Executive Series 12 Dec 22: Coolabah Capital Investments

Executive Series 12 Dec 22: Coolabah Capital Investments

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[MUSIC PLAYING] TOM PIOTROWSKI: Thanks for joining us today. I am joined by Chris Joye, who is the CIO of Coolabah Capital. Chris, it's a great treat to be able to have you here because we talk a lot about equities, obviously, as a stockbroker, but fixed income has really been ground zero for much of what's happened in the markets in the last couple of years. And that is your specialty-- and that's probably understating things a little bit.

CHRISTOPHER JOYE: Yeah, I mean, I run Coolabah Capital. So I'm chief investment officer. We manage about $12 billion in assets and a range of products that pretty much span the full fixed income universe, from hybrids down the bottom of the capital stack all the way to senior bonds at the top.

TOM PIOTROWSKI: So I suppose what makes-- I'm surprised by how youthful you appear given how volatile fixed income in particular has been over the last couple of years. But that is pretty accurate, isn't it? We have seen some extraordinary moves that is probably quite difficult for the average observer to appreciate. There was a point where a significant proportion of the global bond market was negatively yielding.

Now, we have seen an abrupt about face. We've seen a very rapid increase in rates. I'm just interested in the very simple intellectual process that you have in terms of trying to make sense of those moves. CHRISTOPHER JOYE: Yes, so I think after the GFC-- and really for the last 30 years-- interest rates have come down from circa 17% in 1990 to 0% recently. And that was because we had no inflation.

But we always felt that, in response to the GFC, you get low rates and lots of money printing, and that money printing would bid up the value of all assets. And that would inevitably create excess demand and too much inflation. With the pandemic, we threw in a huge supply shock, and the money printing increased with gusto.

And rates were even more stimulatory. And we also had governments, through fiscal policy, give out record amounts of cash. So we had the mother of all supply and demand-side inflation storms. We've been faced with the highest inflation rates in 30 years-- or actually, 40 years-- and late last year, we argued that rates would have to go much, much higher. So the RBA cash rate was 0, in the US the cash rate was 0, and we argued that the Fed would have to lift its cash rate above 3%.

And 10-year bond yields issued by governments, which were sitting around 1% late last year, we argued would have to go to north of 3.2%. Importantly, that would have a few consequences. We forecast that would reduce the value of equities by more than 30%, specifically US equities. We said crypto would crash in December last year. We said in October last year that Aussie house prices would fall by 15% to 25% and that credit spreads would widen. And that's actually all negative for my asset class.

TOM PIOTROWSKI: Yeah. CHRISTOPHER JOYE: Because fixed-rate bonds, their price falls when yields rise. So what we were saying was terrible for fixed-rate bonds. And when credit spreads widen-- and the credit spread is basically what CBA pays above cash in interest to borrow money from me and my clients-- when those spreads widen, prices also fall. So bond markets had, basically, their worst year in about 100 years, or their worst year ever. In Australia, the Composite Bond Index fell by about 13%.

And everything that we thought would happen more or less came to pass. The quid pro quo is now we sit in a world with really high interest rates, really wide credit spreads. And my asset class, which I really strongly disliked, in fact, we put on $10 billion of bond shorts right late last year through to mid this year to express that negative view, to profit from bond prices falling. But those assets, bonds, which look terrible and have looked terrible for quite a while, suddenly look amazingly attractive.

TOM PIOTROWSKI: They look attractive in relative terms given where we've come from. But the question that the markets struggle with often is, at least in this rate-hiking cycle, what's the terminal point at which they stop hiking? And that's vexing every market at the moment. CHRISTOPHER JOYE: Correct. TOM PIOTROWSKI: What's your thinking around that at the moment? CHRISTOPHER JOYE: So here in Australia, we're at 3.1%. We were at 0.1% last year. And that's the biggest-- that's a 300-basis-point increase.

