Global Perspectives: Connecting with credit

Matthew Bullock: Hello and welcome to the latest recording in the Global Perspectives podcast series. I’m the Head of Portfolio Construction and Strategy for EMEA and APAC, based in London, but I’m visiting Australia and I’m very lucky to be joined by Jay Sivapalan, Head of Australian Fixed Interest here at Janus Henderson. Jay, welcome.

Jay Sivapalan: Thanks, Matt. Good to be speaking with you today.

Bullock: Today, we’re talking about credit. And I think before we even get into the opportunities and the threats and the current market environment, I just want to set the scene of, what is credit? I’ll have a go first, and then tell me Jay, if I’m on the wrong path here. When we’re talking about credit, today, we’re really going be talking about debt that isn’t issued by a government. And there’s lots of terminology around all of that, for example, mortgage backed securities, or MBS if you want to use the acronym, corporate debt, public or private debt. So it’s sort of anything that’s not government related, we’re going to talk about today that fair?

Sivapalan: Yeah, that’s certainly broadly correct. I mean, credit has a broad spectrum. But you can think of credit as essentially lending investors monies to companies that need it for productive purposes.

Bullock: Got it. So let’s look at the credit market. And you know, there’s been a lot of talk about the credit market, in particular over the last 12-18 months or so. And I want to sort of do a, let’s start big picture about what the outlook is for credit investing today. And then I’m going to ask you how, in your wealth of experience, how the current environment compares to previous environments that you’ve seen in your career.

Sivapalan: Yeah, so I think looking at where we are in the economic and business cycle is a great place to start when we’re talking about credit. But the views that we will share today will be quite nuanced, whether you’re talking about senior debt, or subordinated debt, or hybrids, for example, or capital notes. And whether we’re talking about investment grade, high yield, loans, and some of those acronyms that you mentioned, mortgage backed securities, MBS, or asset backed securities, ABS, or CLO’s, collateralized loan obligations.

Bullock: I’m going to actually jump in there, just tell me quickly the difference between all of those?

Sivapalan: So essentially, they’re just different ways of borrowing money if you’re a company. So you can either borrow in public markets in bond markets, and if you are high credit quality, you will generally be classed as investment grade. And if you are lower credit quality, you will be in high yield or loans markets, typically loans secured, whether it’s a manufacturing plant or property, whereas bonds are typically unsecured. And then, of course, where you rank in the capital structure will determine senior debt, subordinated debt and so on. So if there is an event of default, senior debt holders get their money first. And then subordinated debt and so on.

Bullock: Got it, great. Sorry, I just cut you off, as you were sort of talking about your outlook and your experience. Do you want to go back into that?

Sivapalan: No, that’s perfectly fine. When we think about the outlook, where we are in the economic and business cycle? We are, we would describe, relatively late stage. Late stage does not mean alarm bells, because going through my own career, there’s been many cycles. Some have ended in disaster, but most have actually been quite manageable, with very good returns for investors. It’s really important to think about what feeds these latter stages of the economic cycle and what drove it here. The first thing that I would point out is this is a managed economic slowdown manufactured by central banks, by tightening monetary policy to deal with inflation, which that job is largely done. Time will tell if we can nail it on its head in 2024, but we believe that job is largely done. Growth on the other side has remained very resilient, which means that corporate earnings has remained quite resilient. So the outlook from that perspective remains robust. I want to pick up on a few nuances there. The large end of town, the very large organisations, whether its corporate America, corporate Europe or corporate Australia, are faring very well and quite resilient and will continue to do so. But the higher rates and the cost of capital has changed the game for many small businesses and those highly levied business and consumer cyclical related or exposed businesses. They are starting to struggle so we need to be very nuanced about our outlook when we talk about credit.

Bullock: And you’ve just started to touch on that, so I want to now go into those opportunities right now. As we’re getting towards that end of a cycle, but in a managed slowdown, as you said, hopefully not one of those disasters that you mentioned. But as we’re going into this environment, are there particular sectors that you’re looking at or particular issuer types? Where’s the attractiveness? Where’s the interesting stuff right now?

