Narrow Road Capital: investing in credit

This week's fund manager interview is with Jonathan Rochford, the CEO, Founder and Portfolio Manager of Narrow Road Capital.

Narrow Road Capital is an institutional credit-based fund manager. It’s not really for retail investors – the minimum investment is $5 million dollars, so that probably cuts you out, but I thought it was worth talking to him about credit, given that we’re in the middle of rate cuts and what’s going on in the world, and income investing is really what he’s on about, or at least, investing in credit.

He’s got some strong views about what central banks are doing and what the world should be doing.

Here’s Jonathan Rochford, the CEO, Founder and Portfolio Manager of Narrow Road Capital.

Jonathan, it’s great to talk to you again, and perhaps you could start by reminding us what your business does, Narrow Road Capital?

Thanks Alan, it’s great to have a quick chat with you today and great for people to get an opportunity to hear something about credits, so thanks for that. Narrow Road Capital is an Aussie credit business working with institutional investors and family offices and there’s a focus on finding the things in Australian credit that are a little bit off the run, a little bit unusual, but that pay a higher yield without necessarily taking additional risk.

Do you mean distressed credit?

It can at times. The opportunities in distressed credit in Australia now are very slim and there’s almost nothing I’ve seen in recent years that I think is worth pursuing, but if you go back to say, 2009 through to 2012, there was a great deal of opportunity to buy things at very cheap prices and ride them for several years and achieve fantastic outcomes from that, so not a great time…

I think the term you use, Jonathan, or a term you use, is ‘cross-over credit’, what does that mean?

Yeah, ‘cross-over credit’ is the cross-over between investment grade and some investment grade, so BBB, BB – and that’s a major part of what I do for clients.

Could you give us an example of something along those lines?

Yeah. There’s probably two main areas I work on for clients at the moment, it’s not limited to these two but it makes up the majority of portfolios. One is the securitisation area, and so there you get different assets down a capital structure from AAA, right down through to unrated equity tranches. I focus quite a bit on the BBB and BB space in that area. Then the other is direct property lending, and so since the banks have pulled back in the last two years, margins have increased quite a lot and even though the cash rate’s fallen, returns are very, very good compared to what you get on a typical investment-grade bond for property debt, that whilst, very illiquid, does have a profile that sits around investment grade.

I take it you mean, lending to developers?

Typically, no. A lot of the things I’m doing are actually constructed complete property. I don’t actually do any sort of constructional and development activity or land-banking. I actually want the property to be built and completed and that makes it something that’s easily saleable if there’s any problems with the repayments.

Right, so how many funds do you have? Do you run it as different funds or what?

It’s all managed separately, so each client has an individual mandate that’s structured to suit them. Different clients will have different preferences, different areas they want to invest in. But, yeah, six clients at the moment and across those clients there’s a mix of anything from AAA, through to BB-type risk.  

I presume that if you’re working for institutions and family offices your minimum investment is quite high?

Yes, starting investment is $5 million dollars.

$5 million! Not many of my subscribers are in that category, I would say. What’s your return been like?

The returns on ‘cross-over credit’ have been just under 10 per cent since inception, and that’s late 2012, Narrow Road Capital. I’ve been managing money for people going back to 2005, so I’ve been doing it for quite a long period of time, but just under the Narrow Road banner it’s just under 10 per cent for the ‘cross-over credit’ space, which is very similar to what the ASX accumulation index has done over that time period.

For investment-grade you’ve got a return of 5.6 per cent since inception?

Yes. That’s something that’s particularly interesting to the institutional space. Big superannuation funds, endowments, will typically have a fairly solid investment-grade portion within their portfolio, and so that’s something that has outperformed the standard sort of investment-grade bond index by quite a bit. The other thing as well within what I do is, almost everything is floating rate and the things that are fixed-rate are short-term, so typically 12 months or less. There’s very little rates exposure in what I do. It’s a real focus on credit and getting paid for, primarily, illiquidity as opposed to credit risk.