It's the biggest increase more or less ever. TOM PIOTROWSKI: I mean, the average equity person won't appreciate the magnitude of what-- that's like the meteorite that killed the dinosaurs, is that [INAUDIBLE]? CHRISTOPHER JOYE: I mean, why do think about it is when CBI was lending, and all the banks were lending home loans to customers in 2020 and 2021, and they were offering these super cheap fixed rate deals at circa 2% for three-year or four-year loans, the regulator, APRA, said to the banks at that time, you only need to stress a borrower's capacity to repay by a 2.5% increase in interest rates, or a 250-basis-point increase. And the RBA has now increased rates by 300 with more to come.

TOM PIOTROWSKI: We're likely more than redlining. CHRISTOPHER JOYE: Yeah, we're redlining. So to answer your question, the market is saying that the RBA will finish at a cash rate of about 3.7%. We're at 3.1% right now. Our sense is they may conk out a little bit before then-- so maybe low to mid 3's. But we're talking about the difference between two or three meetings.

Just make no mistake, though, the RBA is absolutely crushing the economy. House prices are falling consumer confidence is today worse than it was in the GFC. Retail spending is nosediving. Business confidence has collapsed. And there is a risk the economy will go into recession. And according to the RBA's own numbers-- and this is the scary thing-- again, we're at a 3.1% cash rate.

We're going to get to about 3 and 1/2%. The RBA's recently released some research showing that if we get to 3 and 1/2% 15% of all borrowers will actually have negative cash flows. Well, what does that mean? The RBA looked at their incomes, and it took off their mortgage repayments and only essential living expenses.

And so 15% are going to basically not have enough money to repay their home loans at a 3 and 1/2% cash rate, which is only a few meetings away. So we think the RBA's probably overdone it. We think the RBA's aping the Fed. So what does that mean for the Fed? So the Fed is currently at 4%. It's going to lift rates by another 50 in this month, in December, and then it meets again in February and March.

It'll probably do a brace of 25s. So the Fed, by March, should be at 5%. The market's pricing about 4.9%.

We think the Fed could go a little bit further-- 5%, 5 and 1/2%. But I think the good news for everybody if you're long-- so if you own housing, commercial property, equities, crypto, bonds-- the good news is that those terminal cash rates are very much just around the corner. They're in sight.

Whereas if you go back into December last year, when we were saying the Fed was going to have to lift rates above 3%, and said 4% and then 5%, the market was saying in December last year that the peak Fed cash rate would be 1%. So we're multiples there. The bad news is-- and this is super important for people to understand-- is the different asset classes adjust with different speeds.

So in my bond portfolio, if the RBA lifts its rate, that day, it's reflected in my portfolio, and my yields instantaneously adjust. If we think about house prices, they started falling in May in response to the hikes, but they'll almost certainly fall for another 6 to 12 months. And if you look at commercial property, they've hardly adjusted. So commercial property yields remain incredibly low.

You earn more on government bonds and senior-ranking bank bonds than you do on commercial property, which makes no sense. Normally, commercial property pays you about 5% above government bonds, and right now, they're paying basically the same yield as government bonds because it's illiquid and it takes time to adjust. Venture capital and private equity, same deal. They will take time to adjust. Equities is liquid, as you know, and our view is that equities have adjusted to much higher interest rates.

We are forecasting a non-trivial US recession. We've been forecasting one since the start of the year. And we are unconvinced that equities are fully pricing in the impact on earnings of not just a US recession, but we think there will be a global recession.

The Bank of England is saying the UK is going into recession. New Zealand is saying-- the NZ, the RBNZ, is saying NZ is going into recession. The likelihood is we've never seen such synchronised global interest rate hikes, and it's likely to have a big impact on demand.

TOM PIOTROWSKI: So that's interesting in relation to, say, for example you've written that when the US adjusts to an inflation shock, the decline tends to be north of 20% over that period in equities. CHRISTOPHER JOYE: Yes. TOM PIOTROWSKI: So the S&P 500, for example, is already down 17% year-to-date terms. CHRISTOPHER JOYE: Yeah.

