Finding Yield In The Private Credit Revolution | Conviction Capital | Episode 1

Two leading money managers, two different strategies, with thanks to investment markets this is Conviction Capital.

Welcome to Conviction Capital, I'm Juliet Salih.

We're going to discuss today how to find yield in the private credit revolution and what's behind the structural shift towards non-traditional illiquid debt markets versus traditional investment grade bonds.

Joining me to discuss is Gareth Innes from MST Financial and also Cameron Window from IAM Capital Markets.

Great to have you both with us.

Cameron, I might start with you.

How do we find yield here then in this environment?

Well I think at the moment investors have been forced to look for non-traditional securities simply because credit spreads have really contracted in the traditional bond space.

So yesterday we saw the CBA issue a 10 non-core 5 tier 2 at 128 over and a 20 year version at 160 over and we're seeing senior bank paper at sort of 50 to 60 over cash.

Those spreads and margins over cash have really compressed quite heavily over the last 12 months in particular.

Perhaps because we've seen sort of the unwinding of that listed hybrid market and therefore there's a lot of money looking for a new home and that has been coming into the bond space.

So what we've been looking at is how do we find yield within debt markets in a non-traditional sense is that we're forced to look at alternatives.

For us that's predominantly been the syndicated loan market where we see value because we're working as part of a syndicate piggybacking off institutional investors who are driving a hard bargain with issuers to create much better value for investors.

So we're seeing similar type quality investment grade assets at much wider margins than in the bond space.

Where are you looking Gareth?

Well maybe just to start off so Cameron and I we're in different parts of the market so I run a couple of unit trusts at MST Financial and the part of the market that we're involved in is very much that sort of public market space so anything I talk about in terms of private credit you take it with a pinch of salt.

But the first thing to say is that the private space over the last really five years, it's been in a purple patch in terms of where the RBA's gone from to where they are now and where they're potentially going.

You've had that sort of rise in the floating rate component which has allowed for really positive total returns in the private or the floating rate space compared to the traditional fixed coupon bonds that populate most bond portfolios in the market.

So you've had that positive tailwind

In terms of credit spreads Cameron's right you know things have been led by the US I think the last time I checked prior to this last few days sell-off we were about at the second or third percentile in terms of long-term history so effectively 97% of the time spreads have been wider than where we are now.

Australian spreads are relatively tight but not as tight as that.

So at an index level we're at around 90 basis points over and we were lower than that if you go sort of pre-COVID time.

So there is still a very little bit of juice in Australian spreads but you know I think the trajectory from this point is probably looking for mean reversion and then for me in my capacity trying to position a portfolio to avoid the negative impact of potentially widening credit spreads.

Can there be a case though if MST is basically investment grade only, does that hold you back somewhat from getting better returns for your clients?

Not necessarily.

We've got a few levers that we can exploit to extract alpha from the market.

So the three principal ones would be duration strategies and that's us choosing when it makes sense to hold more fixed coupon bond issuance.

If the RBA ever cuts again, those fixed coupon bonds will rise in value and you can generate additional alpha compared to the benchmark.

The other way is by being exposed to credit spreads and how much credit in absolute terms and then which sectors you'd like to populate.

So if I think about our composite style fund, we have the entire credit spectrum from state government bonds to sovereigns and supernationals.

bank senior unsecured, bank subordinated, asset backed securities, mortgage backed securities.

All of these things are potential alpha levers if you sort of pick and choose the right ones at the right point in time.

And then finally I think that the big one is avoiding the losers.

So it's not really about going and trying to pick winners within you know sort of a tight credit market given the asymmetry of

corporate bonds and the return payoffs if you're wrong versus if you're right.

For us it's really about avoiding that loser and making sure that we aren't sort of exposing 2% of the portfolio to a 40% drawdown at any point in time.

Everyone's life mantra really, avoid the losers.

What about Cameron, the difference in doing your homework on a public corporate bond versus some of those syndicated term loans you were discussing?

