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Money where the mouth is
2023 was undoubtedly a bumpy road for fixed income returns, with volatility in abundance as markets continually repriced up and down the path of central bank policy rates in Australia and the US. Over the year, the Research Team was able to capitalise on attractive relative value opportunities, generating alpha 74% of the time on our Buy recommendations (n=35) with an average 5.96% annualised alpha. In total, we issued 182 recommendation changes across 51 unique issuers over 2023.
Against the respective benchmark for each security, our Conviction recommendations (Buy, Sell or Subscribe) provided alpha 54% of the time (n=69), with outperformance dragged down by Sell recommendation performance. When using APRA’s stipulated benchmark, this rises to 67%.
Other highlights include: (1) (i) an average IRR of 16.0% across all our Buy recommendations (n=35), (ii) an average IRR of 17.3% across Buy recommendations on Investment Grade bonds (n=27), (2) (i) alpha generated 85% of the time across our Investment Grade Buy recommendations (n=27), and (ii) a 71% IRR win/loss rate across all our Conviction recommendations made over the year (n=69) and a 97% IRR win/loss rate across all Buy recommendations (n=35).
This is the third edition of our annual Research Review. We have outlined our method of revewing performance below, have highlighted key charts and data, and referenced the best and worst on the desk for 2023. For full disclosure, we have also provided a non-exhaustive list of limitations to the methodology we use to assess performance. Links to prior editions can be found in the back of this report.
Methodology
This analysis is focused on recommendations on credit securities (i.e. bonds, hybrids, and convertibles) and not our Fund Research. All BondAdviser recommendations are timestamped and stored externally in digital format. Such data has been extracted and performance has been calculated in the form of both the unannualised holding period return (HPR) and the annualised internal rates of return (IRR). The start date of performance is determined by the date of a change in rating. The final date of performance is also determined by the date of a change in rating, or where such date is not applicable, the last trading day of the year (or the maturity/call date if no longer trading). Put simply, we define trades as where there is a change in recommendation, and so if we update our credit analysis without a change in recommendation, it is not considered a final trade until either the recommendation is changed, or the end of the year is reached.
In the event where a security remains outstanding at the end of the year, the final date used for calculations is the last trading day of the year. In order to count the entire recommendation across all periods each year, we then use the first trading day of the year as the initial price for the remainder of the trade until a change in opinion the following year. This trade is then included in the annual research review in the following year.
In determining alpha (α), we have opted to be more granular with our assessment – compared to that of simplifying the analysis with a broadly used benchmark metric such as the AusBond Composite Index (BACM0). In using a more characteristic benchmark than BACM0, generally, our investment grade securitites that are fixed rate are compared against the AusBond Credit Index (BACR0); investment grade floating rate securities are compared against the AusBond Credit FRN Index (BAFRN0); while high-yield or non-rated securities are compared against the S&P Australia High Yield Corporate Bond Index (SPAUHYTT). Our alpha calculations use the IRR of both the benchmark and the security recommendation over the time period of the recommendation.
Otherwise, regulatory capital is compared against our proprietary Index Platform, which uses a rules-based, market-weighted calculation of total return (on a franked basis where applicable). Tier 2 securities are compared against the AUD-denominated BondAdviser Australian Tier 2 Index (BAAUT20DNTR), which excludes issuers of risk outside that of Australia and New Zealand. AT1 Hybrid Securities are compared in two formats, firstly, against that of the Australian issuer, AUD-denominated market (BAAUAT1DFTR) and secondly, against a more comparable risk profile, split up by the Big Four Banks (BAB4AT1DFTR) and the Non-Majors (BANMAT1DFTR). Unlike all the other benchmarks, these two differ slightly in that securities must have an expected remaining term to call of greater than a year.
We have used BACM0 as a low watermark in some charts for reference. Additionally, exclusive to Figures 7 and 8, we have calculated alpha differently, based on APRA’s requirements of using BACM0 as the benchmark.
Analysing the Research Team’s recommendations is done across multiple criteria, including nominal returns, time adjusted returns, and opportunity costs. Furthermore, we separate recommendations by type; in terms of Subscribe, Buy, Hold, and Sell. Lastly, we separate by sub-asset type. It is worth noting a Subscribe recommendation is different as it is a primary market recommendation, while Buy, Hold and Sell all apply to secondary markets. Over 2023, we issued 9 Subscribe recommendations and did not issue any Do Not Subscribe recommendations, with 89% of Subscribe recommendations generating a positive IRR, and 56% providing alpha. Across 2023 we made 35 Buy recommendations, 25 Sell recommendations, and 113 Hold recommendations.
In terms of sub-asset classes, we have split our universe into three main groups: 1) Investment Grade and High Yield, 2) Financials and Corporates and 3) the AT1 market. This provides a more granular breakdown of the Research team’s recommendations made over the year.