Just before we move on, can you tell us what your fees are?

Fees are typically around 20 basis points per annum. It’s a very competitively priced offering for family offices and institutions.

That’s right, 20 basis points, that’s very low! That’s ETF territory.

Yes. Obviously, there’s an ability to get some benefits of scale as you get multiple clients doing the same things and so that’s helpful but the business is run in a fairly lean fashion, so there’s no flying in business class, there’s no nice hotels, things are very much run on an efficient fashion so the clients can get both the higher returns and lower fees.

Good for you, Jonathan. How much have you got under management?

It’s just a little over $100 million dollars at this point.

Right, okay, very good. Isn’t this a bad time to be investing in credit given that interest rates – bond rates and cash rates – are at all-time lows? Aren’t you looking at potential capital losses in future as interest rates rise?

Given I’m floating rate, no. I would very much like rates to increase, that would increase the returns for clients. But if you are investing in fixed-rate government bonds, recently I wrote an article about this topic – why bother with government debt, what’s the point of it? And at this point of the cycle, arguably there isn’t a good reason to hold government debt because you can’t see rates fall too much further from here, they’re so low already, but if they ever reverted to normal levels you would have those capital losses that you’ve mentioned, Alan. Things that are focused on interest rates at the moment, certainly there is that risk of underperformance in the future. If we ever got back to 4-5 per cent cash rates, government bonds and other things that are the long-term interest rate instruments would have a terrible run whilst that repricing happened.

In fact, there’s a lot of government bonds in the world that are priced to yield below zero at the moment, what do you think of that?

Yes, I think it’s crazy, I think central banks are nuts, I think they’ve lost the plot and yeah – I’ve just recently wrote an article about the RBA and it’s not very different from other central banks that it’s stopped looking at its mandate in a long-term way. Putting short-term interest rates as low as they are, quantitative easing, that creates asset price bubbles and debt bubbles.  That means there’ll be some great bargains in the future when financial markets reprice and start looking at both debt, equities property, infrastructure assets, everything. When they start looking at all those assets again in a normal way, there will be some heavy dislocations. Bargains in the future, but right now it is tougher to find cheap things in almost any asset class, I’d say.

In fact, the headline on that article that you put on your website was, ‘The RBA Has Lost its Way’, and the first sub-heading was, ‘Low inflation is not a problem’, so explain what you mean by that.

I’d encourage people to jump on and have a quick read of the article. The main thrust of it is, low inflation isn’t something we should fear, it’s actually a good thing. For centuries, people liked the idea that prices didn’t change by much at all. The idea that even a small amount of deflation is a problem just doesn’t make sense. You look at what people spend on, your groceries, you look at whether you pay rent or buying a house, you look at a car. All these things – if someone said to you in a year’s time, the cost of a car will be 1 per cent cheaper than what it is today, would you say, ‘Okay, well my car’s broken down, the engine’s shot, I’ll just catch public transport for a year everywhere, I’ll just get taxis for a year, because in a years’ time it’ll be 1 per cent cheaper.’?

You’re crazy if you do that. Of course, you’ll go out and buy a new car or when your fridge breaks down you’ll get another one. If you want to buy a new house, you’ll buy a new house. A small amount of deflation wouldn’t be that big a deal, people would keep buying their groceries, they’d keep spending their money.

In fact, as you point out in the article, in the 200 years proceeding World War 1, inflation in the US and I think probably here as well – although it wasn’t 200 years obviously – was close to zero. In fact, there are long periods of deflation during the 19^th Century, weren’t there?

Yes, and it simply wasn’t a problem, technology continued to advance, people continued to make investments, jobs were created… Low inflation is simply just not the bogeyman that central banks tell us it is. The best reason people can give for avoiding low inflation is that governments these days – varying levels, but in Australia a bit less than overseas – governments have debt and so they want inflation because that makes servicing the debt easier. Other than that, you don’t really have a good case for why low inflation is a problem.

