Changes in the ASX Yield Market

Our next speaker is Michael Saba, portfolio manager at Arculus Funds Management.

Arculus focuses on fixed income portfolios where, with the imminent phasing out of bank hybrids, a range of new yield opportunities have emerged.

These include fixed income ETFs, listed investment trusts, various types of bonds, and a new bond structure that is relatively unique to the ASX.

Michael has been a participant in listed yield markets for over 30 years and we're thrilled to have him here to discuss how the market has evolved and what it means for investors.

Michael, over to you.

Thanks Darren, and good to be here.

One of my favourite topics is talking about payer sex yield opportunities.

And it's been a sector where investors have got their yield and their portfolios for many, many years.

And that's predominantly been through hybrids.

And for the last 10 or so years, hybrids have been a particular structure, and that's provided some stability.

However, there's a lot of winds of change going on and things are progressing.

The landscape's changing dramatically.

So I want to sort of set the scene first on the landscape changing and then we'll delve into the individual securities and how that actually influences everybody.

So the current hybrids we've had, as I mentioned, have been around for quite some time.

Since 2012, there was some attempt to start a bond market on the ASX.

The ASX and the regulators formulated a standard structure, didn't really take off.

There was three or four bonds and the main issuer in that area was Australian Unity, who are the only ones who have survived.

And they're up to the fifth listed senior bond.

hopefully others do come into the sector but I won't take too much hope for that.

The landscape changed dramatically with APRA two years ago announcing they wanted to phase out hybrids and it gradually took six to 12 months for them to get industry feedback, investor feedback but they made that decision to change take hybrids out of the capital structure of the banks.

Now that's a separate topic about why they did that

for another time, but nevertheless, hybrids are being phased out by 2032.

And that doesn't mean hybrids are dead.

Some people think you must move on.

Not at all.

There's still 38 issues in existence with 37 bill, more than hybrids.

And there's no difference to what they were, except you might argue they're slightly more secure now because APRA have said we want them repaid at the first date in the terms and conditions.

So a little bit of a protected species from that point of view.

I might add that they've been successful for quite some time, even though there's been new distractors, simply because the banking sector is incredibly well regulated by APRA.

They're very solid.

Hybrids sit one step above equity, below the bonds and capital structure of a bank.

but they provided very, very good yield for investors over time.

No bank has missed a payment as was the redemption.

But nevertheless, they're being phased out by APRA.

About two years ago, we saw ETFs emerge.

We've spent a lot of ETFs.

And more recently, we've seen some listed investment trusts and a new structure, which is a bond structure with a slight twister, which I'll go through.

That has emerged with many, many issues forthcoming.

and it's something which investors must understand.

So I'll move along really to what these new yield products are.

ETFs you're all familiar with, I'm sure.

That's quite a mature area now in the ASX in terms of yield.

All the ETF issuers in split four or five have yield instruments.

There's a large range right down the capital structure from government bonds down to subordinated bonds to hybrids.

Additionally there's some funds which have missed their ETFs these ones being bond funds.

And now they've even got some individual ETFs, which give a promise structure replicating that of a government bond.

So a whole variety of things, which is great, which is great.

But the ETFs have got some small problems with them.

They're very well regulated, but if I was looking at that sector, the first thing to do will be to check with Twitter.

That's easily seen by the turnover, but also the size of the ETF, how much has been issued.

Additionally, you've got to also check the bid-ask rate.

If you're paying one cent in the bid ask, it's under $10, then you're actually chewing up some of your yield.

So that combined with perhaps commission brokerage can ruin the yield.

We're looking to yielding.

If we're looking for a five cent yield out of an ETF in the journey, eating up 20, 30, 40 basis points with some rexy argument that we can yield from.

List of investment trusts has been a quite a growth area in the last six months.

List of investment trusts have been around for a while.

Even there's been some yield example, the Petrel, NBI Bergman when they were around, GCI, also Qualitas.

These are listed investment trusts that get a portfolio of credit instruments and from this yield.

Now, with hybrids going, a number of companies have come along with new listed investment trusts with some different exposures.

Listed investment trusts are an open-ended structure.

That means that more security can be issued, but the key thing is a listed investment trust, it is perpetual.

So there was no end date.

The other key thing is the listed investment trust manager takes a fee, but he passes all the income on.

So I was looking this morning at one revolution asset manager.

The yield on their portfolio is around about 9%.

There's about 1% of costs.

That leaves about 8% left for the investors.

So that's good.

All the surplus income is going to investors.

But the problem is because they're perpetual, the NTA does vary.

the market price can vary from the NTA.

It's a normal market, so if somebody wants to sell, they can sell a lot of volume and get rid of the buying support, and these instruments can trade under NTA.

That's the big problem.

There's been some recent issues which have tried to address that by introducing buyback mechanisms, where they can have an on-market buyback, an off-market buyback,

company issuing can buy the list investment trust in other funds and indeed pair can actually come in and buy as well so got all these things in the previous there's no guarantees it keeps the secondary price at the NTA but it does actually help with the promise that there is some sort of buffer in the background

That's already far from this investment trust.

