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Christian Baylis on financial repression in fixed income

Dr. Christian Baylis is Chief Investment Officer at fixed income manager, Fortlake Asset Management, which was established in 2020. For 10 years before founding Fortlake, Christian was Executive Director and Portfolio Manager at UBS.

Financial repression includes policies which deliver negative real rates of return to savers to allow commercial banks and central banks to provide cheap loans to reduce servicing costs for companies and governments. It is called 'repression' because savers are not compensated adequately and there is greater government influence in the economy.


GH: How do you expect to generate returns in fixed interest?

CB: We're taking a different approach to the asset class. Fixed income can be simplified into risk and return, so we've structured our funds into one strategy and three different risk profiles, with commensurate return objectives. So in our short history, the lowest vol (volatility) fund has returned 7% with volatility of 1.7%. Keep that in the context of equity markets with about 15% volatility. In our medium vol fund, the return has been 10.5% with 2.4% volatility, and then the higher vol fund, it's been 15% return with 3.3% volatility.

GH: Those returns have benefitted from some tailwinds, where have the returns come from?

CB: The main point about where we generate our returns is through the financial repression thematic. Real interest rates can go deeply negative, they're not limited by the zero lower bound like nominal interest rates. Over the 1940s and 1950s, we had deeply negative real rates, such as negative 10% and negative 7% (Ed note: these are nominal interest rates adjusted for high inflation to give real rates). And this time around, central banks have tried to stoke inflation and keep interest rates low.

This opens up a big sea of opportunity between the nominal interest rate environment and the real yield environment, and moves into returns along the yield curve, duration, and also corporate structures. We can also play the capital side of this real interest rate thematic. We focus on the integration of these risk silos, so we have a broader opportunity set.

GH: In your previous role at UBS, you managed multi-billion-dollar portfolios. What are your current funds under management and how does it contrast with managing such a large portfolio?

CB: We've tipped over $500 million in the first seven or eight months. The comparison (on fund size) is that it's a lot easier. Your movement around the market can be done in an orderly way without gaining too much attention, whereas at the larger managers, the size of their strategic movements has huge impacts on the market. When a large flow goes through the market, it's very easy and well telegraphed by the brokers who tell other buy-side managers and other brokers what's happening. That affects pricing and the bigger institutions can actually have higher transaction costs, not lower transaction costs because the impact on the market is much larger.

The simple economics are that when we sell our bonds, brokers know there isn't another $200 million order behind it. They know that when we sell, we're probably done, and we don't need to sell to a range of brokers. They know our risk is reasonably limited compared to say someone with $50 or $60 billion under management. A broker doesn't want to be lumped with  risk knowing that another broker is about to be lumped with it as well. That really starts to impact the market so that huge size can be a detriment to returns, particularly in a low-yield environment where transaction costs are so important.

Whenever I hear of managers talking about all the trading they're doing, I squirm a bit. It’s bad for the end investor because they are chewing up returns with frictional costs. And that's really hard to get back, transaction costs are fixed and certain whereas the return side of the ledger is highly uncertain. To trade away a certain negative for an uncertain positive, one needs to be reasonably assured of the pricing of that risk. because we all operate in a world of uncertainty and there's always an element of risk in what we do.

GH: I noticed in your Real Income Fund’s last report, you had 260 issues in the portfolio. So is there another side to being a smaller player? Are you able to command institutional prices when you're dealing in relatively small parcels?

CB: It's really about having minimal impact on the market. You're trying to be light on your feet and not being overexposed to one single part or point at the market or one particular issue. With large single-name investments, you're exposed to idiosyncratic risk. For example, who would have thought the Brisbane and Sydney Airports and stable names such as universities, would be under financial pressure? But we’ve had a pandemic, a one-in-100-year event. So spreading yourself across a range of different names is the better way to approach fixed income. There are much greater asymmetries in our asset class.

It's different with equities. You live and die by the upside. Fixed income lives and dies by the downside. An upside surprise for us might add a handful of basis points to performance but when you have a downside surprise, that can rip a hole in your return profile. If you have a 1% allocation to an issue that defaults and you lose 100% of that name in a low-yield environment, that can lead to 80 to 90% of the excess performance gone. You need to know what you're doing in each single exposure.

