We’re all prone to pulling the plug on our portfolios from time to time, but it’s probably not the most productive approach. – Written by Chris Conway | Livewire Markets
There is one only thing you can control in investing. It’s not how an asset class will perform. It’s not what decision a company will make about capital management. It’s not how the terms of trade will affect the Aussie dollar.
It’s the amount of risk you are willing to take at any point in time. That’s it. That’s all you get to decide. Everything else is out of your control.
It’s also why saying, “I’m waiting to see what will happen with (insert random outcome here) before investing” is an inherently flawed investment strategy.
Firstly, you can’t possibly know what will happen and even if you did, you can’t know how markets will react.
Secondly, whilst you might be reducing your risk by doing nothing, you’re also completely eliminating access to any upside.
As such, the better investment strategy is to determine how much risk you are willing to take right now, and then find suitable investments to fulfil that risk profile.
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This idea is not lost on Manning Asset Management founder and portfolio manager Josh Manning, who recalls presenting to institutional clients on the macro outlook 10-15 years ago, discussing how markets were ‘climbing the wall of worry’.
“What’s changed?” he asks emphatically.
“I can’t recall a period when I haven’t been worried since then.
The key is despite the noise, some of which is conjured up so that investors don’t move money away from certain parts of the market, is to assess one’s options and act rationally and objectively”.
Manning adds that he rarely hears people discuss what they are waiting for, and “if they can – i.e. for rate rises to finish – there is an element of belief that post that point, the outlook will be more certain or the entry point more attractive”.
In his experience, “there will always be something hanging over markets, and if in a rare Goldilocks scenario, markets would have likely adjusted (rallied) well before that scenario is clear”.
The misconceptions in fixed income and credit
As part of the conversation around staying appropriately invested, Manning is keen to dispel some misconceptions around fixed income and credit, one of which is that if the macroeconomic outlook worsens and loan defaults rise, an investor in a fixed income or credit fund will lose money.
He notes that whilst loans in these funds may come under more pressure, “this high-level belief ignores the structural protections such funds typically have. Arrears during COVID went up around three times, “did we have any losses?” “No”.
What determines losses is the quality of the book and protections in place, not arrears rates”.
Manning adds that when his fund invests in a pool of loans, “we expect a certain proportion to default and thus, we need to satisfy ourselves that even if those defaults increase several fold, our capital will be safe.
That is why we target investments that have a so-called ‘first loss’ buffer, which absorbs losses from loans defaulting and have ‘excess spread’, which means the pool of loans is yielding a higher gross yield than the corresponding financing costs so if a loss does occur, it can be paid for out of the excess income that the pool is generating”.
As for the current market conditions, Manning notes that he and his team are not seeing signs that the outlook is any worse than the modelled stress scenarios employed at the time the investments in the portfolio were made.
Heads I win, tails I win
In conducting scenario analysis, Manning believes that regardless of what happens next, fixed income and credit, if structured correctly, can deliver positive outcomes for investors – particularly when compared to other asset classes.
“If optimistic, then your immediate primary concern is participation in the upside, and in this regard, investing in credit, which is delivering circa 10% per annum, is a very healthy level of return in absolute and relative to other asset classes perspective.
If pessimistic, your immediate concern is around capital preservation with credit offering an ability for investors to go ‘up the capital structure’ rather than their return being determined by how a company’s equity performs after debt repayments, which takes priority over equity dividends. Credit is a more defensible and through-the-cycle investment if appropriately structured and managed”.
Without fear of ruffling a few equity investor feathers, Manning points out that in 2020, the ASX fell over 30% in response to an unknown risk.
“Equity investors saw their capital decrease to 70c on the dollar, while investors in floating rate asset-backed bonds issued by some of those companies saw their dollar modestly rise in value.
Today, the ASX is still only back at its prior early 2020 levels with those investors only enjoying bond-like dividends yet suffering huge swings in their capital balance, highlighting how powerful more capital stable investments can be in such times”.
On a more serious note, whilst Manning is advocating investors adopt fixed income and credit investments, he’s not advocating tipping out equity exposure altogether. Rather, that fixed income and credit can be a valuable ‘through the cycle’ contributor to a well-balanced portfolio.
“Credit assets can add that resilience either to increase defensive characteristics of ones portfolio or park capital until the outlook improves, given the attractive return profile and capital preservation characteristics of the asset class”.
What are the risks?
Whilst Manning asserts that credit assets, particularly those he invests in, are ‘through the cycle’ investments, nothing comes without risk.
He points out that even within the credit space, “we are seeing more cyclical lending propositions have stronger headwinds such as construction finance, non investment grade corporate debt and some sectors of the commercial property market”.
More broadly, the worst thing that could happen would be a major hit to unemployment – and even then, it would have to happen fast and garner no policy response from the government to do serious damage.
“For unemployment to double in a very short period and the Federal Government not implementing the policy tools utilised over the prior 20 years [would be the biggest risk].
While people can find a job, they typically continue consuming and paying their obligations, which supports business and broader economic activity alongside credit performance.
The other risk, of course, is that investors go into fixed income and credit investments, which are not robust to perform through the economic cycle or invest in such a concentrated way that a single idiosyncratic risk impacts their capital.
The importance of process
As noted above, one of the risks to avoid is going into investments that are not robust, but how does one manage this?
Manning has a process that they have developed over an extended period and, first and foremost, it involves turning down the marketing noise on any opportunity and going back to the source information for a true read.
“We assess if an asset will perform through the economic cycle based on our experience and in-house data sets.
If we do not have conviction around this, it doesn’t matter what the terms or broader opportunity are; it simply isn’t eligible for inclusion within the Manning Monthly Income Fund”.
If the asset passes that first test, the next step is sizing the investment in the portfolio, and Manning “have a clear risk appetite statement, the idea being if credit spreads are wide, that’s the market telling you that the outlook is likely less favourable and thus, taking less risk to achieve our return objective is appropriate.
On the other hand, if credit spreads are narrow, that’s saying the market views the outlook as favourable and it could be argued, is more likely to be caught off guard if a negative event occurs. Accordingly, in a low credit spread environment, it is vital to stick to your stated risk appetite and resist the temptation to chase higher yields with riskier counterparties or reduced covenants”.
As always, it seems discipline in executing the process is the key.
A recent example
Fixed income and credit are often hard to wrap our heads around, so I asked Manning for an example of a recent investment.
He shares that the team recently invested in a diversified pool of secured business loans.
“These loans are typically requested by growing businesses looking to replace existing equipment (think cars/utes/vans/light trucks/equipment and alike) or in addition to current assets.
From a business lending perspective outside mortgage-backed lending (which we also do), it is one of the lowest risk areas given such equipment is typically ‘mission critical’ – that is, the business cannot or will struggle to operate without it and via purchasing this asset, the business can typically increase revenues which in turn shall pay down the loan”.
Manning adds that whilst the loans within the investment have a positive selection bias (normally lending to growing businesses) which increases the chances of those borrowers being of better quality, “we also insisted on a range of structural protections that could see, in this case, arrears and loss rates rise circa 10-fold before our capital was at elevated risk”.
This is the critical element for investors to understand. Everything carries risk but there are protections that can be put in place to mitigate said risks, whilst still delivering a suitable return.
A track record of delivering income
Manning Asset Management is a specialist Fixed Income fund manager whose sole focus is the delivery of a strong and regular income stream to its investors through the economic cycle. Learn more by visiting our website or fund profile below.