And I want to draw a distinction to what a bond is like, because we've had a lot of bonds issued.

A bond is typically a playful structure where you put your $100 in, you get your promised coupon, you get your $100 back.

That's a bond.

And recently we've seen five to six bonds issued on the AN6 with various underlying methods of forming yield.

There's been an innovation with these bonds as well.

The issuers have said we will guarantee the first 5%, it varies between issuers but let's take an average, we will guarantee the first 5% of problems that may come up over time.

may be a company the running isn't paying interest on their debt or the company defaults and there's more money to be repaid.

So the issuer of these new bonds these new yield style bonds the issuers companies issuing are providing a buffer what we call first loss pits

typically around five percent.

Now that's a lot of comfort and it incentivizes the manager not to have bad instruments or bad loans inside the portfolio because they're the one who's going to wear it.

The difference is there's always some payback.

So as I mentioned with LITs, all the yield is passed on after the manager's fees, but with these bonds, the manager is promising a yield over BBSW.

It varies between three to three and a half percent, depending on the actual issue.

Or let's say it's three and a half percent.

If the portfolio is yielding more, then the manager gets to keep that surplus.

So let's go back to that 90% example.

If the manager is promising BBSW, which is say four plus three and a half, that's seven and a half percent.

The manager gets to keep after his fees, he gets to keep the premium on the nine minus his fees, and say 1%, eight minus a half percent of 7.5.

He's keeping that 0.75 as compensation for putting his 5% buffer.

So there's a little bit of a quid pro quo here.

Again, the manager is incentivized to develop yield, but he doesn't want to ruin it.

his overall performance of his bucking isn't all there is in money.

I like the structure because it does provide some sort of a certainty of maturity date.

It's not open-ended look and pitch yet and also provides some structure in terms of the manager providing the bucking.

So let's compare all these ones together.

I've got hybrids on this table as well, far right-hand side, and I want to look at some characteristics pretty quickly and the style, what actual underlying instruments are held in these instruments.

ETFs are across everything is on Ninja.

Most ETFs are perpetual, but there are some ones with fixed maturity dates, those replicate incumbent bond.

Most of the securities or the LITs don't have a fixed maturity as I mentioned, hybrids do and yield noticeable do.

Most of floating rate, we'll come back to that a little later in questions, floating rate securities are better now, we've got interest rates rising, typically they're all floating rate.

Defined income, ETFs do promise exposure to a certain sector.

So it might be subordinated bank notes.

And the year on that does vary, so it's hard to define it exactly.

They could get a range.

List investment trusts don't really define an income.

They say, this is a style of investments worth going underline.

That yield is what we're gonna pass on after our costs.

But yield notes do define the income and so do hybrids.

Hybrid might be paying two and a half percent over capital rate.

This is a really important point is on the payment frequency.

These newer instruments are paying monthly compared to a hybrid quarterly.

And monthly is good because it helps keep the price more stable around base value.

And price protection,

ETFs are good because there's market makers in the background and they are swapping their units for these and their units with the unit registry.

So that helps keep the price at what the NTA is in an ETF.

That's a very big positive.

I spoke about the LITs, question mark, you know, there's some new instruments have got some techniques.

yield notes there is a price protection but these are going to be repaid at the date and that's good because we have a thing called point par the same is going to be repaid 12 months a hundred dollars in pricing straight too far same thing goes with hybrids so they're the main characteristics the difference between them all if we look at style what can we get we know hybrids that's bank risk private credit

Some of these ETFs are private credit, not a lot of them, but there are some LITs that are private credit, such as Revolution, some yield notes.

Infrastructure, there is no ETFs like to find exposure to infrastructure credit, and there is a yield note that does that.

Real estate lending, that's very popular.

You might look in the newspaper and see XYZ company offering 10%, and in the background, they're lending money to property developers.

Those instruments don't really exist on the own sex too strongly.

So there's a lot of real estate lending.

There's a few examples in private credit in some portfolios of yield notes and LITs, but generally there's not a lot of exposure to that sector.

RNBS, which is registered mortgage bank securities, very, very popular in the over the counter market, and there's one example of that now in the own sex.

And there's funds.

So a lot of these new,

yield notes are actually from fund managers which give you exposure to sort of four of their funds at their choice that's just another way of getting under management but it does give exposure to the expertise that particular fund manager.

So I've drawn some contrast between various instruments here but I want to just mention the sections here I've got in green that's where I really prefer.

I like a fixed maturity, I like a floating rate, I'm happy with bank risk,

I like infrastructure RBS because it's allowing us to diversify and that's the other really big point I want to give to people.

ETFs, there's about 50 out there and they're all different for rapid diversification, but now that these new LITs and yield boats are allowing you to get exposure to other style of underlying credit.

Previously we didn't have that, we just had hybrids.

really a generalized picture here a risk of return in various instruments the more yield that you'll promise the more risk there is.

It just goes without saying and indeed the higher the return is typically that sector is expecting to get some defaults and hence that private at the high return

will eventually be low because it defaults from what's promised so you're going to be very weary with that but there's just a generalized picture of where all these things sit in terms of return versus risk.

