Ying Yi Ann Cheng, Portfolio Manager of the Switzer Higher Yield Fund appeared on Switzer TV to discuss whether central banks can keep interest rates low over the next few years and the impact this has on the bond market.
Peter Switzer (PS): Joining me now is Ying Yi Ann Cheng from Coolabah Capital. She is an expert on the bond market and where interest rates are, where they might be going. Of course, anyone in the property market is comfortable about what’s going to happen with interest rates. Ying Yi Ann, thanks for joining us on the program.
Ying Yi Ann Cheng (YYAC): Thanks, Peter, for having me on.
PS: Let’s just talk about what you’re thinking the reserve bank might do over the next two to three years.
YYAC: That’s a very extensive amount of time, Peter. I think, just given their objectives, and we’ve spoken about this before, with respect to the RBA needing to meet their inflation and employment objectives, though thus far they’re obviously behind on their inflation targets. We’re not at the 2 to 3% sort of band that they envisage us being. In order for them to get to that 2 to 3% inflation, they really need wage inflation. Currently, with the unemployment rate where it is, we need to get to a level to bring that unemployment right down towards the non-accelerating rate of employment. That’s probably in the RBAs mind, around circa 4.5 % and we’re not there yet.
What they need to do is, we need to create the jobs, we need to continue providing stimulus. In terms of what the RBA can do? The policy tools are mostly exhausted in terms of the cash rate. We already have the RBA cash rate at 0.1% and they’ve expressed the fact that they don’t want to move to negative rates. We’re already at the effective lower band there. In terms of the Term Funding Facility, whereby they can lend to the banks out to three years at a very discounted rate – that rate is currently 0.1%. The banks are awash with liquidity and the banks, frankly speaking, haven’t drawn upon this Term Funding Facility since October last year.
If the banks are not drawing upon this facility and we’re already at the effective lower value in cash rates, what else can they do? What we saw the RBA do last year was, in November they started doing QEing where they committed to buying a hundred billion dollars of Commonwealth and state government bonds over the next six months. This program finishes in April. Earlier this month, they announced that they would do another round of QEing – QE 2.0. The reason I touch upon that, QE1 and QE 2.0, and that’s whereby they’ve committed to another hundred billion dollars.
PS: Explain to my viewers, how QE, this quantitative easing, and you’ve said, there’s been one and there’s been two and there might be a third – how does that actually get money into the economy to keep interest rights low?
YYAC: Quantitative easing is not a particularly directed tool. Unlike fiscal policy where you can really put money into the hands of individuals and businesses, with quantitative easing, it involves the purchases of, in this case, Commonwealth government bonds and state government bonds. The objective of that is really to get to lower the yield on these bonds. Lowering the yield means that you’re lowering the interest rate. The idea behind that is that if we can lower the yield at which these state governments and the Commonwealth government issues their debt, that lowers their costs of borrowing, which means that they can have a cheaper source of funds to then create programs and stimulate the economy.
What we’ve seen with COVID is a lot of the private sector has been impaired, as people aren’t necessarily going out and spending money. Although, retail sales are what it is and there’s a lot of online shopping that’s taking place. The dynamics are different there, but what some businesses are hesitant about is creating new jobs. For example, because they’re a bit still uncertain about what the economy could look like six months or a year down the track – we really need the government to spend and create programs to create jobs. The state governments can create infrastructure. These are much longer dated programs that will sustain job growth to really get that employment up and therefore push the unemployment rate down towards that non-accelerating rate of unemployment.
PS: So for people who want to borrow, or are thinking about borrowing to buy a house, what you’re kind of implying is that the reserve bank is creating a very positive economic environment, where at the same time interest rates are likely to stay low for a long time, which is not what we usually expect. We expect that when we get strong growth, we find interest rates start creeping up and eventually chokes it off. You seem to be implying that this is going to be a very special episode in the history of interest rates and economic growth.
YYAC: I think it’s fairly clear from what the RBA said, that because they’ve undershot inflation for a while they’re willing to let inflation potentially overshoot, at least they are implying that they’ll be comfortable with inflation overshooting when we do see that inflation. What, Guy Debelle, the assistant governor, said is that, if anything they’ll err on the side of caution, on doing arguably too much QE rather than too little.
PS: That’s really interesting. Now I know you don’t tend to get into the controversial area of what property prices are going to do, but your your colleague and founder Chris Joye loves to do that. I’m sure you understand what the company view is on property prices. What is the outlook on property prices?
YYAC: We are expecting house prices to rise another 10 to 20%, we’re quite bullish on housing and frankly speaking, that’s because we are seeing the property market really hot at the moment. That continues to be the case. I mean, anecdotally as well. I’m hearing that in Queensland, in parts of Brisbane, there’s not enough housing supply. There’s a lot of interstate movement which is pushing things higher out there. A lot of people are moving up to the sunshine state and as a result, there’s not enough housing and the market’s crazy.
We both live in Sydney and things are going extremely well. Auction clearance rates are extremely healthy. I think also the New South Wales government is proposing to move away from that lumpy stamp duty – that one-off lumpy at the start to move towards more of a land tax, almost an annuity style sort of revenue stream to them, which will make it much more affordable. Frankly speaking, stamp duty is almost like another deposit in itself for a lot of buyers. We can reduce that amount and spread it over multiple years, which removes one of the biggest road blocks for a lot of, particularly first home buyers.