TOM PIOTROWSKI: How much more do you anticipate as far as the next year is concerned? Is much of the work done on that? But the P and Es are still stubbornly high and not necessarily reflecting a recession in company earnings. CHRISTOPHER JOYE: You're exactly right, Tom. And listen, I'm no equities bear. We just call it as we see it. In March 2020 in the middle of the pandemic, when people said house prices were going to fall 10%, 20%, we said they'd rise 20%, and now we're very bearish. On equities, we were a buyer of equities, actually, for some of our clients.

Even though we're a bond manager, we were buying CBA shares in May 2020 because we thought they were cheap. The sad news, I think, for equities is this. Robert Schiller, who won the Nobel Prize, produces something called a cyclically-adjusted price/earnings multiple that adjusts for the business cycle.

So it's like a longer term PE. And the US equity market is the tail that wags the dog. So when we model equities, we just think about the US because everything's going to follow with some sort of correlation or beta. And in December last year, the US equity market had only once in the last 140 years been more overvalued. And that was right at the peak of the tech boom.

And we've looked at, every time these cyclically-adjusted PEs get above 30 times-- and I think we're at 39 times late last year, it's staggering-- TOM PIOTROWSKI: But then, again, sympathetic to what was happening from a central bank perspective. CHRISTOPHER JOYE: Very sympathetic. Like the PEs late last year, if you believed Phil Lowe that he was not going to raise rates, even think about it, until 2024, and if you believed the bond market that told you the right interest rate on our 10-year Aussie government bond was 1%, not the circa 3% to 4% we have today, then you could make sense of those equity valuations.

But we got the inflation shock that we expected, and yields went much higher, and equities have had to adjust downwards. But here's the data. When we look at every time these cyclically-adjusted-- or they're called CAPE, C-A-P-Es, CAPE PEs, or the CAPE ratios, they go above 30 times, and we're at 39 times, we've modelled since 19-- well, since, actually, I think the late 1800s-- we've modelled what the 10-year returns to equity look like, as in US equities, specifically the S&P 500.

And in the next decade, equities most of the time give you negative returns after adjusting for inflation. There are a few periods where they've given you small positive returns, but the returns are not that flashy. So the problem is, as you say, we've seen the S&P 500, I think, peak-to-trough at some points this year has been down as much as 26%.

NASDAQ has been down as much as, I think, 36%. Equities have adjusted a lot, but the starting point was heinously expensive. The average cyclically-adjusted PE is 15 to 16 times. Today, we're at 29 times. So we are still massively expensive compared to history. And I think a lot of that was explained by the idea that rates would remain low for long, and also the idea that money would be-- as a corollary-- very cheap for a long time.

We do, Tom, this interesting analysis where we hunt for zombie companies globally. And a zombie company is a company that doesn't have enough earnings to pay the interest on its debt for three years running. So EBIT, earnings before interest and tax, is less than their interest expense.

And we've looked at zombies in the US, Europe, UK, and Australia. And we've found that the share of listed firms that fall into that category has almost doubled over the last decade. And today, they account for about 12% to 15% of all listed companies based on FY21 financial data.

This was before we had the rate hikes, when rates were 0%. So think about how many more zombies there are out there today with the RBA's cash rate at 3% rather than 0%. So I think the tech market, growth stocks, I'm not an equity expert. I am an expert on banks, hence why we were trading bank stocks.

But I think balance of probabilities, the returns from equities if we have a synchronised global recession over the next year-- which is our central case-- the returns for equities will be very poor. And I think the existential crisis for all the investors listening to this is this-- bank stocks are paying you, as one example, a fully-franked dividend yield, sound CBA shares, at 5%. But I can get almost 5% on a CBA senior bond. And I can get 6% on a CBA tier two bond. And I can get about 5 and 1/2% on a CBA hybrid. So these are safer securities-- much safer than equity-- and they're giving higher yield than equity.

And that doesn't make sense. It doesn't make sense for commercial property to pay 4 and 1/2% to 5 and 1/2%. Across the Aussie equity market, the fully-franked dividend yield is about 6%, with government bond yields at 3% to 4% and bank bond yields at 5% to 6%. The yields on everything, they need to increase. And the way that happens is through much lower prices.