I want to finish up essentially to make a point that returns and the promised return our IPO

that changes over time.

So just as you might have a PE on stocks in the market and that PE ratio changes over time, it's always a guide to how expensive the market is.

So if a market's got a PE of 22, that's a lot more expensive than the market that had a PE of 15.

Same thing occurs in the credit markets.

The credit spread varies over time.

depending on credit markets in general, default levels, the economic cycle if we go into recession, and some companies could go broke, so the market will require higher credit spread.

So credit spreads vary and this chart shows four major areas.

The bottom green one is investment grade credit in Australia.

and that does change.

The next is US triple B, which is like mid-range investment grade credit.

I've got Aussie hybrids there in the orange and in the red was high yield.

So there is a little bit of an order as to what credit spreads are, but just look at the variance over time, and I've included on the chart back to March 2020 when they had COVID.

Credit spreads went out.

If that occurs, the price falls.

You might still have the best underlying credit.

So it might be a Commonwealth Bank but if credit spreads move down in general and all the credit instruments in the Commonwealth Bank will fall in price to reflect the new credit spread.

So this is a sector which has got a lot of things going for it at the moment.

Great spread, breadth of instruments and style is expanding, but credit spreads are always important, what we're paying.

The oval there on the right hand side of the chart shows that credit spreads historically are pretty tight.

So the way around that is to build a diversified portfolio, different sectors underneath, different maturities.

Make sure you're diversified in what style of credit you've got.

There's nothing wrong having a hybrid in a portfolio and a list of note, even some LITs if you like, the under one credit.

Do homework and a major message I would like to put across is make sure the yield you're being quoted is correct and a lot of people get it wrong.

So get your yields from good source because at the end of the day you're buying for yield and you want it to be accurate.

That's it Darren.

Thank you very much, Michael.

Lots of different opportunities within the yield market for investors.

Why are so many of these securities floating right and what's the impact in yield and how should I think about that as an investor?

Yeah, so typically in history, people have issued high, sorry, fixed rate yield or floating rate yield.

So just so everyone's aware, fixed is that they are promising you a total yield, let's say 6%.

Whereas floating rate, they are promising you a margin above the bankless swapper.

So cash rates go up as they have this week by 25 points.

The next coupon total will be 45 minutes high.

So it depends on where you think it just rates are going.

However, because we've had some spout periods of time,

last four or five years where interest rates have jumped a lot and that's not good if there's a fixed rate bond that means the price the capital price will fall the market's taken a more conservative path and gone down the floating rate avenue and especially when we came out of COVID rates were really low there's only one way for rates to go that was up so people wanted to get exposure to those

rising rates, the demand was there for floating rate, hence we've got more floating rate securities.

What you should look for is time length.

If you're buying a security for one year versus some five, if interest rates are going up, well then the five year one's going to give you more exposure to rising rates over time, so they tend to be on their hands, so they're found for a minute.

And maybe alluding to one of the slides you showed earlier, Michael, around the risk and return.

Generally, the higher return, the higher the risk, I think is certainly a truism.

Private credit, we've seen in many a headline over the last couple of weeks and months, seems to be a topic du jour.

Should I be worried about private credit as an investor?

Well, you sure always have a casting eye on any underlying income series.

So, it might be private, it might be bank, etc.

But just a little bit of a backdrop.

This is a sector which has been around that 10 years, grown enormously in the US.

A lot of banks have pulled their heads in lending and naturally others come along and do the lending.

Typically, they're

fund managers who raise money and then lend it out to credits.

In the US it's growing to be about 3% of the lending market but it's still you know truly an old sector nevertheless.

And it's not really hardly leverage, this is the important point in the USC's portfolio you've got 50% leverage.

I say that because compared to the GNC, there was massive leverage.

Banks were legged 50 times, so a little bit of a loss can wipe the bank out.

In this case, investors put the money in, there is some borrowing, and they invest in private lending.

And that's just lending to large companies.

That's not really the case in Australia.

You don't have the leverage.

Should you be worried?

Well, it comes down to the economic cycle.

And in the U.S. it comes down to Ford in the U.K.

There's been some large examples of companies torturing their problems in returns and actually faking almost like Enron back in the early 2000s.

So credit really, private credit, which you'll be slightly cautious over.

I'm not worried about it in Australia because we don't have the leverage.

There isn't the number of flood managers there who have flooded into the sector.

So when that occurs, you always get some road players who don't have as good lending standards.

In Australia, they're very experienced managers and they don't have leverage in their portfolios.

So at the moment, I think Australian private credit is all fine.

Because it's a new sector, it's like it's just reached adolescence.

It's going through growing pains.

And that's good because it'll sort itself out and going forward, there'll be better due diligence done on where they're earning money, which has been the column in the works.

In Australia, things are travelling.

Always do your homework, Michael, I think is the lesson I'll take out from that.

Thank you very much for your presentation today.

That was a very interesting and a great overview of the opportunities within the yield market on the ASX.

Thank you.