GH: And another fund, the Sigma Fund, has 68% of its exposure to Australian issues. Is the local market deep enough to find the best opportunities?

CB: You need a strong rationale to go offshore and buy bonds in a foreign currency. In crisis periods, currency hedges have large, outsized effects on portfolios when there are huge amounts of currency volatility. So our belief is that the core of the portfolio should be set up in very high quality AUD or domestic names, and that only special opportunities in offshore markets should be added into the portfolio.

GH: But is the range of issuers and types of bonds and liquidity good enough in the Australian market?

CB: Let's say about 40% of the domestic market is financial institutions and ADIs which are all repo eligible so the liquidity is good, and it's dominated by the major banks anyway. So we think the better way of structuring portfolios is to have a very clean liquid core. And then for our higher returning portfolio we can reach out for the higher-octane type of maturity or issuer. So you'll find that 70% of the fund is very stable but the other 30% swings around with the degrees of risk and opportunities that are out there in the global market.

GH: You wrote recently about how economies will be less resilient to shocks in future due to the massive spending we've seen in the last 18 months. It’s notable that the market hasn't really delivered any adverse consequences yet, we still see the US 10-year bond around 1.3%, near the Australian level. The signs of inflation are not translating significantly into bond markets and we have equity markets at all-time high. Why are markets relatively complacent and do you see the threats and the weaknesses in the future?

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CB: Again, this goes to the heart of the financial repression thematic, the magic that we're experiencing worldwide. Low nominal interest rates help to reduce debt servicing costs, obviously. A high incidence of negative real interest rates effectively liquidates or restructures existing debt. And so the simple arithmetic is that if you have $100 of debt, you've got 5% of inflation, effectively, you've been given a free restructuring of 5% of the debt, that's been wiped out just by inflation.

So that's what we call liquidation of debt or financial repression, that's inflation solving our debt problems if we keep real interest rates very low for a long period of time. And so, financial repression is the most successful format, in terms of liquidating debts, and that's really what Japan's been doing or at least trying to do. That's where we're all going. We can run these high debt loads on the basis that inflation is going to pick up at some future point and solve our problems via an inflation led restructure.

So throughout history when you look at it, the debt to GDP ratios have been reduced by one, economic growth, two, a substantive fiscal adjustment or some type of austerity, three, explicit defaults restructuring private and public sector debt. And four, a sudden burst of inflation and five, a steady dosage of financial repression. The high-yield market has basically had no defaults since January 2021, so this repression is really working in bringing zombie companies back to life. Spreads have come a long way as well. Those markets, typically priced for 20% probability of default, are experiencing one-tenth of that.

And central banks are buying risk assets, buying high-yield bonds, buying state government debt, all this sort of stuff and it's creating this displacement effect where people like us sell those bonds to the government or the RBA or the Federal Reserve, and then we move down the risk curve and buy things like hybrids and Tier 1 debt, so everyone's just constantly ratcheting down into these high-risk parts of the market.

I think it's a time for being very conservative in the way we approach risk assets because we don't know what this will look like once central banks step away from these types of assets.

GH: And do you think that this is building in some vulnerability in the future?

CB: Without a doubt because we're too used to the medication that's been given to us. And the risk for us is that, once the stabilising beams are taken away, we have lost our market coordination, so to speak. There's been no psychological scarring and it's very easy to forget this ever happened. Who would have thought that with the biggest fall in GDP it would also be the briefest and condensed into such a short time frame? Moreover it is now accompanied by record highs in the equity market. This is the scale of the official sector involvement in our assets and that masks over what's been ultimately a horrific real experience in the economy. So there's a huge disconnect and it's all artificial and inorganic and we really need to see how this plays out.

GH: Yes, and one result is governments have been spending money to make wealthy people wealthier, so there's an inequity about all this as well.

