Swimming against the fixed income tide

Jarod Dawson
— 1 minute read

'Anomaly-based' investing can positively affect yields from income securities, says PM Capital’s Jarod Dawson.

Jarod Dawson

Most investors, and especially the one million strong army of SMSF members and trustees, are likely to have a ‘dinner party’ view on equity markets and many popular and prominent stocks, given the overweighting of SMSF funds in this sector.

But should the dinner conversation turn to fixed interest, the talk is likely to quickly pass to the footy results or the latest film.

Why? Because a many people find the world of fixed income less than thrilling and, equally, the subtleties of investing in the sector are often not widely understood.

Gone for the foreseeable future are the days of term deposits yielding 6 per cent, 7 per cent and 8 per cent interest rates.

In the not too distant past retirees were happy to park a big slab of their savings pool in term deposits, debentures or (heaven forbid) unsecured mortgage securities – or a mix of all three.

Unfortunately for many investors, and particularly retirees, the ‘new normal’ is lower interest rates for the foreseeable future.

Fixed interest however still has an important role to play in many portfolios.

The average professional investor, such as myself, will have a concentrated number of personal investments that they truly feel they understand, and some cash to varying degrees – so why would an adviser invest a clients’ money any differently?

Focusing on the quirks

At PM Capital our fixed income process is built around the idea that we are only interested in the anomalies in global credit markets, and not the broader market itself.

This is somewhat unusual for the industry, but a small minority of managers, both here and globally, adopt this approach rather than constructing portfolios around a generic bond index, and measure performance against that index, for example the Bloomberg bond indices.

Anomalies can be defined as those opportunities that only come along every so often, and for various reasons are materially mis-priced in absolute terms, (often due to factors unrelated to the fundamentals of the business), rather than just being a little cheaper than the broader market.

They are hard to find, require a considerable amount of detailed due diligence, and often won’t be found in Australia.

The communication and technology revolution that we have witnessed over the years has contributed to markets becoming increasingly global, and hence in order to assess the merits of an investment in Australia, investors can and must look at how they stack up against similar investments offshore.

Too often investors confine themselves to their local market, at the expense of significantly better opportunities offshore. It is these offshore markets that have been a great hunting ground for the fund I manage.

There have been periods of significant dislocation over the last six or seven years (including the GFC and a couple of European crises to boot) providing excellent opportunities to invest capital if you look in the right places.

‘Looking’ includes considerable time spent travelling overseas by the investment team to meet with management of the debt issuer to get first-hand knowledge of the business being analysed, just as we do when assessing and researching equity investments.

For example, buying the debt of listed property trusts in Australia has been a well-trodden path for many Australian fixed income fund managers over the years and still is today.

However, many investors would not be aware that the senior debt of some high quality listed commercial property companies in Europe for example (where property values are considerably more reasonable), is currently trading at over double the credit spread of its Australian counterparts.

Reasons to stay at home

So in a globalised market, why would you buy the Australian debt over the European equivalent?

This is a good example of the sort of anomalies managers like us are looking for.

Another common mistake that people make is trying to ‘diversify away’ risk. Buying a huge number of bonds that are all highly correlated with each other is not diversification, we would argue.

It is virtually impossible for a fund manager to be across the literally hundreds of individual investments that you will find in many of the world’s bond indices, at least to the degree that we would argue an investor should be across them in order to confidently put their clients hard earned capital into them.

Yet this is what the average mainstream fixed income fund manager is attempting to do by, in some cases, investing in more than 200 supposedly different bonds.

We believe that the best way to minimise risk, is to have a significantly smaller portfolio of investments that we truly understand, and about which we have a have a strong degree of conviction.

The logical corollary of this approach, of course, is to have significant capital invested in those ideas that will actually make a material difference to the outcome of the portfolio as the investment thesis, based on being an anomaly, plays out.

While the approach just described is definitely only adopted by a minority of fixed interest managers, an examination of comparative returns over the long term between conventional managers and those dedicated to unearthing anomalies will give cause for thought when next making decisions and recommendations on where to place any given fixed interest allocation.

Jarod Dawson is a director and portfolio manager at PM Capital.



Swimming against the fixed income tide
Jarod Dawson
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