Sivapalan: Yeah, so in our assessment the sweet spot really for investors is investment grade credit. Today in most of these markets, including Australia, you can comfortably get a yield of about 6%. And what we call MoRoCar, that’s move, roll and carry, that’s a technical term. But essentially what I’m talking about is a total expected return on a forward-looking basis, we think we can generate something like an 8% return. And that 8% return is quite reliable because defaults in investment grade are very rare. In fact, in Australia, really rare. Whereas once you start moving down the spectrum to high yield and loans, and some of those other pockets which are more cyclically exposed, where especially right at the bottom end of credit rating quality, what we call CCC’s, we’re starting to see the defaults come through. The sticker yield that you see is probably not achievable over the coming 12 months. The sweet spot is in the high-quality segments and less so in the low-quality segments.

Bullock: So is that something that you’re seeing a bit of a behavioural change? Because if I think about, from the global financial crisis to today, the focus was on yield and getting as much return as possible. There wasn’t really that much focus was there on the credit quality side of things.

Sivapalan: Certainly the environment and the journey that we’ve been on is a very low yield environment for coming up to close to 15 years now. But of course exacerbated during the pandemic period when we had 0% cash rates. I remember reeling out our fact sheets, which had a yield of 1 or 1.5% yield. It’s a long time since we’ve been able to do that. And today, most of these bond products and the market broadly have 5, 6, 7% type yields. It’s a very different environment today. And the investor base is really rethinking asset allocation in terms of quality now, because when you had such low yields, you had to chase the yield. You had to chase lower quality to get returns. Today, as I said, in high quality instruments, you can still get a yield of 6% and investors are really thinking about that as if I can get CPI plus 3% in a relatively safe way, maybe that’s actually a good way to invest, even against other asset classes.

Bullock: Another area that comes up occasionally is then private credit, the illiquid side of things. Do you have any particular views on that in this current part of the cycle?

Sivapalan: Certainly, I’ve got a pretty open mind about public and private markets indeed. There’s a role for both in investor portfolios. I guess just to walk through a couple of the key differences, firstly, there is a liquidity difference between public markets and private markets. And when you’re getting paid well in private markets, it’s worthwhile allocating to that. The second part some down to the credit quality. For the majority of private markets, at least in Australia, and this is certainly the case in the US, private markets tend to be more concentrated in sub-investment grade credit quality. If you really want to compare like-for-like, we need to be comparing it with a high yield market. And today, we would suggest that perhaps a liquidity premium isn’t quite there as it was perhaps three or four years ago. And then also at this point in the cycle, should we be thinking more about default risk in those low-quality segments?

Bullock: Actually, just on that, default risk is quite an interesting topic because I do want to, again, think ahead and go, looking at the credit market, looking at that high-yielding space, what is the risk of defaults increasing quite significantly? How worried are you about that?

Sivapalan: Certainly, so far, we’re already observing defaults lifting, but it’s quite nuanced as I mentioned in certain industries. Here in Australia we’ve seen a pretty decent pick-up in defaults centre around the property development and construction areas. But also, hospitality is starting to follow through now. And then in the US, we’re starting to see some of those consumer cyclical areas like auto loans, credit card receivables and so on. These are not scary yet, and they are not at levels where you have to worry about an en masse default cycle. But certainly, they’re tell-tale signs that the policy is working as intended and it is having some impact. In terms of navigating portfolios through that journey, I think if you, at this point in the cycle, stay on the more resilient businesses, and the less cyclical businesses, that may be the better way to invest through the cycle.

Bullock: That’s how you think about mitigating risks right now?

Sivapalan: That’s right so focussing on industries like core infrastructure, airports, sea ports, some of the traditional areas like toll roads, but also some of the contemporary areas like national broadband network, data centres and so on with government contracts.

Bullock: From that perspective, you’re looking at the downside risk, the default risk as being manageable. And also, I just want to go back to one of the earlier things you said. Because when you’ve talked about previous stages of your career, when you’ve seen a slowdown, and I think you used the word disaster, and it made me sit up in my chair, and I dare say for the listeners as well, they probably sat up in their chair. But to be very clear, you’re saying that this is not that sort of scenario where you see an increase in defaults, you’re not expecting a disastrous type of situation, and that’s largely down to this being managed slowdown for the central banks. Is that correct?