TOM PIOTROWSKI: So that's the thing to, I suppose, tease out of that last point in particular-- that when you have these extraordinary moves where cash rates are concerned, effectively going to 0, bouncing back, the whole landscape of investments is just distorted or at least-- you could even say it's perverted. I suppose you're in the privilege of position of being able to move quickly within those pricing discrepancies. But then, there's a window of time, I suppose, in which things readjust to a slightly more normalised environment. Are we heading towards anything that's going to look normal in the next little while, given what we've experienced in the last couple of years? CHRISTOPHER JOYE: Yeah.

I think what will happen is, my view is all the central banks will hike too far. Economies will go into recession. They'll pull back rates, but not to 0%. TOM PIOTROWSKI: Yeah, of course not.

CHRISTOPHER JOYE: They won't do QE. They won't print money. So if you look at the US 10-year government bond yield, that sort of implies the Fed's going to 5%, but it may end up at about 3 and 1/2%-- circa 3% to 3 and 1/2%.

And so what that means is in the same way the world spent decades adjusting to ever-decreasing rates, I think we're going to spend probably anywhere from one to three years adjusting to a new normal of structurally higher rates. But I think those rates will be a bit lower than where we are right now. TOM PIOTROWSKI: Right. CHRISTOPHER JOYE: And I think it's also important for investors to understand, we've been hardwired to expect these huge bounces.

Because since 2008, the central banks cut rates to 0%, and then they pulled out the printing press, and they bought everything. They bought all the bonds, and they bought equities. And, of course, that fueled the mother of all rebounds. And this time around, that won't happen. And so what I think happens is you'll probably get some sort of modest bounce, but once asset prices, and I mean everything-- property, crypto, equities, bonds, et cetera-- adjust to the fact that risk-free cash will pay you 3% to 4%, so you'll be able to get TDs for the foreseeable future paying 3% to 4%, and anything competing against term deposits is going to have to pay much more-- thereafter, I think you're going to see markets driven by income growth, not interest rates. So if you think about house prices, all the house price moves, really, since 2007 have been driven by huge changes in the RBA's cash rate.

But once it settles again, I think house prices will track wages. Wages grow at 3% to 4%. House price growth, rather than being 7% to 10%, is likely to be a lot lower. And I think that's also true of equities and other related assets. TOM PIOTROWSKI: So I mean, you touched on it a moment ago, but one thing that has been much discussed is the rate cliff that mortgage holders are going to fall over.

And you spoke about the Reserve Bank arguably goading people into very low rates of borrowing. Things are going to readjust manifestly higher. To what extent is that going to help that mechanism of slowing inflation? Because that's an important inter-relationship. CHRISTOPHER JOYE: Yeah, just to give you the facts, basically, 23% of all Aussie home loans-- of all loans-- switch by the end of the next year from a super cheap fixed rate that was set between 1.75% and 2.25% to a rate that

will be 5% to 6%. So there's going to be the mother of all interest rate shocks on 1/4 of all borrowers. And the RBA, of course, knows this, and they didn't arguably goad. They did go. They told us, go out and borrow, spend, invest.

Go out and take-- Phil Lowe and the RBA expressly said, take advantage of these cheap rates. They gave the banks $188 billion of three-year money at a cost of 0.1% to 0.25% to get the banks to give people cheap three-year loans.

So they were the guys lending. It really wasn't the banks. It was actually the RBA. We got those-- well, I should actually write that up in the [INAUDIBLE].

I don't think I've ever actually expressed it that way. But it was actually we were borrowing-- TOM PIOTROWSKI: [INAUDIBLE] the transmission mechanism. CHRISTOPHER JOYE: Yeah, we were really borrowing off the RBA, not off CBA. And the RBA has, of course, pooh-poohed this a bit and said, well, we didn't promise not to raise rates. But they spent billions defending the yield on the 2024 bond to keep it at 0.1%.

