important place to start is just thinking about, well, how do Australians actually invest and this data is taken from a survey conducted by the ASX.

And it's looking at where Australian average retail investors invest.

And what you can see here is that they're heavily weighted towards Australian shares and direct property.

So very, very heavily weighted towards shares and property.

And there's some good reasons for that.

You know, the baby boomer cohort, which is a big demographic bulge, is being focused on growing their investment portfolio ahead of retirement.

There are some real tax benefits to investing in shares and property in Australia.

And to be honest, it's been the sensible play.

You know, it's been a strategy that's been generally really profitable for investors over multiple decades.

However, as we move to an environment where, you know, Australian general, generally Australian investors' priorities might be changing,

you know, the question remains, well, is that weighing towards shares in property, heavy weighting towards shares in property still suitable?

And we talked about this, but you know, how does it work?

If you look at the ASX returns over the last 10 years, the income component of shares has been reasonably steady, but obviously the capital component can be quite volatile from year to year.

And that's important when you think about, you know, for older investors, and again, looking at the same survey,

around what investor priorities are, but as people move towards and into retirement, incomes becomes a much more important objective for their investment portfolios.

And there's some survey data here that helps support that argument, particularly for investors that aren't at the very high net worth.

category.

So for those in this survey splits them into the top 20% and then the bottom 80%, you can see there for the non high value investors, they have a real preference for stable and potentially even guaranteed returns, given that they're likely relying on their income from that portfolio in order to sustain their lifestyle.

So steady and sustained income is a core objective.

And I think, you know, as the Australian population continues to age, it will become more and more important to more and more investors.

So how does credit potentially fit in with that?

Well, what you can see here is this looks at the return of the Australian share market, the dark blue line, the Australian credit market, so floating rate credit, which is the yellow line, and then the brown line being the government bond index, so interest rate risk or government bonds.

And you can see there that the two fixed income strategies have been a lot less volatile than shares, but if we dig underneath that and look at what that looks like in an inflationary environment,

You can see that over 2022, when inflation was rising and rates were having to rise to meet that inflation, that the government bond index put in its worst year on record, shares were volatile as well, whereas credit was a steady performer.

Yes, it wasn't completely unimpacted, but it was a steady, positive, nominal returner.

And so we're not saying that the government bond investments are bad, it's just that they perform different roles in a portfolio.

being quite granular and distinct around how you allocate to fixed income between interest rate risk and credit risk, I think is important in terms of portfolio strategy and will continue to be more important as more and more investors move into that retirement phase of their life and are looking for a steady income.

So just summarising everything we've talked about, we think that we're cautious on the outlook for the Australian economy and we think the fixed rate mortgage cliff has delayed the impact of higher rates and the impact on consumers.

We think as investors move towards retirement, portfolio strategies that have worked for them over the last 40 years will need to be different for the next phase of their life.

And then credit as a steady income producer through different market environments can be a really, really useful part of that solution.

Thanks, Adam.

Now we have some questions for you.

First one being,

Yeah.

How have the interest rate rises through 2022 and 2023 impacted the performance of Alexander Fund's products?

Sure.

It's a good question.

And I think it's worth reiterating that our funds are floating rate portfolios.

So we're credit managers.

So our portfolios are always floating rate and not taking

direct exposure to changes in interest rates, how the change in cash rate influences our portfolio is in the running yield.

So as the cash rate rises, the yield on our portfolio rises.

And if the RBA gets to a point where it's cutting rate, then the yield on the portfolio will reduce as well.

But there's no direct impact to the capital value of the securities in our portfolio.

from changes in interest rates versus say a government bond portfolio where if interest rates are falling then the capital value of those securities will rise and the reverse is true for when interest rates are rising.

What are the advantages for investors in assessing different parts of the credit market, and which segments carry the most risk currently?

they can perform differently through different environments and offer different outcomes depending on what's happening in the world.

And so we think having a strategy where you have a really, really broad lens across the credit universe and can tilt your focus to the part of the market that's working at any one point in time is really important because there'll be times when there are technical forces at play that make parts of the credit space uneconomic or not good relative value.

And so making sure that you're with a strategy and with a manager that can traverse a really, really broad set of the credit universe is important to making sure that you don't find yourself cornered in a part of the market that has been rendered uneconomic for reasons outside of your control.

I think in terms of where we're seeing risk at the moment, I think the most risk lies in parts of the credit market where they have really taken advantage of this sort of

cyclical and generational lows in interest rates that we saw post GFC and use that to add more and more leverage into the average investment within that space.

So leverage finance is one where we think that there's potential opportunity to be an elevated level of defaults going forward, just given that you'll have companies being forced to refinance into a market where interest rates have risen substantially from where they issued the original loan.

Thank you very much, Adam, for your presentation, Q&A.

Great to see you.

Take care.

Thanks, Angelina.