June 2023 was a milestone month for Mutual’s High Yield Fund (‘MHYF’) with its running yield breaking through 10% per annum, aided by the inflationary backdrop and RBA rate hike cycle.
A ‘running yield’ is an important feature of fixed income investments. It is like a real time barometer of how the investment is expected to perform, by measuring the weighted average coupon rate of the portfolio of bonds held by the fund. For example, a $100,000 investment in the Mutual High Yield Fund with a 10% running yield would be expected to return over $10,000 (gross) over the coming year (paid quarterly), all other things being equal.
While the actual one-year performance of the Fund may be higher or lower than the running yield at any given time, it still demonstrates an attractive return proposition for investors. For the one year ending September 2023, the Fund returned 9.4% net of fees. This is lower than the prevailing rate because running yields have been rising with underlying interest rates. The one year number captures a period where the running yield was lower. For broader context, the Fund returned 6.5% versus the ASX 200 Index return of 5.3% over the past three years per annum.
Bonds have a lower risk profile than equities
A key consideration here is the difference in risk associated with equities versus bonds and the impact on investor portfolios. Bonds, unlike stocks, generally have a more predictable return profile, and exhibit less return volatility – both from an income and capital perspective.
Bond holders have priority over equity holders
The other key difference is the income generated by bonds are contractual and legally must be paid before any other distributions can be made, including dividends. Stocks on the other hand, which pay income via dividends are purely discretionary. Payment is at the discretion of company management and can only be made once all contractual payment obligations have been met. Accordingly, stocks returns are typically 3 – 5 times more volatile than bond returns.
Bonds can be fixed rate or floating rate
Expanding on the risk profile of bonds, it is important to make the distinction between fixed rate bonds and floating rate bonds, more commonly called floating rate notes.
Add to this the term fixed income is used generically for the asset class and can encompass both fixed rate bonds and floating rate bonds.
A fixed rate bond pays a constant coupon from issuance to maturity. In a rising interest rate environment, such bonds are exposed to duration risk, which means when interest rates are rising, the attractiveness of a fixed coupon stream reduces. In a rising interest rate environment, duration risk exposes a fixed rate bond investor to capital losses. This works in the opposite way when interest rates are falling.
How coupon payments are set
The coupon payable on a floating rate note is set as a margin above a reference rate, typically the Bank Bill Swap Rate, or BBSW. The reset period is every 30 or 90 days depending on the security in question. The BBSW rate in turn is strongly correlated with the RBA cash rate.
Accordingly, as the RBA has hiked rates over the past year and a half, BBSW has risen, and in turn floating rate note coupons have increased. For example, a year ago the 1-month BBSW rate was approximately 2.70%. The coupon available on say a ‘BBB’ rated Residential-Mortgage-Backed Security (‘RMBS’) was around +450 bps, so the coupon was set at 7.20% (2.70% + 4.50%). At the last reset, at the end of September 2023, the 1-month BBSW rate was 4.05%, so the coupon is now 8.55%. Floating rate notes have minimal duration risk and as such capital variability is much less than for fixed rate bonds.
Credit risk is mitigated by portfolio diversification
Another key risk for bonds, with fixed and floating rate bonds impacted equally, is credit risk. This is the risk that a bond issuer (the borrower) is unable to pay the promised coupon due to financial difficulties. Within a managed fund however this risk is mitigated by holding a diversified portfolio of bonds across multiple issuers.
Can the Fund’s high running yield be maintained?
As a consequence of the COVID pandemic and measures taken by governments and central banks globally to negate the pandemic on their respective economies, inflation has reared its head – after being largely dormant for many years. The traditional tool used to combat inflation is monetary policy, which has seen interest-rates rise sharply over the past year and a half thanks to the RBA increasing its cash-rate target. In turn, BBSW has risen, which has supported higher coupon rates on the underlying securities – floating rate notes – in the Fund’s investment universe.
The Fund is made up of approximately 80% Residential Mortgage-Backed Securities (RMBS) and Asset-Backed Securities (ABS). Each of these bonds are generally made up of close to thousands of collateralised loans that can range from Australian mortgages to auto loans. The Fund holds approximately 50% - 60% of funds under management in RMBS and 15% - 20% in ABS. At Mutual we diligently review and monitor each ABS/RMBS bond we hold on a loan-by-loan basis. While rising interest rates place pressure on mortgage serviceability, and in turn mortgage arrears, RMBS structures are designed to withstand materially worse conditions than those expected for even the most severe worst-case scenario.
In this regard, we point out no rated RMBS note has ever defaulted in Australia.
Outlook for interest rates
Inflation, as measured by the Consumer Price Index (CPI) is still running well ahead of the RBA’s target range, 6.0% vs 2.0% - 3.0% target, with CPI not expected to be back within target ranges until late 2025 (RBA forecast). As a consequence of these expectations, interest rate markets are not pricing any meaningful drop in the RBA cash rate or BBSW until well into 2025. Accordingly, for the year ahead floating rate note coupons will continue to be reset at margins above a cash rate of at least 4.10% for the foreseeable future.
This information has been prepared by Copia Investment Partners Limited (AFSL 229316 , ABN 22 092 872 056) and Mutual Limited (“Mutual”) ABN 42 010 338 324, AFSL 230347), the Responsible Entity and issuer of the Mutual High Yield Fund. This document provides information to help investors and their advisers assess the merits of investing in financial products. We strongly advise investors and their advisers to read information memoranda and product disclosure statements carefully and seek advice from qualified professionals where necessary. The information in this document does not constitute personal advice and does not take into account your personal objectives, financial situation or needs. It is therefore important that if you are considering investing in any financial products and services referred to in this document, you determine whether the relevant investment is suitable for your objectives, financial situation or needs. You should also consider seeking independent advice, particularly on taxation, retirement planning and investment risk tolerance from a suitably qualified professional before making an investment decision. Neither Copia Investment Partners Limited, nor any of our associates, guarantee or underwrite the success of any investments, the achievement of investment objectives, the payment of particular rates of return on investments or the repayment of capital. Copia Investment Partners Limited publishes information in this document that is, to the best of its knowledge, current at the time and Copia is not liable for any direct or indirect losses attributable to omissions from the document, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions. © 2023 Copia Investment Partners Ltd.