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Credit premiums look attractive right now – if you have a good active manager

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Credit is one of the most reliable and repeatable sources of above-market returns, argues Perpetual’s head of fixed income Vivek Prabhu. In this article Prabhu explains why – in the hands of a skilled active manager – credit investing can achieve better fixed-income returns than government bonds alone.

CREDIT is the one of the “most reliable and repeatable” sources of above-market returns for fixed income investors – as opposed to pure fixed-interest government bond portfolios.

That’s the view of Vivek Prabhu, Perpetual’s head of fixed income.

Credit mostly refers to bonds issued by companies.

Corporate bonds are usually rated by agencies such as S&P and Moody’s and tend to offer a higher yield (or interest) rate to compensate investors for default risk.

By comparison, government bonds are considered higher quality (lower risk) and therefore offer lower yields.  

The difference in yields between government bonds and corporate credit is where a skilled active manager can find “alpha” or above-market returns.

“Historically, credit premiums have overcompensated for default risk,” says Prabhu, who manages Perpetual’s Diversified Income Fund.

“Provided you’ve done your homework properly and accounted for default risk, you usually have a very clear line of sight as to the end outcome.”

How to manage risk when investing in credit

“As credit risk is asymmetric, you've really got to do your job well on accounting for that downside risk, however,” says Prabhu.

Perpetual’s credit and fixed income team has a meticulous and well-practised investment process which examines individual issuers and their industries.

That includes an annual review cycle (bottom up analysis) for corporate investment-grade credit and ongoing market surveillance.

The investment team refreshes their credit outlook (risk appetite) fortnightly and also form a matrix of investment preferences by industry sector, credit rating and tenor (maturity).

Each portfolio manager wears three hats he says: PM, credit analyst and dealer.

“In an over-the-counter market like fixed income, it's important to have your finger on the pulse. That can give you early warning signs that other managers may not get who aren't so active.

“Our active management means we are regularly facing the market and can see subtle changes in liquidity or pricing.

“This can provide an early warning sign as to when market conditions are changing, offering a signal of when to de-risk or add risk.” 

When to buy and when to de-risk

As an example, in February Prabhu outlined his strategy for investing in subordinated bank debt –  a type of tradeable, unsecured debt issued by banks to raise capital.

“I'd foreseen a strong prospect that ratings agencies S&P and Moody's would upgrade major bank subordinated debt,” he says.

“We continued that overweight position in this fund because I thought there was a strong likelihood of ratings upgrades.

“We published that article on February 7 and right on March 6 Moody's upgraded it from Baa1 to A3.

“Then on April 2, S&P also upgraded it from BBB+ to A-.

“So that position performed really well in April as credit spreads contracted on that bank subordinated debt, causing the bonds to appreciate.

Knowing when to de-risk is just as important, he says.

“For example, in terms of my current investment outlook, BBB credits are starting to look pretty expensive relative to more highly rated bonds.

“While BBB bonds are still considered investment grade, you're no longer getting much of a credit premium in comparison to higher-quality single-A rated bonds.

“Why is that? It's because the market is becoming less discerning about risk as it chases return (yield) at any cost as credit premiums have fallen. And there's a lot of cash looking to park itself in credit or fixed income in general.

“I've been rotating out of BBB and high-yield credit because I see that as a key risk for the coming six-to-12 month period.”

“That’s the main thing that's changed in my portfolio outlook and positioning at the moment.

Passive versus active fixed income investing

The rise of passive investing is well known to equities investors. But Prabhu strongly argues against an index-approach to fixed income for several reasons.

First, by their nature, fixed-income index funds can be said to back the losers rather than the winners.

“Passive might work in equities because the companies that are doing well typically have a bigger market cap.”

(The bigger the market cap of a company, the larger its weight in a passive index fund, which means it has a greater influence on fund performance).

“Passive equities funds will build a higher weighting to the winners so to speak – the companies that are growing and getting a bigger market cap.

“But it's actually the opposite in fixed income. With fixed income, the index representation of a particular company or government is driven by how much debt they have on issue.

“As companies or governments issue more debt – and become worse credit quality and more financially leveraged – they actually become a bigger part of the index. “

In addition, the huge pandemic-era debt issuances of governments meant index investors lost exposure to the premium offered by credit issuers, Prabhu says

He points to the graph below as an illustration.