Benchmarking Against Your Future, Your Super
Whilst our first piece of alpha analysis assigns benchmarks to each trade based upon our methodology, Figures 7 and 8 display our relative performance to the catch-all fixed income index stipulated by APRA, the AusBond Composite Index. The Index is widely known but is not necessarily the best indicator of relative performance on a broad basis across all securities. This is because it is largely composed of government bonds (91% as at 26 April 2024), and is consequently duration-heavy but also lower-risk, which may not be a good benchmark for certain market subsets such as the AT1 market.
The AusBond Composite had a bumpy year as a function of markets continually repricing the path of central bank policy rates and economic data (the latter namely being a strong driver of long-term yields). Given the index primarily contains government bonds and high quality corporate credits with significant fixed-rate exposure (5-year weighted average modified duration), this had a significant impact on monthly return volatility. Despite bumpiness along the road, the index ended the year strongly on global rate cut expectations priced in by the market, finishing the year with a modest 5.1% annual return for a low-risk, AA+ rated index.
Under such benchmarking criteria, our relative performance on Buy recommendations was robust; with a 13.78% mean and 7.91% median alpha recorded across 35 Buy recommendations, with a 91% alpha win/loss rate. In terms of all Conviction recommendations, we generated a mean and median alpha of 6.36% and 3.80%, respectively, with an alpha win/loss ratio of 67%.
Our relative performance on our Sell recommendations was considerably weaker, with an average and median alpha of -4.44% and -6.09% versus the AusBond Composite across 25 Sell recommendations, respectively. This was a 24% alpha win/loss ratio, and was comparable to our performance last year across Sell recommendations. On reflection, while our Sell recommendations reflect our perceived overvaluation of securities, ultimately significant spread widening (and in the case of fixed-rate bonds, risk-free rate widening) is required to offset the coupon income (i.e. think negative carry) which generates negative returns from a “short” perspective. This is why Sell recommendations require the highest level of conviction, as these recommendations have to compete against returns attributable from carry. Additionally, for all recommendations (Buy, Sell, Hold, Subscribe), the AusBond Compsite may not be the best benchmark for specific securities, such as floating-rate securities, and the riskier spectrum of credits, given differences in interest rate duration exposure and credit risk exposure.
Investment Grade – Positive Result Weighed Down By Sell Performance
While performance results in this section include AT1 hybrids, discussion of such individual security returns is in the following section.
Whilst our performance across the Investment Grade space was strong over 2022 amid one of the worst years for bonds on record, we delivered even stronger results over 2023. We made 132 recommendations across Investment Grade securities, of which 49 were Conviction recommendations. Across all Investment Grade securities, we generated an average 9.42% IRR (3.47% HPR, across varying time periods for underlying recommendations), outperforming the relevant benchmarks by 1.48% on average. Across our Buy recommendations, we generated an average alpha of 7.70%, with an average 17.3% IRR (5.07% HPR). With bond markets ending the year positive, this made it hard to generate positive returns from Sell recommendations, despite perceived security overvaluation. As a result, our Sell recommendations underperformed the relevant benchmarks by 6.61% on average, with a -3.11% annualised average IRR (-1.47% HPR).
Some of our best performing recommendations were made across AT1 hybrids. These types of recommendations we make are generally short-term, capitalising on any mispricing that may arise as a result of a relatively inefficient market. We use our proprietary technology to capitalise on these opportunities. We discuss these trades in detail in the AT1 section.
Some of our strongest (non-AT1) Buy trades included SCA 2.45% 2029 and Wesfarmers SLB 2.550% 2031, which generated alphas of 42.2% (64.8% IRR) and 35.3% (49.9% IRR) on, respectively. For the Wesfarmers bond, we saw attractive valuation claims after spreads were still elevated from the June 2022 market selloff. After significant spread tightening, we viewed value to have faded, closing out the trade with a Hold recommendation. Whilst credit spread tightening benefitted the price of these bonds, falling risk-free rates from the end of December 2022 to the date we closed our trade in February 2023 was also a tailwind to strong alpha generated, given this bond had greater duration than the benchmark (AusBond Credit, ~3.15-years modified duration).
High Yield – Unexpectedly Risk On Year Drove Strong Market Performance
After a tumultuous 2022, fixed income markets started 2023 strong, much to the surprise of market consensus predicting economic fallout from one of the fastest interest rate hiking cycles of all time across developed economies. Whilst there were bumps in the road during the year, the high yield markets in the US and Australia finished the year strongly with significant spread compression driven by markets pricing in seven rate cuts in the US, and lower risk-free rates on stronger economic growth expectations. We had less conviction in Buy recommendations at the more speculative ends of the markets, given our house view of economic deterioration driving the credit spreads of riskier issuers higher. We appreciate liquidity is often difficult here, and a domestic high yield benchmark is yet to be adopted institutionally, which makes performance comparison difficult. We also caveat that the benchmark index we use for corporate high yield bonds has only three underlying constituents, which is a result of a limited rated corporate high yield bond market in Australia.
