Fixed interest at 22%!

Fixed interest used to seem the boring part of many investors’ portfolios – as well as the most overlooked as equities and property consistently hogged centre stage. Well, fixed interest markets have been anything but boring since the subprime crisis erupted – and are now offering equity-like returns for a higher level of security.

Some of the bigger stories behind the headlines have been played out on the credit markets in recent weeks: the collapse of Lehman Brothers; the times when no one wanted to touch Macquarie Bank debt at any price.

And there’s plenty of confusion remaining. It’s yet to be seen just how the Federal Government is going to guarantee the fund-raising of Australian deposit-taking institutions, with the market suspecting there will be a two-tier system of existing and new debt.

Confusion and volatility create opportunities. At the more exciting end of the fixed interest spectrum are products such as QIC’s Global Fixed Interest Alpha Fund, an absolute return fund that made 22% in the year to July 31 and has averaged 14% over the past three years. Those sorts of numbers come from one of Australia’s top fixed interest teams going long and short credit market derivatives, making the most of extremely volatile markets.

QIC also runs less dramatic products, such as its Diversified Fixed Interest Fund, but even for a long-only fund, there are some high-yield but not necessarily high-risk opportunities opening up. Even in the much maligned MBS (mortgage-backed securities), there are rich pickings for those who know where to look.

As QIC’s active management managing director, Susan Buckley has been steering the Queensland-based fixed interest team through the maelstrom. Her performance has mainly been to the benefit of QIC super funds and institutional clients, but the QIC GLI Alpha Fund and Diversified Fixed Interest Fund are now accessible to retail investors through DDH Graham.

To see how to make 22% in a year from “boring” fixed interest markets, and gain an insight into the ructions caused by the credit crisis, read on:

The interview

Michael Pascoe: Fixed interest used to be considered boring; it obviously hasn’t been for the past year. Where have your strong results come from?

Susan Buckley: Volatility certainly has picked up in fixed interest markets, as it has in a lot of other asset classes as well. You’ve seen considerable movements in credit spreads as well as enormous volatility in rates, and that provides great opportunities for a manager who can be long or short.

The QIC Global Fixed Interest Alpha Fund had a return of 22% in the year to July 31. How have you been going in the past couple of months?

We’ve done very well because we’ve been able to sense the downturn in the US economy early and get an early handle on the balance sheet problems among financials. This is a fund that will go long or short credit markets, as well as take outright directional positions in rates. So with our derivative capability across all fixed income markets, we’ve been able to be very opportunistic through this volatility. Towards the end of last year we were able to get short credit, then we got long credit going into the first quarter of this year, and then take some profit by the middle of the year and then start to get long again in more recent weeks.

Can we break that into two parts: first on the derivative side – that sounds like pretty risky, hedge-fund-type playing?

It’s all about getting an absolute return out of fixed income markets. We’re not benchmark-driven in this fund. We certainly do manage long-only and benchmark style funds for some of our clients as well, but in this particular product it’s all about making strong positive return and we aim to deliver cash plus 5–10% in this product. We do a lot of work on valuations in markets right across rates, right across credit, and then drill right down into particular parts of markets, across G10 countries where we want to be positioned, either long or short. So we will have scorecard signals.

For example, we have been long US two-year rates for quite some time. We believed the US curve would steepen up, so that’s a great alpha generator. We use a range of counterparties, domestic and global banks – we deal with 30. Obviously there’s been a lot of concern about counterparties in the past few months. We also have a credit team that does a lot of due diligence on counterparties; we need that diversity in a lot of derivatives, but we’ve managed to avoid the Lehman Brothers and the sort of blow-ups that we’ve seen.

The blowups have occurred in the biggest names in the business. How have you avoided them?

We’ve had good luck and good management – put it that way. We have a credit team of eight people; they’re doing all the due diligence on every credit that we invest in and every counterparty we deal with. We talk to the treasurers, we seek to understand the balance sheets and if we see some smoke signals then that’s a red flag for us; and there were certainly some smoke signals that were coming out of a few counterparties.

But in the recent weeks we’re seeing a dramatic sea change occurring for financial markets. We’re seeing things that we’ve never seen before in our careers as managers – the government interventions in US financials and globally – that in some ways give debt holders a lot of comfort. And we’ve seen credit spreads move really significantly in the last few days. Take, for example, Morgan Stanley: it was trading two or three thousand basis points over cash! This dislocated markets because there was fear that these banks were going to collapse. Later in the week in the credit derivatives space, exposure to Morgan Stanley rallied into 400 basis points over cash. Dramatic rallies! These are enormous opportunities if you can stomach the volatility. You do good research and no single strategy should dominate across a diversified suite of strategies, but there are enormous opportunities across rates and credit right now.

Also enormous opportunities to lose money if you get it wrong though?

Yes. We continue to do rigorous credit research and that has held us in good stead. Now you’re being paid to take credit risk, you can even afford some defaults in your portfolio, not that we’ve had any '¦ touch wood. Prior to last year, you were not being paid to take credit risks. We use the full breadth of fixed income markets: we can go short or long; we have a specialist team of 18 investment professionals; and we scour for the best opportunities across interest rate and credit markets.

On the domestic market, did Macquarie Bank look as if it was being manipulated?