PS: The outlook for interest rates remains low. The outlook for property prices remains on the up. I know you don’t make predictions around economic growth, but the implication is we’re looking at some periods of serious economic growth over the next one to two years.
YYAC: Yes. That’s the objective because we need that growth. We need to take out any sort of slack from the economy in order to create that sort of inflation. Inflation won’t be an issue or a concern in the future, but it may appear in say five years’ time at which point, and we’ve spoken about this many times, this is why we don’t have any interest rate duration or what we call fixed rate risk in our portfolios and not in that Switzer Higher Yield Fund you’ll find it that we run for Switzer.
The reason behind that is because in a rising rate environment, which is what happens when you start to get inflation, you have a central bank that wants to hold inflation, fixed rate bonds sell off. At the moment, we’re not going to see duration. What we call duration or fixed rate risk run anywhere too dramatically because the RBA is going to be holding rates. They’re not going to be cutting rates further.
In fact, what we’re seeing in the interest rate markets is that the market is already getting ahead of itself. They’re actually pricing in what we call the reflation trade. In the US, in anticipation of all this stimulus coming out of the Biden government, we’ve seen what we call ten-year US Treasuries sell off dramatically, i.e. the yield that you push higher and what we call the yield curve steepens and that’s affected our market as well, because the Aussie interest rate market is also driven by expectations around the US market. So, markets are already getting ahead of themselves on that reflation trend. The fixed rate bonds have had a very volatile period in the last couple of months.
PS: Do you think that there could be a real butting of the heads of central banks versus the bond markets themselves?
YYAC: Potentially. The objective of the RBA is trying to push the yields on Aussie government bonds lower and where they’re buying is 5 to 10-year government bonds. Yet our government bond yields are pushing higher because of what the market’s doing. They can’t control that but there is potentially quite a bit of angst around that.
PS: You did bring up the Switzer Higher Yield Fund. How has it been performing?
YYAC: It’s done exceptionally well. Inception was the 18th of December 2020 so it’s still fresh. You’ve known Coolabah for quite a long time, our inception on our first strategies was 2012. We’ve got a very strong track record. Since the Switzer Higher Yield Fund’s inception, the portfolio has done a 0.52% versus the benchmark of the RBA cash rate plus 1.5%, which only means 0.19%. What we call the ‘alpha’ or the excess return has been 0.33%. In the month of January, the Switzer Higher Yield portfolio has done 34 basis points or 0.34% versus the benchmark of 0.13%. In that month alone, there’s been 0.2% of out-performance.
PS: On an annual basis, what’s the goal and what have the first few months made you think this goal is possible?
YAAC: The benchmark is the overnight cash rate plus 1.5%, so that’s 0.1% at the moment and that makes the benchmark 1.6%. In the month of January, we’ve had about 0.2% of out-performance, but as I like to remind everyone, past performance is not a guide to future returns. All I can say is the benchmark is 1.6% given where the overnight cash rate is. In the month of January, we’ve had in 0.2% above performance. Whether you want to annualise that or not, I will leave that to you, but again past performance is no guide to future returns.
PS: That’s right. I think the bottom line is: this is not a fixed a deposit, the bank said there’s no guarantees but you guys tell my viewers what you’re invested in in this fund, because they tend to be very secure type investments.
YAAC: The philosophy that we have at Coolabah and particularly with respect to the Switzer Higher Yield Fund is we only focus on entities that are highly rated that have very little intrinsic credit risk. This would include oligopolies or monopolies and edgies that have items with zero explicit government guarantee. Examples of the types of issuers that we would invest in would include, for example the Aussie major banks, like a Woolworths or a Coles, very strong oligopolies, after Singtel. We’re very conservative in the types of credit risks that we put in the portfolio.
By the way, a large proportion of the portfolio is also in state government bonds as well. We are very active in how we manage things. We’re not a traditional buyer to hold to maturity sort of investor. So typically in fixed income, you see a lot of managers that try to drive returns through giving you more fixed rate risks, or they give you more credit risk, or they give you more illiquidity risk. What we’re doing at Coolabah is, we’re trying to minimize those sorts of risks.
Average credit rating tends to be either A to AA. In the case of this portfolio, the average credit rating typically is probably around A, and what we’re doing there is we’re seeking to look for bonds that are what we call ‘this price’. We’re looking for bonds that are paying too much interest after you adjust for all the risk factors. After you adjust for its credit rating, its turn to maturity, the liquidity of the bond, where does the bond sit in the capital structure, the industry of the issuer, and after adjusting for all of the risk factors, some of which I mentioned, what we’ll do is we’ll look to buy those bonds that are paying too much interest, as long as we’re comfortable with the underlying credit risk. Then as that interest rate or credit spread drops towards bear value, we sell it for a capital gain, so much like your active equities manager, but in fixed income and really concentrating on highly rated securities issued by entities that I mentioned to you, Peter.
PS: Ying Yi Ann Cheng, you really make it sound exciting and it’s really hard for the bond market, let me tell you. Thanks for joining us on the program. We’ll talk to you in a few weeks’ time. Thank you.
YYAC: Thank you.