The best risk adjusted trade of the next 3 years?
Recently, we’ve published a number of articles about our caution regarding the immediate outlook on investment markets, and equities in particular. However, we have also talked about our quest for investment opportunities being presented in this current period of uncertainty.
One area that we have only briefly touched on – and likely not provided enough insight into, given it is arguably our largest individual position and/or overweight in portfolios – domestic Investment Grade credit. The below is a simplified example and leaves out some technicalities regarding interest rates and other technical factors, but even when accounting for those the result is the same, so adding them in just makes it more technical and difficult to read without changing the message, hence we have kept it simple.
Given that the most volatile position in portfolios is usually a clients’ equity positioning, this is naturally an area that clients and professional investors focus on, and since late June of this year we have received some mixed messages, adding to short-termism and confusion. Offshore in places such as Europe and the US, markets have been up and down over this period with lower highs and lower lows as data has switched from being better-than-expected to worse-than-expected.
This has been aggravated by monetary policy, with the subsequent actions of the Fed in particular being to stay the inflation fighting course. Compare that to Australia where a 0.25% rate rise was irresponsibly reported in the press as a ‘pivot’ (how could continued tightening be a ‘pivot’? That’s just ridiculous) and the situation is even more confusing. However, if one is not in a position to determine the weight of evidence for and against an equity market rally, what assets could one own that are attractive irrespective of future market direction? This is where we think domestic IG credit is currently attractive irrespective of outlook and likely to provide a fantastic risk adjusted return over the next 3 years.
What is Investment Grade Credit?
In short, these are bonds (or debt) that can be fixed or floating rate, issued by companies assessed to have an extremely low chance of default. Given they are bonds issued by corporates, their credit risk and the premium you receive for taking on that credit risk is important in determining their price – hence the colloquial term ‘credit’.
Why do we think it is attractive?
With credit instruments, there is always a risk that an issuer could default on its bonds (i.e. not pay it back in full). When we look at domestic IG credit, there have effectively been only 2 defaults over the last ~30 years, and both these instruments were downgraded before default anyway. If instead we look at global defaults during recessions, we still only see rates of default peaking well below 1%, and in the event of default, because you own a bond and not equity in the company, you receive payment from the liquidation of assets (bond holders are senior to equity holders in a liquidation event, so get paid first).
Currently, you can buy a basket of domestic IG bonds paying a yield to maturity (YTM – click here for an explanation) of around 5.5%, with an average price of around $95. Given the issue price of these bonds and the amount you get back at maturity is $100, this represents a price buffer of $5. As an example, ANZ currently has two bonds, maturing in 2032 and 2027 currently priced slightly above $93 and $96, paying a YTM of approximately 6.5% and 5% respectively.
If we look at what is priced into a portfolio of IG bonds at an average price of $95 compared to what might happen in a bad-case scenario, we can make some assumptions:
- Assume defaults hit 2% (which has never occurred in domestic IG credit, even during the GFC)
- Assume recovery rates on defaulted bonds of about $0.50 in the $1
This would represent, if those bonds were held to maturity, a loss of 50% on 2% or 1% in total. However, our basket of IG securities is currently priced at $95 – essentially (and this is overly simplistic) that 1 in 20 of the companies in our portfolio will default and we’ll receive nothing from the value of their assets.
A more likely scenario if you were to hold these bonds to maturity is that they will mature at $100, and you will get paid the coupon, equating to a yield on your purchase price of around 5.5% p.a. PLUS get the capital upside of buying them for $95 and getting back $100.
So, given this, we see a pretty attractive opportunity irrespective of what markets do. Credit instruments seem to have factored into their price a bad-case scenario regarding future recession – all but a 100% chance of occurring. Equities, at least domestically, seem to assume the chance of recession is far less likely to occur. If the credit market is right, you are already paying a price that has factored in a high likelihood of recession and a pretty bad default cycle – worse than any we have domestically on record. Yes, prices could fall further, but you have a pretty good margin of safety already factored into the price. You’re also getting paid an attractive yield to wait it out. However, if the equity market is right, and the future outlook is far more attractive, owning these instruments will pay you a yield of approximately 5.5% with price appreciation of $5 (or 5.26% on $95). If that’s received over the next 12 months (assuming markets continue to improve from here), we’re looking at 5%+ capital return plus a 5.5% yield over the next year – or a 10% – 11% total return on a fixed income instrument. That’s equity-like returns for less than bond-like risk!
A large position in domestic IG credit is one we have already taken out in client portfolios, however, the opportunity has not eroded recently and still represents excellent value in our view. The above example is simplified for illustrative purposes, but the point remains the same – the downside to these instruments if things get worse is largely factored into the price already, but the upside isn’t, meaning it has an asymmetric future payout tilted to the upside.
Whilst these instruments won’t generate the type of total return equities post in an economic recovery or resumption of a bull market, they do offer a return adjusted for risk that we believe is far superior to most other assets in the market at present. If market conditions deteriorate further, other opportunities will present themselves, and we are scouring for those opportunities at present, but based on current prices and the uncertainty about the future direction of markets and economies, having the ability to allocate to an asset that is attractive irrespective of what happens in markets is worthy of close consideration – and the reason we have such a large overall as well as overweight position for our clients.
As a final note – the above can be executed in a floating rate fashion – which is what we have done. The diversified portfolio of bonds can be floating rate bonds paying from a 4.5% yield on A+ rated floating rate notes, and up to 6%+ on BBB+ rated floating rate credit instruments. In the event rates keep rising, their coupons (and hence yield) will rise as well, meaning you get paid to wait for opportunities whilst also minimising your after-inflation losses that would occur in cash given that the cash rate is currently well below the rate of inflation. Pretty simple really.
 Prices vary based on issuer, coupon and yield etc. But putting together a portfolio of IG bonds at an average price of $95 isn’t unrealistic
 This ignores the requirement that fixed rate bonds will have to pay a higher yield if inflation and interest rates rise, however, there are a meaningful amount of bonds with short time-to-maturity or issued as floating rate bonds to build a diversified portfolio that isn’t likely to be overly effected by future rate rises.