Corporate versus Government debt


by Clive Tompkins

Transcription of Finance News Network Interview with Antares Fixed Income Portfolio Manager, Andrew Rivers.

Anastasia Mangafas: Hello I’m Anastasia Mangafas from the Finance News Network. Joining me today is Antares Fixed Income Portfolio Manager, Andrew Rivers. Andrew welcome to FNN.

Andrew Rivers: Thank you Anastasia.

Anastasia Mangafas: Now Andrew, one of your key responsibilities at Antares is the long and short credit overlay investment process. Could you explain what this involves?

Andrew Rivers: Sure, credit overlay is a strategy that we employ in a number of client portfolios. And what it is, it’s a strategy whereby we combine two related positions in different credits to generate a return, above the index. Essentially we go short one credit and long the risk of another credit, and ideally we’re looking at the relative spread between two credits. So not the absolute return of either, but the relative difference between the two and looking for that change in a way that would benefit the portfolio.

Anastasia Mangafas: Can you provide a recent example and what made this attractive?

Andrew Rivers: Sure. The middle of last year we noted that the difference in spread between QBE Insurance Group Limited (ASX:QBE), the global general insurer and say some of the Australian major banks, credit spreads were at historic tights, so that is coming towards a sort of minimal differential. Now it’s not a question of being overly negative or fearful of QBE’s credibility, but investors need to be compensated when there’s more risk they’re being asked to bear.

We see QBE’s creditors as more risky than a bank; essentially they’re exposed to claims under resulting from natural catastrophes. Their income is more volatile due to the marked market on their investment portfolio and as such, they’re a much smaller company than an Australian major bank. Where Australian major banks have a very granular portfolio that’s exposed to, what we consider, the stronger Australian economy. And ultimately, when they do get into times of extreme stress, will receive - or have in the past, received public policy support.

So ideally if you’re holding QBE credit risk which again, I don’t believe is going to fall, we think you should be paid more to hold that than you currently were. So we bought protection on QBE by credit default swaps in the middle of last year and at the same time, sold protection on a number of Australian major banks by credit default swaps. As we entered Q3 and the European crises and a period of risk aversion entered the market, it became apparent in the market and spreads in general widened, QBE’s spread underperformed fairly materially and we were able to generate a profit for the portfolios.

Anastasia Mangafas: So it’s ultimately a question of relative valuation?

Andrew Rivers: That’s correct; it comes from looking at credit a little bit differently perhaps. Rather than looking at the absolute yield holding a particular credit provides, we look at the difference between two credits and the relative spread between those two. We’ve found that strategy quite attractive because it’s worked in both rising and falling markets for us, so it’s potentially provided a level of market neutral returns. And the other, sort of attraction of that strategy, is that it’s provided asymmetric payoffs in the past. By that I mean we’ve been at risk of potentially losing one dollar, but making four or five which is something we’re drawn towards.

What we’ve found is when defensive and cyclical credits the spread gets compressed, there comes a point where the weaker or the cyclical credit just doesn’t compress anymore. And so, therefore, as the market continues to rally, we really don’t lose a great deal more. But in the event risk aversion comes back into the market, we stand to make an outsize profit from that strategy.

Anastasia Mangafas: Now corporate paper comes in many varieties. Are some potentially safer than government debt?

Andrew Rivers: That’s a question many investors are asking in a way they haven’t asked in the past. I think that that’s become apparent since the GFC (Global Financial Crisis). I mean during the GFC a lot of nations attempted to stimulate their economies by running deficits on their balance sheet. And also some of them quite critically, took on a level of liabilities from their domestic finance sectors. Now that was with the view that as the economy returned to strength, there would be a period of fiscal consolidation. Unfortunately some of those economies have actually slowed and some of them in Europe have gone into recession, which has placed enormous strain on their credibility or their solvency.
You know, in Australia - we have a different scenario, particularly at the national level. At the moment I can’t see a corporate in Australia that is less risky than the Australian Government. But if I was a European based investor looking at credit, I think I would provide a different answer.

Anastasia Mangafas: To the banks, funding cost pressures have been blamed for their reluctance to pass on full RBA (Reserve Bank of Australia) interest rate cuts. What are the implications for corporates and interest rates over the medium term?

Andrew Rivers: Sure. I think when we consider this question of banks passing on cuts; ultimately we remind ourselves that the RBA is using monetary policy to influence the economy, via the rates that borrowers are accessing in the market. Now they’re terribly well informed the RBA, so I think we can assume that the interest rates that are in the market are those that are roughly what the RBA thinks are appropriate for the economy. So whilst the transmission mechanism is different to what it’s been in the past because of the bank’s higher funding costs, I think the rate that borrowers face today, are about what the RBA hopes them to be.

I think with a reduced – with a different transmission mechanism, the RBA may run official interest rates a little lower than perhaps they ordinarily would, but borrowers probably face about the rates the RBA intends them to face. I think when we consider that the issue of corporates and banking in Australia, the monetary policy is sort of an important and high profile portion of it. But I think access to credit is a critical thing and probably distinguishes the Australian corporate landscape to perhaps what’s happening in Europe. Australian corporates and well rated public ones, can still access borrowing from banks at reasonable rates, which is not the case globally.

The other thing we look at when we are thinking about corporates in Australia and particularly the banks, is the changing capital regime. And going forward, it’s possible that banks will need to put more capital behind a given set of loans. So that’s something we’re very mindful of and will that affect the flow of credit to Australian corporates in the medium term.

Anastasia Mangafas: Finally on a relative valuation basis. Do you see the corporate or government bond market performing better over the next year?

Andrew Rivers: Again when we think about credit, it’s important not to see it as one homogenous pool, but as you break it down, one has to be selective in using credit and of taking credit risk. We think defensive credits at the current time provide a decent return to investors. We think their yields are somewhat elevated. Now they may go higher in the short term as we experience some sort of economical volatility, but ultimately we think that they are providing return. And in answering that question, I think it’s very important to remember that government yields are at multi decade lows and investors are receiving the smallest return they have for many decades, from holding Australian Government paper.

Anastasia Mangafas: Andrew Rivers, thank you for your time today.

Andrew Rivers: Thank you.