Well, I think as I said, the advantage of being in syndicated loans is that you are investing alongside institutional investors.

So these are not small transactions.

These institutional syndicated loan transactions can be anywhere from 100 million through to a couple of billion dollars.

And so a lot of the work has really been done for you.

You know that you're investing alongside major global institutional players and so they have done a lot of work generally to improve the covenants in place and protections and security packages in place for investors and drive the best possible outcome in terms of yield.

I think in terms of getting access to that information, it's all there if you know where to look and it can be provided for you and that's something certainly that we do as part of these syndicated loans.

We'll have external research, we provide our own credit summary, so they're a little harder to find I guess than your traditional bonds, but the research is there and the depth of the market is there via that institutional market.

We touched there briefly on the RBA, I mean a hot inflation print again today so indicating that there could be another hike whether that's March or May.

How does that I guess affect some of what you're doing and expected returns here potentially at the longer end too?

Yeah I mean I think we hoped it might be a one and done strategy from the RBA but you're right today's number suggests that's probably not the case and our market certainly is pricing another rise somewhere in the next two to six months.

How does that impact upon the curve?

The forward, the short end of the curve is quite steep.

So we've seen that now and it'll be steeper again today in the last hour or two since that inflation number, just pricing in that further hike.

But somewhat counterintuitively that will probably serve to flatten the longer of the curve.

It won't go so far as to invert the curve yet, but that is certainly a possibility in future if we do go a bit hard at this.

But right now I think what we'll see is a steeping in the front end of the curve and a flattening in the long end.

And Gareth, correct me if I'm wrong but I think MST running with this hold potentially for longer from the RBA.

How does the long duration bet pay off though if there is another hike sooner than expected and I guess if inflation sticks around longer than many of us expect?

You can break it down a couple of ways.

The first way is similar to what Cameron was saying in terms of the shape of the curve.

In our composite style fund, in the last six months or so, we've had almost a permanent curve flattening position on implying that we thought that the short end

yields would rise a lot more than the long end and that curves flattened from about 90 basis points pick up to around it's sort of in the low 50s now and further today as Cameron mentioned so that's one way you can play you can actually extract alpha by being right on the curve position

The other way, I think, similar to what Cameron was saying, in terms of the forward-looking prognosis for interest rates here, yeah, they may well raise rates once more, but that was already priced before today, right?

So ultimately, what we're trying to do as bond portfolio managers is look at the available data, look at where the market's already pricing something, and then saying, okay, is there a gap versus expectations more generally?

So it was already pricing in more than a hike already.

Today hasn't really done too much to the short end of the curve.

I think the last time I checked before I came in, it was maybe two to three basis points.

That's a pretty modest sell-off.

It doesn't really change the picture.

I think in terms of MST's view on the RBA being on hold,

That speaks more to a couple of things.

One, some of the changes going from a quarterly to a monthly CPI print.

I think those are probably being discussed quite broadly already.

But secondly, we certainly acknowledge that the second half of 2025

It's no secret there was a cyclical pickup in Australia.

We can see that in the equities research that MST Financial does.

So we're getting sort of micro pictures from the bottom up sell side guys from earnings transcripts and earnings calls.

You can hear it in what corporate Australia is saying.

You can see it in the credit growth.

And there were meaningful reasons as to why that happened, such as the 5% deposit scheme that was introduced.

you had the phase three tax cuts being introduced halfway through last year and then you had a couple of massive sports tours such as the British and Irish Lions tour that happens once every 12 years.

You had the Ashes probably every four years or so.

If you look at the December or the November

inflation in the domestic tourism sector that was huge right and I think there are obvious things so on a forward-looking basis you need to have that same kind of impulse to justify why you think inflation will stay at the same level or even go higher and I think already in terms of consumer confidence we're seeing almost a mirror image between rate expectations

you go back six months everyone was pricing or thinking that we were going to 3% now everyone's thinking it's 4.2, 4.3% so we've had one hike but the market has effectively tightened four or five hikes already and that's material and that will have a dampening impact on consumer and we've seen that in JB HiFi in their most recent update.