TOM PIOTROWSKI: Which is an expensive signal to send to the market. CHRISTOPHER JOYE: Yeah. So I think to answer your question, for sure, all those 1/4 of borrowers having their interest rates more than double, it's like a second round of rate hikes. It's going to smash the economy and housing.

And that will facilitate inflation coming down. Already in the monthly data, we've seen a big downside surprise in the Aussie inflation data. And everywhere you look-- credit growth, building approvals, retail sales, GDP-- everything's softening. TOM PIOTROWSKI: Yeah. CHRISTOPHER JOYE: And that's all the macro data is going to be really crappy for the next year or two.

And at some point, that will reverse course-- but not completely-- to a new, higher rate. And everyone's going to have to provide-- anyone offering an investment is going to have to provide a really attractive hurdle above a 4% term deposit rate. TOM PIOTROWSKI: So basically, compensating investors for taking risk, which has been something absent from that setup for a while now.

CHRISTOPHER JOYE: Exactly. TOM PIOTROWSKI: The other thing I was going to ask you about is that one thing that has seen a moderation in bond yields-- there's been a bit of a rally from the recent peak-- is that we've seen a moderation in core measures of inflation in particular. That rally is about to have its feet put to the fire later on this week. We're talking just before the release of the US CPI figures. We're also talking just before the interest rate decision in the US as well.

How convinced are you that this moderation in core inflation has got some legs? CHRISTOPHER JOYE: It definitely has legs. The question is, it's one thing to moderate from 8% down to 6%, but the central banks are targeting 2% core inflation. TOM PIOTROWSKI: Yeah. CHRISTOPHER JOYE: So how quickly do we move from the 6% to 2%? And I think that's the question that nobody has the answer to. And I think, unfortunately, the central banks are going to err on the side of being tougher and hiking further. They don't want to leave any doubt at all.

I mean, they never expected this inflation shock. All of last year, they said, don't worry about it. It's all good. And they realise their credibility is on the line, so they are going to smash the economies until they get the weakness they need to see.

So really, what they're very explicitly trying to do is they want to get unemployment up. They want to get wage growth down and demand down. And that will put downward pressure on prices. So they can do that. I think the good thing is they've gone hard and fast. They have been high-conviction.

It is, though, an interesting question to see whether this bond rally can sustain. My expectation is that core inflation will continue to decelerate, but I just don't know whether it will be fast enough to prevent central banks from hiking further. I definitely think they're all going to pause early next year. They've been synchronised on the way up. They're all signalling that they're going to pause.

So the good news is we'll get some relief. But the risk is we see another phase of hikes in the second half of next year. My suspicion is they'll probably be cutting rates-- certainly here in Australia-- in the second half of next year.

TOM PIOTROWSKI: That's an excellent forecast in terms of what our view is, because I think Gareth Aird has been forecasting something along those lines for a while now. But in terms of other markets, I know that many of our listeners are very enthusiastic participators in the hybrid market, and they have been for four years. You play an important role in the hybrid market.

You are the operator of the BetaShares Hybrid ETF. Tell us a little bit about what you're seeing in that landscape at the moment. CHRISTOPHER JOYE: Yeah, so the hybrid market was the best-performing liquid fixed income market in the world in FY22. Nothing beat that I know of. So they've been amazingly resilient.

The supply-demand technicals are favourable because I think there's $1.23 billion that CBA will pay in the next week to the holders of CBA PD when it repays that security-- so a huge amount of cash coming into the system. We have a maturity-- so a hybrid that is due to be repaid in March from ANZ, but that is the last major bank hybrid for 2023.

There will definitely be other major banks issuing next year, but there are no maturities. Spreads are-- the spread above the bank bill rate is roughly about 2 and 1/2% right now. Historically, it's been about 3 and 1/2%. So that spread's a little skinny. But on the other hand, last year, the Bank bill rate-- specifically something called the Quarterly Bank Bill Swap Rate, which is just a proxy for the RBA cash rate-- last year, that was basically 0%.