“As a passive investor, a decade ago you were collecting a credit yield premium on 14% of the passive replication of the Bloomberg AusBond Composite index benchmark.

“Today corporate bonds represent only 9% of the fixed rate bond benchmark.

“You've been collecting less and less of that credit-yield premium if you're a passive investor as governments have issued more and more debt.

“Of course corporates have issued more and more debt too, but governments have just outpaced them post GFC and post pandemic. 
“That’s potentially costing you returns compared to an actively managed fund.

Best opportunities in a decade

“We’re currently seeing some of the best opportunities in fixed income in a decade,” he says.

“Not only are equities or growth assets expensive – but fixed income is offering some of the best opportunities relative to equities.

“You can have your cake and eat it too at the moment, because you can get equity-like returns with the stability of fixed income.

“It should make investors think about their asset allocations. Is this the right time to tilt away from growth assets and into fixed income – because it's looking cheap on a relative basis?”

“And then there is the inflation genie, which people thought was going back into the bottle, but is now a resurgent theme again. “
Stubborn inflation has seen support for the “higher-for-longer” theme as central banks back away from potential rate cuts.
“Floating-rate credit has offered a good hedge for inflation historically,” points out Prabhu. 

Find out about Perpetual’s Diversified Income Fund

 

About Perpetual’s Credit and Fixed Income team

Perpetual offers a range of cash, credit and fixed-income solutions and are specialists in investing in quality debt.

We take a highly active approach to buying and selling credit and fixed income securities and invest extensively across industries, maturities and the capital structure.

Find out more about Perpetual’s Credit and Fixed Income capabilities

Want to find out more? Contact a Perpetual account manager

Vivek%20Prabhu.jpg
Vivek Prabhu
Head of Fixed Income
BBus, FCA, Grad Dip App Fin & Inv, MBA, GAICD
Vivek Prabhu
Vivek%20Prabhu.jpg

Vivek Prabhu

Head of Fixed Income BBus, FCA, Grad Dip App Fin & Inv, MBA, GAICD
Bio

Years of experience: 31
Years at Perpetual: 19

Vivek is Head of Fixed Income and joined Perpetual in 2004. He has over 30 years of experience spanning accounting, finance, investments, governance and risk management. He has managed multi-billion dollar fixed income, credit and currency portfolios and his role involves credit analysis, trade execution and portfolio construction.

Previously, he spent nearly 8 years at Macquarie Bank in roles including Assistant Portfolio Manager (Credit, Global Fixed Interest and FX), Credit Analyst, Compliance Manager (Funds Management Group) and Operational Risk Analyst (Internal Audit). Prior to this, Vivek spent almost 4 years at Coopers & Lybrand (PwC) as an accountant / auditor.

He's aimed to give back to the communities, organisations and people with whom he's connected. Vivek joined the Board of The Deaf Society of NSW in 2011 and currently serves as Director and Treasurer. He joined Perpetual's Diversity Council in 2012, chaired by Perpetual's CEO. Since 2010, Vivek has regularly mentored university students, colleagues & finance industry professionals, leading the Fixed Income stream for Perpetual's Investment Analyst Program.

He was awarded the 2011 Financial Services Institute of Australasia (FINSIA) Hugh DT Williamson Performance Scholarship, an award recognising professional accomplishment, social responsibility and leadership. In 2011, he was also awarded a not for profit directors scholarship from the Australian Scholarship Foundation.

This article has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426, as the issuer of the Perpetual Diversified Income Fund ARSN 601 199 035 (Fund).

It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The information is believed to be accurate at the time of compilation and is provided in good faith. It may contain information contributed by third parties. PIML does not warrant the accuracy or completeness of any information contributed by a third party.

Forward-looking statements and forecasts based on information available at the time of writing and may change without notice. No assurance is given that the forecast will prove to be accurate, as future events may impact actual results and these could differ materially from those anticipated. Any views expressed in this article are opinions of the author at the time of writing and do not constitute a recommendation to act.

The product disclosure statement (PDS) for the Perpetual Diversified Income Fund, issued by PIML, should be considered before deciding whether to acquire or hold units in the Fund. The PDS and Target Market Determination can be obtained by calling 1800 022 033 or visiting our website www.perpetual.com.au.

No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor's capital. No allowance has been made for taxation and returns may differ due to different tax treatments. Past performance is not indicative of future performance.