Jonathan, it’s not just governments that have got debt. I mean, everyone’s got debt, the amount of household debt, corporate debt, government debt is at record highs. For that reason, isn’t it valid to want inflation to melt away that debt?

In the short-term that argument makes sense. In the short-term you want to make the servicing of debt easier because there’s a risk that any recession and asset price deflation, that’s painful. People lose their jobs for a period of time, people look at their investments and they’ve gone down. I can understand that people want to avoid that in the short-term, but in the long-term what low-interest rates do is they muck up the relationship between how people save, invest and borrow. The lower interest rates go, the more people switch from being savers to borrowers. The classic mechanism is that someone who used to get 5-6-7 per cent on their term deposit, looks at the low return on term deposits and says, ‘Well, why don’t I buy an investment property now?’

And so, they take that savings they had, it becomes the equity and then they borrow on top of that. And so, they’ve gone from being a saver to a borrower. Yes, they’ve got a property asset, but if you multiply that out over an economy, that’s how you can get very high house prices, is all these people who are switching out of safer low-risk assets that were giving them a return they were quite happy with to try and capture the capital gains that Australian property has delivered over the past 20-30 years.

Do you think, just looking at the economy and the way the world works at the moment, do you think we’re in for low inflation for a long time?

There really isn’t a good reason to see it changing, except for places where they go down the hyper-inflationary road. Venezuela and Zimbabwe are recent examples of that. Some countries that print their currencies excessively will go through hyper-inflation. At the moment, someone like Argentina is having a lot of problems as well just from printing money excessively, failing to balance the budget, government spending needs be brought under control. For some economies, that’s what they’ll see, but if all the major economies are printing money in roughly equal measures, you probably don’t see hyper-inflation. But it is a sort of outside long-shot risk that you’ve always got to bear in mind when you’re building your portfolios.

In fact, central banks have been bringing inflation and interest rates down for 30-40 years now since 1980, on average, and in your piece you talk about how low-interest rates cause asset bubbles. Would you assign that to the declining interest rates that have occurred, that the falling interest rates have caused the various bubbles that have occurred in the last few decades?

Well, I think that, but perhaps, more importantly, the RBA’s done its own work and they recently published a paper linking the growth in Australian house prices in large part to the dropping interest rates. They pointed to global interest rates more so than local, but clearly, local interest rates affect local property prices. The yield on all sorts of assets, whether it’s bonds or infrastructure assets – toll roads and airports, commercial property, residential property, all of those yields in some way link back to the long-term expectations of government bonds.

If the long-term expectation for government bonds was 5 per cent instead of closer to 1 per cent, all of the infrastructure, commercial property, residential property, all of those markets would have a substantial fall if a long-term interest rate expectation changed, because everyone would say, ‘Why would I take risks on those assets when I can take close to no risk on Australian government bonds or some AAA rated paper of other corporations or securitisation?’ So, yes, low-interest rates have a big impact on asset prices because people simply compare the yield.

But also the risk-free rate, which is the government bond rate, usually the 10-year rate, is the basis of valuation, isn’t it?

Yes.

As the rate comes down, analysts do their valuations of assets based on that and it increases the valuation. It’s not just a comparison, it’s a valuation. What’s your take on that?

Certainly, that’s exactly what has happened. It has been a big part of the increase in asset prices and if it ever reverts, it’ll be a reason for the unwinding of those asset prices. It’s very much buyer beware of that particular way of looking at the world at the moment.

What do you think will cause it to revert?

Well, will the central banks ever wake up and realise the problems they’ve created? In the short-term, probably not. But in the medium-term, the group of voices – and I’m just one small voice within it – who is speaking about the problems that low-interest rates have caused, who are speaking about debt bubbles and asset price bubbles, how that’s not good for an economy, who are talking about the need for broad tax reform, productivity reform, governments controlling their spending and cutting back on inefficient spending… All those sorts of measures, people who do their economics, who go through the thinking process, are landing at that outcome that that’s where we need to go to.