So in December last year, a five-year CBA hybrid paid you about 2% above bank bills, and bank bills were 0%, so you were at 2%. Right now, they'll pay-- a five-year hybrid will pay about 2 and 1/2% above bank bills, and bank bills are about 3.1%, so you're actually getting 5.6%. So the all-in yield on hybrids is very attractive. And it's very attractive-- you're getting more yield on hybrids than you are on bank shares dividends, even grossed up for franking, more yield on hybrids that what you get in commercial property, a similar yield on hybrids to what you get on the overall equity market.

So on that basis, hybrids are attractive. But when we look up and down the capital stack, we have other options. So I can invest-- if you think about CBA, it's got about 10% of the capital stack in risk-weighted terms is equity. Actually, about 12%, but make the numbers easy.

You've got about 10% in equity, and then you've got some hybrids. And then, above hybrids-- so hybrids are safer than equity-- and above hybrids, you've got something called tier two subordinated bonds, and they're safer again. And above them, you've got senior bank bonds-- so senior-ranking bonds. And above that, you've got deposits.

And above deposits, you've got something called a secured senior covered bond. Now, we invest in all of those. HBRD can invest in all of those. And for the first time in history, something bizarre has happened. We've seen the spread above the bank bill rate on major bank tier 2 bonds it has actually been slightly bigger in the last week or two than the spread on major bank hybrids.

So normally, major bank hybrids pay you about 1.8 times to 2 times the spread that you get on tier 2 bonds from the same issuer. But for a bunch of reasons, hybrid spreads have compressed, which has helped the performance of hybrids, and tier 2 bond spreads have moved wider, which has hurt their performance.

So in HBRD, we've actually been pivoting a little bit. I think we're, in the portfolio, down to around circa 85% hybrids, and we've actually been loading up on tier 2 bonds. So we've got 10% to 15% of the portfolio in tier 2 because, relatively speaking, they pay a more attractive spread now. The, I guess, difficult thing for retail investors and SMSFs is you can only access hybrids on the ASX. ASX, it's very hard to access tier 2 bonds. They're an OTC instrument.

You can access them through HBRD because we're investing in them. But I would say just across the capital structure, we think bank equity looks a bit expensive. We think the hybrid market we're neutral on. The overall yield is very attractive, but the spreads are unattractive.

Tier 2, we think, is absolutely insanely attractive, and we've bought probably about $2 billion of tier 2, and then the bank senior bonds. I was shorting these bonds. We had about $10 billion of shorts late last year through the mid this year. So we were shorting major bank senior bonds last year, and they were trading at a spread-- a five-year CBA senior bond was trading at a spread above bank bills of about 25 basis points last year, and bank bills were paying nothing. So the interest rate was like 0.25% annually.

Now you're getting as much as 1.25% above bank bills. So now you're getting mid-4's. And if you buy-- that's for the floating rate senior bond. If you buy the fixed-rate bond, you've been able to get up towards 5% and even 5 and 1/2% at various points. So bank senior bonds, super attractive. Similarly, yield to the equity, bank 2 super attractive.

Hybrids we're neutral on. Bank equity we're negative on. TOM PIOTROWSKI: So I mean, there's a lot to unpack within that. But I suppose what it ultimately comes down to is that there are historical distortions which have begun to normalise a little bit, but then there are some anomalies-- CHRISTOPHER JOYE: Correct. TOM PIOTROWSKI: --as well.

Bottom line, that's the sort of thing that you would expect when the outlook for rates and inflation is, perhaps, as unclear as it is at the moment. And that represents opportunities that you're probably going to struggle to time yourself as an unprofessional investor, and you're probably going to be looking to what professional investors are doing as a theme. So have you noticed anything happening within that capital stack that suggests these anomalies are going to address themselves longer-term? CHRISTOPHER JOYE: Yes, so I have actually seen a lot of our more sophisticated clients have been coming to us and saying, Chris, buy me the tier 2, or buy me the senior. And we've seen a bit of surge in demand to buy senior and tier 2, particularly in the last month.

