Beneath the yield fixed income investors receive, there are often overlooked avenues of transaction income many investors are missing out on.
The decade high RBA cash rate has been a boon for investors, seeing fixed income expected returns soar. While most investors focus on yield (often termed ‘running yield’), they overlook there are often additional sources of income available from the transaction.
When a new fixed income asset is originated, it should be little surprise that not all investors have the same access or negotiating power. Therefore, terms between investors shall vary. Generally, the larger the investment, the better the economics that can be achieved on a given transaction. As a wholesale capital provider, fund managers like Manning see three important ways to generate returns for their investors.
Firstly and most importantly, fixed income investments typically have a consistent yield paid to the providers of that capital. This rate may be fixed or floating, pegged to the RBA cash rate or bank bill swap rate. In our experience, 80-90% of investor returns come from this source, although the actual percentage can be higher or lower depending on the asset class.
When a new transaction is issued, larger investors can often charge an establishment fee (or upfront fee) of up to 2% (or higher in certain situations), which can be quite material depending on the yield and maturity date of the investment.
Lastly, while uncommon, larger investors may negotiate options or warrants in the issuer themselves in certain circumstances, such as for a newer originator. The rationale being if a manager like Manning can invest a material amount in the new fixed income issuance, that is commercially very attractive to them as opposed to having to court many underlying investors taking time and money, and therefore, there should be some share in the commercial upside. Where this does occur, it is more likely to be in our higher returning strategies (Manning Credit Opportunities Fund) and these can materially boost returns, albeit over a longer timeframe than the above.
How different managers treat these sources of return matters
Across the Australian market, we see a wide range of practices in how these sources of investor returns are shared between fund managers and their investors. In some cases, managers will retain a portion of the yield (e.g. an investment pays 9%, and the manager passes on 8% to the investor, retaining 1% in fees). We also see some managers pass on 100% of the yield and charge a fee for managing the fund overall.
We also see a variety of practices around how the establishment fee is shared with investors. This is a crucial element for investors to consider. The rationale being an issuer of a security is indifferent to paying a 2% establishment fee and 7% yield or a 9% yield assuming a 12 month investment. Therefore, if a manager keeps these establishment fees, that manager is incentivised to trade off investor returns for higher establishment fees in which they keep. This same principle can also be applied to options or warrants when they are not given to the investors whose capital is being used to invest.
Understanding the attribution of your return is key
Investor attraction to fixed income is timely, given the higher expected returns from the elevated RBA cash rate. To maximise investor returns, investors should understand what level of returns are being taken by the manager, and what is being passed on. To do so, an investor needs to understand if the manager is retaining a portion of the running yield, if establishment fees are passed on and if not, how much these fees are and lastly, the treatment of other benefits such as warrants. We believe that providing a manager is transparent and discloses these facts, it’s simply around evaluating how much a manager is paid in total vs the value they deliver to investors and whether the fee structure delivers an alignment of interest that favours investors. If this transparency is not forthcoming, investors should exercise caution, seek further clarification, and consider other investment options if not satisfied.
We urge all investors to understand this equation and ensure the fund manager you are using is genuinely maximising your returns.
(For transparency, I have included how Manning treats such profits
- Percentage reduction in running yield = 0% (i.e. 100% goes to our investors)
- Percentage of establishment fee kept by Manning = 0%
- Percentage of options kept by Manning = 0%
- Manning charges a fee at the Fund level that on average, equates to circa 1% per annum)