So then for those that are looking at capital preservation in general and really just want to be defensive, how is your AA minus fund

a good protection then?

So that one if you think about the maybe the sweet spot for capital protection or preservation as you say you could go out and buy two or three year government bonds now so you know for the time being AAA credit ratings are very high in that respect not very much duration sort of call it a year and a half to maybe two and a half years of duration you buy and hold to maturity and you're probably going to get 4.2 to 4.3 percent over that time period and that comes well with

where the ASX 200 dividend yield on a forward looking basis is already.

So you can go into something very safe, very limited duration and preserve capital if that's what you're after.

Further out along the curve obviously you can start introducing credit strategies and you can start

I suppose, over-weighting and under-weighting different sectors, as I mentioned before, and then also extracting alpha from curve positions.

I think at this point, we've been running with this curve flattener for six months.

Given where we see the RBA now, given we see some of the data starting to roll over, not today's inflation just yet, but it probably argues for us reallocating some of that long-ended exposure back towards two to three a part of the curve and looking for a potential steepening again.

And for capital preservation at IAM I believe you recommend only investment grade debt?

Well I think certainly if capital preservation is key then absolutely that's the way to go and you know to Gareth's point we're trying to avoid losers right now and also on that point around the AA fund because credit spreads are so tight you're really not giving up a lot.

to go up in quality.

So because you're only, I said major bank seniors at 60 basis points over, so you can come back into government bonds and you're only losing half a percent, but gaining obviously much more capital preservation, much more capital stability and better liquidity.

So I think in terms of whenever there's a little bit of risk out there, obviously going up in terms of credit quality, coming in on the curve a little is prudent, but you are gonna sacrifice some income.

Let's talk a little bit about liquidity fee structures and maybe like a choose your own adventure style portfolio if you will.

What sort of performance edge do you see in terms of direct ownership giving an investor that they can't get potentially in a highly utilised fund?

Well, I think you can be over diversified in a fund.

Obviously the counter argument to that is diversification provides greater protection, but sometimes there aren't 100 great options.

Sometimes there are 10.

And if you have that conviction in those top 10 or 20 positions, then you can extract extra alpha from having a more concentrated approach.

It obviously also allows you to assert your own view.

Now that may or may not be

Better than their professionals, but if you have a particular view on interest rates or on currency then or on credit Then you can assert that view yourself.

You know we have just as within our professional market There are those that think the RBA holds there are those that think it will raise again shortly There are those who think the curve will flatten etc etc you can assert your own view if you feel qualified to do so and

I think therefore you're not driven by what other people are doing and you can either adopt a buy and hold strategy which to Gareth's point you could do that right now and still achieve a very good return if you're prepared to accept that bit of mark to market and wholesome duration.

The alternative for that is we also have a managed discretionary account where we can do that for you.

I guess the benefit of that is that we can make decisions without delay.

So where we've got a professional manager there who will make decisions based on his views, where we're sort of maximizing returns through by also accessing that syndicated loan market in quite sizable detail as well.

Those are the two options that we present, either direct investment and having control versus a managed account type option.

The managed account provides one set fee and everything done for you.

So a lot of our investors, they're predominantly running a self-managed super fund and they want to travel the world and not have to wake up in the morning and check what's happening with their portfolio.

So having a managed account allows you that.

that option but if you do wish to have more control then you can just trade and as you would with a stockbroker trade like that as a fixed income broker.

The MDA I believe though a bit of a high minimum so what would your unitised fund be able to provide for those who may not be able to meet that?

Yeah, so one of the good things about the unit trust structure is that we can accept applications from as little as $10,000.

So basically it's a democratized access to a very diversified portfolio.

So to put it in context, our high quality government sort of duration fund that you mentioned before, that's got about 50 different holdings in it at the moment.