Using the S&P Australia High Yield Corporate Bond Index, we were burnt from an alpha perspective given such a strong rally in benchmark high yield spreads and risk-free rates occurring at the back half of the year. The rally in spreads and risk-free rates was sudden and unexpected, and in our view, unfounded given risks are still on the horizon. Across the 50 High Yield recommendations we made over 2023, we produced an average and median IRR of 9.28%, and 6.62% across all recommendations. This corresponded to an average and median alpha of -1.75% and -1.55% respectively, with underperformance being a function of strong high yield “market” performance. Positively, we recorded an average IRR of 11.44% across the 27 Buy recommendations, and 10.46% across 3 Subscribe recommendations. The latter corresponded to a 7.36% average alpha to the benchmark, one positive out of our High Yield recommendation performance.
Our best performing High Yield Buy recommendation was on Qube Subordinated Notes (ASX: QUBHA), generating a 30.0% IRR (3.1% HPR), equivalent to a 24.3% outperformance to the benchmark. We had conviction in this because the Notes were set to mature in six weeks’ time, the Group had access to cash that was greater than 4x the amount due to redeem the Notes, and QUBHA was trading below par on a clean basis. Effectively, QUBHA was trading as if there was uncertainty surrounding the Group’s ability to redeem the Notes when there was no reason for such uncertainty.
A special mention goes to Latitude Capital Notes (ASX: LFSPA), which we generated a 68.6% IRR (5.1% HPR) on our Hold recommendation, or a 43.5% outperformance to the High Yield benchmark. After putting LFSPA on a Sell at a price of $91.5, it subsequently fell to $83.5. With additional time post cyber breach to see how the company was recovering, we became comfortable with a first call maturity, warranting an upgrade. In hindsight, we could have moved this to Buy, however we had a sub-80 price target for this that was never met.
One of our worst performing High Yield trades was Centuria 5.00% 2024, with a -5.1% IRR and -0.5% HPR. This was on relative value grounds not fundamental. Also hurting returns was the “timing” of the recommendation. This Sell was originally placed in 2022 and carried into 2023. What this means is that the 2022 returns were counted in last year’s report, and the 2023 returns are included in this year’s report. In 2022 the Sell recommendation did well, and in fact on a complete basis from 9-Feb-22 to 7-Feb-23 the IRR was a mere -0.49%.
Financials (Banks, Insurers and Div Fins)
While performance results in this section include AT1 hybrids, discussion of such individual security returns is in the following section.
Our performance across the Financials (senior unsecured, subordinated, regulatory capital) space was robust over 2023, with positive alpha generated across all types of recommendations on average. Most notably, we generated an average alpha of 4.23%, and 13.87% IRR on our Buy recommendations with a 90% alpha win/loss ratio, and outperformed the market on 63% of all Conviction recommendations across the Financials space. We note that this universe includes the performance of AT1 securities, which are discussed in greater detail in the next section. Our Sell recommendations performed significantly better relative to our Corporates recommendations, with a 1.91% average alpha generated, and a 3.77% IRR on average. This is a function of our Financials recommendations largely being floating-rate. Short-term capital performance is made up almost entirely of credit spread movement, rather than risk-free rates, which are a big driver of investment grade fixed-rate bond returns and are difficult to predict over the short-term.
One of our strongest (non-AT1) Conviction calls was a Sell recommendation on Latitude Capital Notes (ASX: LFSPA), which we recorded a 22.9% IRR (6.5% HPR) on, returning 13.1% annualised above the benchmark. We saw LFSPA as expensive after weak 1H23 earnings and high turnover in the C-suite, at the same time it was recovering from a cyber breach – a higher degree of risk needed to be priced into the assumption of first call and the market eventually convegered with our view. Our Subscribe recommendation on Pepper Money Subordinated 6.75% FRN, a subordinated bond issued by non-bank lender Pepper Money, resulted in a 16.1% IRR (1.2% HPR), outperforming the benchmark by 12.4%. Whilst this security was on the most risky spectrum of domestic credits, we viewed the offer to have strong valuation claims for the level of credit risk on offer based on primary pricing.