I think the demand for the hybrid market is just long and strong. For various portfolio reasons, we've had to sell about, I think, $2 and 1/2 billion of hybrids since March this year, and the liquidity in the hybrid market has been absolutely exceptional. So it's been resilient.

It's super liquid. TOM PIOTROWSKI: Has that surprised you? CHRISTOPHER JOYE: Yeah, we're the biggest participant in the market, and yes, it has surprised us. And we always thought it was much more liquid than people realise, but there's been an underlying depth to the hybrid market that I think is extremely attractive. And the other thing we haven't mentioned is most of these bonds and hybrids are floating-rate, so they absolutely benefit from the RBA lifting the cash rate.

The more the RBA lifts the cash rate, our floating rate bonds interest rate increases, and the price is unaffected. With a fixed-rate bond, if the RBA lifts the cash rate, the yield has to adjust. So the yield goes up and the price goes down. So the hybrid market performed brilliantly in FY22 because, notwithstanding these rate hikes, they just got higher interest rates, and the prices weren't adjusted. And we argued-- I said up Coolabah Capital in 2011, ironically, to prepare for a world of higher interest rates and higher inflation. And, of course, from 2011 through to 2021, all we ever got was ever-falling rates.

And we specialised in building floating-rate portfolios with what you call zero interest rate duration risk. And for folks who had duration risk, that was a more attractive place to be than what we were offering. But I guess the opportunity for floating-rate bonds and floating-rate notes has absolutely materialised now.

And I think that's probably another driver of interest in hybrids where it's a massive, $40 to $50 billion market, and it's floating rate, it's easy to access, and it's profiting from RBA rate hikes. Whereas if you look at a composite bond ETF, and you look at the peak-to-trough of 13% [INAUDIBLE],, you're scratching your head saying, well, my hybrid book was up over the same period. The AA-rated, so the safe bond index, was down 13%, And the BBB- rate hybrids, which are ostensibly much riskier, were up. How does that figure? And equities are getting smashed, and housing and crypto and everything else is getting smashed. So yeah, I think the hybrid market has a really important role to play in portfolios, but I think, as you said, for a professional investor that can access the unlisted or so-called over-the-counter bond market, the opportunities right now are generational.

We have not seen bonds pay higher yields than equities for a very, very long time, and we haven't seen 7% interest rates on CBA and other major bank tier 2 bonds in over a decade. Hence, we bought a couple of billion of them. TOM PIOTROWSKI: That's what you call conviction, I suppose.

But that suggests that from your point of view, perhaps the ceiling is in place for yields as far as the next little while is concerned? CHRISTOPHER JOYE: Yeah, I think, like I said, is when we talk about yields, well, there's probably two key components. One is, where's the RBA cash rate going? The RBA cash rate has to go a little higher. But the bond markets, we're at 3.1%, and remember we talked about the terminal cash rate, which is the bond market's guess as to where the cash rate is going. That's at 3.7%.

So that yield, that 3.7%, is already in, say, a three-year bond. We're getting the benefit of that today.

So I agree, I think balance of probabilities, with one in four home loans switching from fixed to floating and that Armageddon coming into place next year, you'd have to think the terminal cash rate pricing with the RBA seems about right. If anything. I think it's a little high.

So that's 0.1. And the minute the RBA feels like it's done, and is going to genuinely pause, and may even countenance considering easing rates, then what will happen is the yield curve will invert-- which it hasn't, really, in Australia much. It's very flat.

It'll invert because the market will start pricing in cuts. So that's one part of the yield equation. The other part is what I've been referring to as credit spreads.

So remember, we discussed how a year ago CBA was paying 25 over cash to borrow five-year senior bond money from people like me-- although I was shorting, not long, at that point in time. Now, they're paying about 125 over cash or BBSW, or the bank swap rate [INAUDIBLE],, and that cash rate is no longer 0%. It's kind of 3.1%. Those spreads seem quite wide to us. It's not to say that they couldn't go a bit further.