The monthly income fund, which is more of a credit skewed, you know, focus on income generation rather than capital gains necessarily.

that's got about 85 so not quite the hundred that Cameron mentioned but 80 we think we can find a good 85 out there I suppose when you're looking at the sheer number one thing to bring into it as well is that you have to aggregate these things up so you can have 25 different bank bonds but at the end of the day you've got you know call it 30% of bank exposure and

So what we look at is sort of on a bottom-up basis how much you have in each each bond because as to the point I mentioned before one bad loser there that's ultimately what you're exposed to 1% 2% but the way that you manage the risk and where we sort of extract alpha is looking at it more at the sort of the holistic sector level and say all right well do we want to be 30% in senior security financials or does it make sense to trade into asset backed securities given a spread pickup.

Yeah let's talk about losers let's talk about winners here and where you might see some opportunity particularly if we are looking at the phasing out of bank hybrids where do we look here?

So this is, yeah, this has been a big discussion point for the last sort of 18 months.

We've got the official clearance on the timing of when this is gonna take place.

And there's a bit of a scramble in the market.

You know, everyone's trying to sort of get into the schematic because it's a multi-year, in addition to the under-allocation of fixed income more generally from Australians compared to other markets, this is a very clear, we've got the next five years to create some solutions for investors.

We think at the moment the monthly income fund that we offer provides a reasonable alternative because as we've been mentioning before spreads are so compressed so to go from an additional tier one bond you know you're probably only picking up maybe 160 to 180 basis points at the moment if you buy today.

You can trade out of that, sacrifice maybe 20 to 30 basis points of spread, but move up in the capital structure so you're more secure, you're not as subordinated.

And you're probably more liquid as well because the reality is there are a big cohort of investors who will probably just hold these hybrids until they get phased out.

You know, you've got a pretty hard call in place.

It's changed the dynamics of that hybrids market.

So if I'm an investor, that extension risk has gone now.

So liquidity within the remaining hybrid space is probably compromised versus what it was before.

So we can offer something a little bit more liquid, a bit more diversified than just layering another bank instrument, CBA shares, CBA hybrids.

We can provide lots of non-financial corporate exposures, real assets, that sort of exposure without giving up too much in spread.

And where do you see the opportunity?

Well, I've mentioned syndicated loans previously and I think that's where we see value.

So we'll continue to promote that product within the space.

I think, I agree with Gareth, there's probably a little bit more to go in terms of spreads compressing in Australia.

So I think in terms of a lot of that hybrid money will flow into the tier two bank space.

We might see further compression there.

I guess to provide some alternate theories, we could look at duration again.

CBA was out yesterday with a 20 year at 6.4% fixed.

Now, that's going to have its day in the sun.

If you are prepared to accept a little bit of mark to market, and you can be patient, 6.4 is always going to hold up well for a bank over time.

And I think whether it's a year from now, two years from now, or five years from now, that will be a good quality long-term position.

So I don't mind having a little bit of duration now that we have seen that, if the theory is correct and we do see further flattening in that long end.

I think the other thing where we have investors quite active has been US markets so currency is elevated compared to what we've seen in the last couple of years so it's not a bad time to be buying US dollars.

We've got an economy where we're talking about cuts so potentially we get a combination there where yields are falling and our currency is improving would provide excellent returns for investors.

And do you have any views on ETFs?

Not specifically in my space.

I mean I think they're an excellent way to enter the market for people.

If you are trying to understand how fixed income markets work, they're a low cost listed opportunity for you to go to this point.

The Australian market is just so horrendously under exposed to fixed income that I think if ETFs are the way that you can comfortably get started in this space then do it.

What about your view?

I'd agree mostly with Cameron.

I think they are an excellent vehicle if you know what you're actually buying.

So I think it is incumbent on the investor to understand the difference between one ETF from another.

They all have their unique flavours and unique exposures and ultimately

you can pick something that looks bond-like, but it might be pure tier two subordinated debt, which if you look at the documentation of those bonds, there are explicit write down or conversion to equity dynamics that you may not appreciate unless you actually do the due diligence.