Sivapalan: That’s right. So of course none of us can ever predict a left field event, and they’re by definition, very hard to predict. But when we think about the ingredients that led to where the economy and businesses are and the strength of their balance sheets, they’re actually in good shape. Of course there are business around the world and indeed in Australia that have overleveraged balance sheets and they’re slowly starting to get resolved. And they’re not getting necessarily resolved by default, but by refinancing, by investors putting in more equity capital and reducing the total amount of debt and really managing that interest cover. Which is a key challenge, it’s servicing of the debt that’s a key challenge. If I contrast this with some of the past episodes that have ended up in more crises, the global financial crisis is one, the tech bubble in the early days is one, WorldCom Enron was another one and then of course the European sovereign debt crisis. All of those had hallmarks of pockets of debt that were unsustainable. This time around, it seems to be more managed. But as I said at the start, a left field event can’t be excluded. One of the areas that we really like at the moment, despite being quite constructive on investment grade credit, is how cheap credit protection is today. We use the credit default swap market, the CDS market, and out view is buy things when others don’t want it. We’re actually quite surprised as to how cheap credit insurance is today. Whilst we’re enjoying the high yields and the higher credit spreads for investors, we’ve also got the other foot on the credit protection side and buying credit protection.

Bullock: That’s insurance against a default?

Sivapalan: It is insurance against a default but what happens in practice is the mark-to-market before defaults occur starts to become very strong on the protection, which then offsets any mark-to-market on the physical assets that you might hold in a portfolio.

Bullock: Right, got it. I want to briefly talk about sustainability because it’s one of those areas that is comes up a lot in the equity side, but I also know that you’ve been doing a lot of work of the fixed income side. If I look at the sustainable market what role do you see ESG factors, for example playing when it comes to the selection of securities and the corporate debt side of things? How important is it?

Sivapalan: Yeah, so ESG has always been and should always be very important as part of a strong investment process. And I’ll explain why. There are two parts of ESG. The first part is really avoiding risk. And what we mean by avoiding risk is those non material risks that can lead to adverse financial outcomes for companies. And here in Australia, we’ve certainly seen many examples of companies that have been on the wrong side of regulation. And or have had elevated ESG risks that have either defaulted, or have been downgraded to junk status, and of course, and underperformance of the bonds. So that’s the risk management side. Now flipping that on its head to the other side, we know that we’re in a period of change and the world is changing. We have a great deal of work to do in terms of the energy transition. We know that companies are held to more, you know, higher account in terms of the social licence to operate. So those companies that are aligned with where the government is going, where regulations are going, where taxation is going, where subsidies are going, and where to the consumer and society’s going, they are likely to fare better than those who are trying to swim against the tide. And so that’s really important in terms of ESG and sustainable investing.

Bullock: On the government intervention side of things and the regulation, what’s the risk then that the direction of travel changes? So Whether it’s a change of government, change your government policy, what’s the chance though of being wrong-footed?

Sivapalan: Yes, certainly, governments can change their mind relatively short notice, especially through election cycles and changes of government. But I think the big events and the big picture, challenges that the world has to face are not going to go away in a hurry, and they will be the same regardless of the government. So we’re starting to see policies that really target that. So in the US, we know that the inflation Reduction Act, a part of it is reducing inflation. But the other part is really dealing with some pockets of climate change, some pockets of supply chain, resilience, and so on. And we’ve got an equivalent one here in Australia, where some of our best companies are getting heavily subsidised loans, for investing in certain areas. And so that is going to provide a tailwind. And if you’re a bond holder lending money to these companies, that likely resilience of their cash flows, and therefore returns, are going to be that much greater.

Bullock: You said returns. Is there any impact on returns when you start going into the sustainable side of things?

Sivapalan: I think this is one of those misnomers in fixed income versus equities, for example. Typically, in an equity portfolio and equity managers, especially if they’re thematic in nature, they tend to have some biases in terms of industries. Whereas in fixed interest, that doesn’t actually occur. If you took a broad basket approach and universe in fixed income, you’re generally highly diversified across industries. And the main driver of the fixed interest returns tends to be the interest rates or bond yields and also the credit spreads, the additional yield you get for lending money to those companies. As a result of that, the returns tend to be either neutral to vanilla bonds or actually positive. And in fact, we undertook an internal study which proved out that over the last three years, label bonds, sustainable bonds, green bonds and so on, performed in line or better than vanilla bonds.

Bullock: Jay, we’re out of time, but I wanted to thank you very much for all your thoughts on credit and to thank also our audience for listening. Of course for our listeners, if there’s anything they wish to learn more about Janus Henderson’s investment views, or if you have any other questions, then please don’t hesitate to contact your client relationship manager or visit our website.