AT1s – Elevated Volatility, But the Market Prevails
2023 began with all-time tight spreads across the B4 AT1 space, with our proprietary B4 AT1 Index recording a market capitalisation-weighted trading margin of 1.97% as at the end of 2022. After the write-off of Credit Suisse’s AT1 hybrids overseas, the domestic space subsequently sold off dramatically on write-off fears, with our B4 index widening ~100bps from trough to peak over the span of a month. We viewed the domestic selloff to be unfounded given differences in structuring between our local hybrid space and the Credit Suisse AT1s, and sought to capitalise on suddenly wider credit spreads.
On average, we outperformed the benchmark on our high-conviction trades over the year, utilising our proprietary quantitative technology to generate a 3.57% average alpha to benchmark over the year. Across 6 Buy recommendations, we produced an alpha win/loss ratio of 83%, and 59% across all 22 Conviction recommendations. Notably, when we issue a Hold recommendation, we expect a security to perform in-line with the market. Across 43 Hold recommendations, this resulted in an average alpha of -0.89%, reflective of slight market underperformance. As previously noted, our Sell recommendations performed reasonably well considering negative carry is a headwind on Sell recommendation returns, with an average alpha of 4.79% and an alpha win/loss ratio of 56%. Minimal interest rate duration in the majority of AT1s (which are primarily floating-rate) results in credit spread movement being the main driver of price movements, allowing us to exploit any mispricings in the market we were able to locate using our in-house quantitative tech.
We have broken down the chart of aggregate AT1 recommendations into the B4 AT1 and NM AT1 markets for further granularity. Our best B4 AT1 Conviction trade was a Sell recommendation on PERLS XI (ASX: CBAPH), with a 7.43% IRR (0.99% HPR) recorded, which was a 14.14% alpha to the benchmark. We had downgraded CBAPH to Sell on 6 December 2022 at a 0.41% margin with the security screening as very expensive, trading 76bps below the B4 ASX AT1 curve. The recommendation was raised to Hold on 16 February 2023 at a 1.81% margin, when it was fairly valued relative to the curve. Our worst performing call from an alpha perspective was on a Subscribe recommendation on Westpac Capital Notes 10 (ASX: WBCPM). Whilst we posted a strong 21.2% IRR (1.70% HPR), the benchmark index performed exceptionally well, and as a result this call underperformed by 10.79%.
Performance was a lot stronger across the Non-Majors, where we produced an average alpha of 5.57% and an alpha win/loss ratio of 71% across all our Conviction recommendations. Our average IRR on Buy recommendations was 19.80%, with a 4.84% average alpha and an alpha win/loss ratio of 80%. Our Sell recommendation on Suncorp Capital Notes 2 (ASX: SUNPG) was a success, where we penciled in a 30.19% IRR (3.86% HPR), or a 33.99% alpha. The recommendation on SUNPG had been lowered to Sell on 16 December 2022, when it was trading at a mere 0.18% margin, screening it as extremely rich compared to the All ASX AT1 curve. It was upgraded to Hold on 8 February 2023 at a 1.83% margin, at which point it was fairly priced, albeit on the slighltly cheaper side of the curve.
Corporates – Great Performance Overshadowed By Benchmark Performance
Corporates largely issue fixed-rate bonds as a way of hedging their interest expenses, and whilst they may issue floating-rate bonds dependent on investor demand, they are issued far and few between. This leads to a naturally duration-heavy space to invest in. As a result, although a security may be attractive based on the credit spread in secondary markets, market pricing of the macroeconomic outlook impacts risk-free rates, driving swings in capital prices.
There is an overlap between the Corporates segment and the Investment Grades space, given the lack of a domestic high yield market. Our IRR performance was strongest across the Corporates sphere relative to other market segments, with an average 10.51% IRR, however this only corresponded to a 0.20% outperformance on average to each respective underlying benchmark. We performed poorly on our Sell recommendations due to market rallies over the year, with an average -18.05% alpha across 13 trades. This weighed down heavily on our average alpha across Conviction recommendations, resulting in an overall underperformance of 1.71% across Conviction trades.
Outside of the two aforementioned recommendations in the Investment Grade section, we recorded a 33.22% alpha on our Buy recommendation on Lend Lease 3.70% 2031, which we closed in February 2023. We saw the credit spread as cheap, especially verus peer REITs. This recommendation was also influenced by the aforementioned 2022/2023 end/start date factor related to timing. When viewing the recommendation over its unstratified performance, the actual IRR was less impressive at -2.78%. The margin on this security actually blew out 50bps over the course of the unstratified recommendation.
One of our worst performing trades across this market segment was a Sell recommendation on Lend Lease 3.4% 2027, where we recorded a -27.58% IRR over a ~1.5 month period (-3.05% HPR). This equated to a -42.53% annualised alpha. Likewise, this recommendation was also impacted by the end/start date factor when splitting returns across annual periods. When considering the full investment time frame from open to close (change in opinion across years), this was a -3.46% IRR, and a -1.59% HPR.
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