So for people who know what they're doing, I think it's a really low cost, easy, liquid way of playing the cycle.

But that's only for those people.

I think, you know, the reality is that most people, fixed income, it's not an overly complex asset class, but it's certainly one that isn't spoken about as much on the Channel 9 news in the evening or, you know, even at university, I can think of maybe one or two units that I did that was focused on bonds and bond maths.

But all of it was equities focused.

So the general sort of knowledge base and the capacity to make those sorts of asset allocation tactical decisions, it's probably not as broad as people think.

Where are you seeing the overall I guess you know you touched on a lot of opportunity here but macro environment given where we are and potentially in a rate hiking cycle versus what we're seeing on the global stage and potentially more cuts from the Fed?

From a macro point of view we're at this is probably the most interesting juncture we've had in a long time because if you think about sort of pre-COVID it was low yields forever all central banks were

moving lower and lower and then COVID happened, everyone moved to zero effectively and then you had a very synchronised increase in inflation everywhere coming out of COVID and you had a synchronised central bank response.

Where we're at now, as you say, the US

For different reasons there is a bit of a growth turnover there and we do see disinflation taking hold in the U.S. To the point I made earlier about what is already priced.

You're already seeing sort of two cuts priced into that U.S. market.

So going and allocating to the very front end of the U.S. now you need to have conviction that the Fed is going to deliver more than that and over what time period.

Our view for what it's worth is that

There's a bit of a cyclical upswing as well in the back end of last year in the US, which probably means the Fed won't cut in a hurry.

But we ultimately still think that two-year US bonds have a little bit of value at this stage.

So you probably have to wait to capitalise on that opportunity.

And then of course you've got things like Japan, which is creating, you know, Japan was something that we didn't have to think about for a long time.

It was an exporter of capital that would go and find homes in US investment grade credit, Australian government bonds, state government bonds, given what's taken place in Japan over the last two to three years and this new government that's just come in.

There's a lot more of a fiscal push.

Inflation for the first time in a generation is something that they actually talk about and have to respond to.

You've got the government forcing through wage increases to try and change the psyche of your person in the street.

So Japan is different.

Yields are much higher now and we are now competing.

with Japanese investors looking at their own domestic options and government bonds or their own corporate bonds rather than sending money everywhere else.

So it's a very interesting point in time.

Those dynamics probably speak more to the curve shape in Australia and how much we think that the long end of the yield curve can rally here, which is why if you have conviction in the economic cycle, the front end is basically your best expression of the trade at this point.

And your view on the overall macro picture as well, given what we just heard there too, but also given we never really know what's going to happen from the US administration day to day.

No, it's definitely a bit more exciting in our world when you have Trump in charge over there.

So definitely a bit more volatility.

I mean, we've got economies heading in different directions.

And to Gareth's point, it's quite interesting for us to look at that, to have

Australian bond yields so much higher now than the States to have the Fed talking cuts and us talking potential further hikes.

It's very strange because you do get used to Australia will follow what happens in the US.

You know, we wake up in the morning and the first thing I think we all check is what's happened in the US overnight.

That's likely to flow through what's happening today, but we're not seeing that anymore.

The US is no longer really the benchmark for the rest of the world.

It's not guiding us.

We've sort of gone in our own direction now.

Many of the other major economies are heading a flat or cutting.

we're in a very different stage of the cycle.

But there's always geopolitical risk, there's always the risk of government intervention as well as locally and abroad that can have an impact on our market.

I think the best protection to that, yeah, relatively short in terms of duration, be well diversified across your fixed and your floating positions across industries, across credit, and that's probably the best way.

If we're looking at capital preservation as opposed to extracting alpha,

then diversification, shortening up the duration, probably the right play right now.

Diversify and avoid the losers.

Cameron Garrett, thank you so much.

Cameron Window from IAM Capital Markets.

Gareth Innes from MST Financial.

And thanks for watching Conviction Capital.

I'm Juliet Sallee.

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