Particularly, we've always struggling with these known unknowns, unknown unknowns. What happens with China and Taiwan, and Russia-Ukraine. So if there are any major risk-off events, yes, I think spreads could bleed wider. But like in tier 2, we've been close to 300 over BBSW and that's where they were in the GFC.

That's where we were in '11-'12, '15-'16. In 2020, for a very short period, we got into the mid-300s. But at that level, I feel like there's a really fat margin for error. TOM PIOTROWSKI: Yeah. CHRISTOPHER JOYE: And the assets are demonstrably cheap.

TOM PIOTROWSKI: And that's been rare in recent years, to feel comfort in that margin of error, because of this pricing of ultra-low rates, right? CHRISTOPHER JOYE: Correct, yeah. You're 100% right. Like everything in the whole world was expensive.

That's what we were saying last year. We're in cash and interest rate-hedged government bonds, because we couldn't buy bank bonds or corporate bonds, which is what we, as a credit manager, we would normally do, because you couldn't rationalise accepting the spreads that were on offer. They were back at 2007 levels, just prior to the GFC. The other thing, the other-- just watch out on this-- we talked about zombie companies.

One area we're very worried about is the high-yield bond market. So if you're a zombie company, and you don't generate enough income to pay the interest on your debt, it's going to be hard to get a loan from a bank. So what do you do? You TOM PIOTROWSKI: Issue junk bonds. CHRISTOPHER JOYE: Yeah, you issue junk bonds, or you go and borrow from a non-bank lenders, or a private loan manager, or a private credit manager. And the private credit market has exploded since the GFC because the regulators in the GFC have said, oh, all you banks are taking away too much risk. We're to clamp down on that risk.

And that made it harder for banks to lend to risky, zombie-style businesses. So they've been funded by non-banks. And our fear is that the new subprime crisis is not going to be in resi lending, because resi lending is very conservative.

There's going to be problems. There'll be defaults, and house prices are falling, blah, blah, blah. But the subprime crisis is going to be in SME and business lending.

And particularly in areas where you have a relatively high share of zombies-- and in our analytics, when we look at the US, UK, Europe, and Australia, the biggest industry sectors that have the highest relative share of zombies are real estate, technology, communications, energy, and health care. And one of the things that the banking regulator in Australia has done really well, I think, is it has steered the banks away from lending against commercial property and resi development property. Because historically in Australia, over the last couple of hundred years commercial and resi development exposures have been the biggest bank-killers. We saw in the '91 recession that ANZ and Westpac almost went insolvent because of their commercial property and resi exposures. And so the banks today, I think, are absolutely rock solid. The four majors are the best-capitalised banks in the world.

But I do believe we're going to see a bunch of defaults and funds freezing in this space. And actually, you might be aware that-- I think it was Blackstone just this week froze their commercial property fund in the US. And why? Because basically, investors were trying to pull their money out because they knew the valuation the fund was claiming was not the right valuation.

The real valuation was much lower. TOM PIOTROWSKI: Yeah. CHRISTOPHER JOYE: You saying this in the REIT market on the ASX. Office REITs and resi development rates have been trading at 40% discounts to net tangible assets.

Why? Because the NTS is BS. And we're hearing it that there's no commercial property trading right now because nobody wants to sell properties at much lower prices and then have to write down all their assets, because that would screw the investors and the lenders who are lending against them. And if you open up these private credit portfolios, they're chock-a-block, chock-a-block full of real estate debt.

So that's another watch out for investors. TOM PIOTROWSKI: Chris, we could go on talking for a lot longer. It's been a real treat having a chat with you today. And this will be the first of, hopefully, many more conversations. So thanks very much for your time. You're about to head off for a holiday, which is no doubt well deserved.

We look forward to kicking off a new round of chats in the new year. CHRISTOPHER JOYE: Yeah, well, thank you, Tom. It's great being here. You're an absolute legend, and a privilege to be invited.

TOM PIOTROWSKI: Thanks, mate, have a good Christmas. CHRISTOPHER JOYE: Thank you, buddy. TOM PIOTROWSKI: Take care.

And thanks for joining us for the "Executive Series."

2022-12-18 09:29

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