Certainly the Macquarie Bank derivative spread blew out quite considerably towards the cash plus 1000, over 2000 at some point. Whether that’s manipulation or not, I can’t be sure. But certainly you had a situation where at some point, no one wanted to take Macquarie risk even at that level. There was just an absolute fear that that organisation was in trouble, as was AIG, as were Merrill Lynch and Citigroup at times, and a whole raft of US financials as well as some domestic names. That’s why we’ve seen unprecedented action by governments and central banks.

As of Sunday, Macquarie Bank – all Australian deposit-taking institutions – are 100% Triple-A government guaranteed. What’s that done to the credit market?

We’ve had a positive reaction so far. So there’s been a significant rally in reaction to the Australian government move, but also the global coordination. That is really starting to thaw these frozen credit markets and for us that’s a very positive development. Prior to this, we’ve been starting long financials and short industrials. It’s a theme that we '¦

Sorry, what do you mean, “long financials, short industrials”?

We can structure quite a diversified basket of financials across Australia and the US and Europe and go long their credit derivatives, their spread, and then we could short a basket of industrial companies. We still have a theme in our portfolio, where we expect the US and the global economy to slow down; the US going into recession, Europe, Japan – hopefully Australia escapes that. There will be higher funding costs from the banks being passed on eventually to corporates. Financials have priced systemic fear and risk into their spreads; that will be unwound to some extent. Industrials have to suffer through a default cycle like any normal recession. Financials are trading well above industrial credit spreads and that’s not sustainable in our view. That trade has started to work and should that continue, we’ll take profit on that.

Just like you would play a theme in the equity space, it’s now possible to play that in a credit derivative space.

With the government guarantee though for Australian deposit-taking institutions, shouldn’t they be just trading at government bond levels?

Credit will come in, it’s still to be tested. There will be new issuance under the new arrangements. There’s still some confusion and doubt about the existing debt. So we’ll probably have two curves: a government guarantee curve and then you’ll have the previous or the existing debt that will trade higher.

Leaving the derivatives alone, looking just at the physical, because of the dislocation of markets, there seem to be some extraordinary yields on quite highly rated industrial corporate debt. Are long-only strategies looking good at the moment?

Generally speaking, we do think now is the time to be looking at credit exposures and you are certainly getting paid now for taking that risk. But there’s still going to be some dispersion. As I said earlier, we think the industrials still have to cheapen up to some extent; we would be more overweight the financials. We are still going into a recessionary environment, we are still going into higher defaults and that’s still to play out. But there are parts of the credit markets that we do think are now cheap, and we want to be able to be overweight those parts in the market. One particular area we’re interested in is defensive high-yield. We’re not talking broad high-yield '¦

Sorry again, in plain English, what’s that?

Things like infrastructure debt. You can now get yields like cash plus 5–6% in BB-type infrastructure companies like BAA (British Airports) or Thames Water (South-East England water utility). These are companies that are operating highly regulated, highly geared, but have very strong cash flows – utility-type companies, whether it’s water, rail, ports, airports – and you’re getting equity-like returns for being much further up the capital structure in that debt space. So you have to wipe out the equity holders before you get touched. That’s a space in the credit market that we do like.

And with the unwinding of CDOs and CLOs, we’re certainly seeing a lot of this paper now being forced on to the market, so loan prices have been quite volatile. They’ve been trading in recent days down to 60¢ in the dollar. Obviously with no defaults, these will drift back towards 100¢ in the dollar.

CDOs are considered the root of all this evil, yet, held to maturity, what are the odds on most of them being 100¢ in the dollar?

There’s good and bad among the structured credit part of the market. A lot of unwind has happened earlier in the credit crisis through hedge fund collapses and unwinds. The latest unwind we’re going through will come with the Lehman Brothers and the underlying exposures to loans – we’re probably seeing that forced liquidation more obviously right now. We’ve certainly been through a period where the SIV (Structured Investment Vehicles) funds unwound – they’re like cash funds that had been invested in a lot of CDOs and as they were downgraded they had to be unwound. We’ve been through many phases to this credit cycle of unwinds. Now the unwinds are more related to banks delevering and needing to clean up their balance sheets.

Closer to home, we’ve had the National Australia Bank having to take a big charge. Is that an example of something that might eventually be written back up?

It is potentially. We’re in a period of total dislocation and if you’re a forced seller, there is a chance that you are going to sell at the worst price and for buyers cashed-up this is a great opportunity. So, if you don’t need to be a forced seller, you would not be selling into these dislocated markets.

Is there a window now to just buy and hold physical fixed interest securities with yields that will really outperform what people tend to expect to get out of an investment portfolio anyway?

I think it’s possible to get 10–12% returns by going into some defensive high-yield assets right now. But again, you do need to do your due diligence. You need to buy those assets that aren’t going to face funding pressures and that are going to ride out the cycle. We do a lot of work on those assets.

What about mortgage-backed securities? How are they trading?

Mortgage-backed securities traded for many years about 20–30 basis points over bank bills and then they widened out to 200 basis points over. In our mind, they’re also a tremendous opportunity in terms of a lot of the seasoned or older pools. Sure, we’re going into slowdown here and some stress in terms of pricing, but there are a lot of pools that are well-seasoned, that have low loan-to-value ratios around 40%, 50%, 60% and you’re getting great yields. That’s another area where we are overweight.