The people who are linked to the past and who have a narrow view of the world and whose jobs and economic credentials depend on the old views, many of them will stick with it until we get a whopping rate recession and that may include some decent size governments defaulting on their debt. Italy’s an obvious case in point, it’s going down the same road as Greece. At some point, Japan is going to default or restructure its debts. Either that or it keeps printing and goes through a major currency devaluation. Those sort of instances – people generally wait until something like that major happens and that could be quite a while away or could be sooner than we think.

Well, in fact, the Reserve Bank and I think the Fed are miles from waking up, as you put it, they’re in the middle of cutting rates. We’re speaking on the morning of Tuesday, 2^nd of July, the broad consensus is that they’ll cut this afternoon, again, for the second time in a row, if not this afternoon, then next month. So, they’re a long way from, as you put it, waking up.

Yes, they are. I think people are generally expecting a rate cut today and we’ll all find out this afternoon.

One of the things you said in the article in question is that fiscal policy isn’t the answer. As Paul Keating would put it, ‘the pet shop gala’s are saying that at the moment,’ including Philip Lowe, the Governor of the Reserve Bank. Why isn’t it the answer?

Well, part of it I agree with their argument. People are saying, ‘Let’s build some productive infrastructure assets.’ And I agree with that part, we should do that. One of the biggest problems we have at the moment is because we’re importing so many people, all of the engineers, the architects, the construction workers, are pretty much at full capacity, and so you regularly read a newspaper, people say, and we just can’t keep up with all these transport projects, we can’t hire enough staff. The first part of that is we’ve got to stop importing so many people and let the infrastructure catch up to the population we have now. I agree with the concept of building infrastructure, providing it’s stuff that’s going to be efficient and effective, not toll roads that nobody’s going to use because they’re too expensive. That part I agree with, but the problem that everybody’s looking to is that debt’s cheap, therefore we can borrow as much as we like and don’t worry about every paying it back. That’s based on the assumption that debt will remain cheap forever and therefore it’s never going to be a problem servicing it, which locks you into low-interest rates forever if you’re desperate to avoid a recession. Also, there is wasteful spending amongst governments, it’s pretty common knowledge. I think Grattan Institute did one study not too long ago and they said, ‘about a third of health spending was probably wasteful.’ That’s just one starting point.

There’s plenty of spending that could be cut and shift that across to infrastructure spending, keep balancing the budget and ideally getting it back to surplus and start paying down the debt, because the interest isn’t free, you have to pay it in the future. The debt that we take on now, locks in future generations to spending more of their federal budgets and state budgets paying back that debt.

If fiscal policy isn’t the answer or isn’t the alternative to the RBA cutting rates, what is?

Tax reform and productivity reform are the things that pretty much every economist will agree on, that we should be doing it at the moment. Monetary policy and fiscal policy, people debate that. Tax reform, at a very basic level, but tax reform that Australian needs, particularly as the population ages. We need to be reducing income taxes, so that’s both for companies and individuals, particularly individuals. We need to encourage people to work and we do that by lowering income tax rates. Obviously, we need to offset that and so broad-based land taxes, as has been done in the ACT, following that example of bringing in a broad-based land tax both on residential and commercial property and also broadening the GST and potentially increasing the GST as well, so shifting tax collection from income, whereas the population ages there’ll be less people working to assets and wealth, which is you can only get through a land tax and through spending, through the GST.

One of the things that often gets forgotten in the discussion in Australia is that the GST applies to about 45 per cent of our goods and services. In New Zealand, it applies to about 97 per cent, so that’s the kind of shift that we need to make. As the population ages, as people are less focused on income and we’ve got to focus the tax system on wealth and spending and that shift that comes through tax reform.  

Great to talk, Jonathan, thank you.

Thank you, Alan.

That was Jonathan Rochford, the CEO, Founder and Portfolio Manager of Narrow Road Capital.