CB: Yes, the savings rate that has gone up to 20%+ in the US and similar here and it is correlated and equivalent to the amount of debt that's been taken on by the public sector. It's been a huge fiscal transfer from government balance sheet across to the private sector and directly into those savings accounts. The consumer is bound up and ready to spend. They've got huge capacity on the saving side to come out and do what they need to do, and this goes to the unintended consequences on the inflation side when that gets unleashed. They are heavily incentivized to spend quickly as inflation exposed savings accounts are losing around 2-3% per annum. The real side of the economy doesn't have the capacity to respond to it due to the latency in scaling up supply chains, you may actually get disorderly inflation outcomes or at the very least the probability of this is far higher coming out of a one-in-100 year event. You need to be prepared and you need to be hedged for it.

GH: Finally, tell me about the access point to your funds. You don't have any listed funds yet, any plans in that direction.

CB: Yes, we do have plans to offer all our funds through an ETF format with Chi-X. We have the scale for a listed fund now and that's where the market is going.


Graham Hand is Managing Editor of Firstlinks. Dr. Christian Baylis is Chief Investment Officer at Fortlake Asset Management, a boutique fixed income manager affiliated with Income Asset Management (ASX:INY), formerly Cashwerkz (ASX:CWZ), a sponsor of Firstlinks.

This article is general information and does not consider the circumstances of any investor. Please consider financial advice for your personal circumstances.

For more articles and papers from IAM Capital markets, please click here.


September 05, 2021

I've read this through a couple of times but is Dr Baylis just basically saying buy inflation linked bonds rather than ordinary ones?

Fortlake Enquiries
September 06, 2021

Thanks for the question Graeme - Inflation-linked bonds (ILBs) are a good start, but they also have duration, which means you can be exposed to interest rate risk. Equally, ILBs tend to be issued by governments and not many corporates tend to issue them, meaning you also give up on return. Consequently, hedging inflation can be done in a variety of ways which doesn't necessarily have to happen via ILBs. There are numerous ways in which we can buy inflation insurance across global markets, in order to avoid the drop in return and negate interest rate risk.

September 06, 2021

"There are numerous ways in which we can buy inflation insurance across global markets, in order to avoid the drop in return and negate interest rate risk."

Perhaps a couple of examples would be helpful please?!

Fortlake Enquiries
September 03, 2021

Great question Mark - Anything with a fixed price or fixed dollar amount is explicitly exposed to inflation. As are nominal contracts, which don't allow for inflation. Governments earn inflation-linked revenue and therefore it is beneficial for them to issue bonds or have liabilities that are not linked to inflation, especially so if inflation is likely to be higher in the future. This creates a gap between the revenue and the liability which compounds over time at the inflation rate.

The building of the Harbour Bridge is a simple and useful example here - originally built for $13.5 million - let's assume the NSW government borrowed all of that in 1923 with fixed-rate debt when it was built. Revenue back then was in the order of 80,000 pounds ($160,000) per year, to start with. The revenue from the Harbour Bridge is approximately $7 million a year today as inflation has run at 3.9% on average for 98 years, since 1923. Assuming the number of cars crossing the bridge remains constant, only for the benefit of this example, we can see how inflation over time eroded the significance of the debt load. It took 65 years to pay off the Harbour Bridge (1988) whereas it could now be paid off within 2 years of revenue. Moreover, if inflation had run at double the pace from 1923 to 2021 revenue from the Harbour Bridge would now pay off the debt load within approximately 9 months. You can see here the significance of the inflation rate and what a difference it can make.

September 03, 2021

Thanks, I've been wondering what this financial repression meant. As I retiree, I certainly feel repressed by low rates and the RBA giving priority to property investors who did not need to make owning a home even more difficult for first home buyers. We're leaving behind a generation who will never own a home which we all took for granted.

September 02, 2021

Thank you for this informative interview. Could you please explain the below debt example further from a corporate or individual borrowers perspective, in terms of how 5% of the $100 debt has been wiped out by inflation.

CB: Again, this goes to the heart of the financial repression thematic, the magic that we're experiencing worldwide. Low nominal interest rates help to reduce debt servicing costs, obviously. A high incidence of negative real interest rates effectively liquidates or restructures existing debt. And so the simple arithmetic is that if you have $100 of debt, you've got 5% of inflation, effectively, you've been given a free restructuring of 5% of the debt, that's been wiped out just by inflation.


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