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Credit where credit is due


Chris Durack

Chris Durack

Country Head of Hong Kong and Head of Institutional Asia Pacific

Oliver Trusler

Oliver Trusler

Investment Director

The Schroder Credit Securities Fund has met its objective of returning the RBA Cash Rate +2.5% p.a. over a reasonable timeframe (2-3 years), outperforming term deposits with significantly less volatility than the equity market, while remaining a liquid investment and providing investors with a regular income stream.

In this paper, we investigate the ability of a broad based credit portfolio to deliver sustainable returns for investors over time in excess of cash. The motivation to look at credit comes at a time where returns on cash based investments, including term deposits are declining. More recently, we have seen some market participants arguing that equity markets are showing increasing appeal as a source of yield for investors primarily seeking income. While dividend yields available in some segments of the equity market have certainly moved higher, as always, the appropriateness of any asset class or investment strategy will depend on an investor’s objectives (among other things). For this reason, we investigate the merits of equities, cash and credit in delivering a sustainable total return over shorter and longer term periods.

The paper begins by examining the performance of Australian term deposits to illustrate their strong success over recent years. We then broaden out the discussion to look at how the Schroder Credit Securities Fund (as our proxy for a broad based lower volatility credit portfolio) compares as a source of sustainable income for investors relative to cash based investments. With over 10 years of track record, through different credit cycles, this strategy serves as a good proxy for potential returns available from the credit market. The capital volatility of the Schroder Credit Securities Fund is then compared with the equity market to understand how taking on investment risk might impact on investor objectives. Finally we compare the relative merit of taking on the potential for increased returns relative to cash and draw some conclusions as to whether taking on increased risk helps deliver sustainable returns and if it does, how much is required.

The success of term deposits

The reasons underpinning the success of term deposits over recent years have been well documented and include satisfying the need for regular income, a stable capital base and of course in a relative sense, increased safety relative to other asset classes which performed poorly during the GFC. The increased demand for term deposits was also enhanced by the higher rates offered by banks given their preference to raise funds from retail investors as opposed to less certain offshore capital markets, again as a result of the GFC. To illustrate, the chart below shows the rates offered in the term deposit market over the past 10 years but also the margin of term deposits over institutional cash investments over the same period.

Chart 1: The Performance of Term Deposits

Source: RBA to 31 March 2013, Term Deposit rate for balances >$10,000 over 12 months

- Term deposits have outperformed institutional cash markets since the GFC. Over the last 12 months term deposits have outperformed by a margin of between 90 and 100 basis points. However in late 2009, the margin of term deposits over cash exceeded 200 basis points. Prior to the GFC, term deposits typically offered rates consistently below institutional cash markets. It is probably reasonable to expect term deposits will remain competitive relative to cash markets but moderating in terms of their margin to cash from this point going forward.
- However, in absolute terms, 12 month term deposit rates have declined from over 6% in 2011 to around 4% now (May 2013).
- As these rates decline investors may require higher returns than is likely to be available from term deposits.

Is the “Demand for Income” really demand for safety and sustainability?

In the “post retirement” market where investors are more reliant on their investment portfolio (as opposed to employment income) to fund their consumption needs, it is still the total return that matters most where investors primarily seek:

- a reliable return stream; and
- avoidance of severe downside outcomes.

As a proxy for these objectives, investors and their advisers often express a desire for income based investments. But if an investor is enjoying retirement and therefore drawing on their investment portfolio, their tax position is often such that there is no difference between income and capital (an investment through an allocated pension attracts a 0% tax rate on both its income and capital component). Moreover, if an investor is still subject to tax, there may well be arguments to seek capital returns given they may attract discounted treatment relative to income. It is for reasons such as these that it may be instructive to “look through” the income and capital components to the total return and evaluate what types of total return meet the objectives outlined above.

Analysis of a sustainable return profile

If sustainability of a total return is a primary objective, how have the returns from inception for credit stacked up? The Schroder Credit Securities Fund invests in corporate debt and other income producing securities across the world and with an Australian investor in mind and has a target of outperforming the RBA cash rate +2.5% (gross of fees) over rolling three year periods. The strategy has been operating for over 11 years since October 2001, including through the GFC, where the fund remained liquid and open to client redemptions. The table below shows the returns of the Fund compared with its objective of outperforming the RBA Cash rate +2.5% over rolling three year periods.

Table 1: Performance of the Schroder Credit Securities Fund

To 30 April 2013 1 year % 3 years % pa 5 years % pa 10 years % pa Since inception %p.a.
Fund (gross) 9.1 8.1 7.1 6.8 7.2
RBA Cash rate 3.3 4.2 4.2 4.4 4.7
Excess (gross) 5.8 3.9 2.9 2.4 2.5

Source: Schroder Credit Securities Fund (gross of fees) inception: 23 August 2002, strategy inception 18 October 2001
Past performance is not a reliable indicator of future performance

- The Fund has achieved its performance objectives over the long run while producing even more favourable returns relative to cash over the most recent three year period.
- It is notable that the Fund has delivered its objectives over the longer term given that the 10 year period spans more benign market environments as well as the Global Financial Crisis.

Comparing apples with apples

One issue we need to deal with to ensure we are properly taking into account what investors receive is the impact of the potential for term deposits to remain higher than the RBA cash rate, particularly in light of their recent experience, and the management fees for the Schroder Credit Securities Fund. We have therefore augmented the performance analysis below for these effects as follows:

- We apply the full 75 basis point wholesale manager fee1 for the Schroder Credit Securities Fund; and
- We apply a 50 basis point return premium to the RBA cash rate to allow for term deposits offering higher returns over more recent periods.

This has the net effect of reducing gross excess returns by 125 basis points reflected in the table below.

Table 2: Net returns of the Schroder Credit Securities Fund compared to an adjusted cash benchmark

To 30 April 2013 1 year % 3 years % pa 5 years % pa 10 years % pa Since inception %p.a.
Fund (gross) 9.1 8.1 7.1 6.8 7.2
RBA Cash rate 3.3 4.2 4.2 4.4 4.7
Excess (gross) 5.8 3.9 2.9 2.4 2.5
Subtract 125 basis points p.a. to allow for wholesale fees and assumed TD premium
Excess (net) 4.55 2.65 1.65 1.15 1.25

Source: Schroders. Fund Inception: 23 August 2002, strategy inception 18 October 2001
Past performance is not a reliable indicator of future performance

If the Fund’s performance objective is to deliver returns around 250 basis points over the RBA cash rate, making an allowance for fees and the potential for TDs to consistently offer returns above the benchmark cash rate, over the long run the Fund has delivered at least an additional 100 basis points. We consider this to be conservative given recent history of the Fund shows the potential to earn much higher excess returns. When considering the impact of 100 basis points, it is important to view this in the context of an overall expected total return. For example, with the cash rate currently yielding 2.75% p.a. (and 1 year term deposits now offering around 3.75%), an additional 100 basis points represents around 20% of the total expected return.

Capital stability: Is the GFC still the elephant in the room?

A key concern for investors in seeking higher returns is the amount of volatility their investment may be exposed to, and most importantly, the extent to which they may suffer capital losses. To gain some perspective on this, we looked at the most recent 10 year period for the Schroder Credit Securities Fund, comparing this to the experience of both cash and equity markets.

The following chart shows the rolling 3 year returns over the 10 year period to April 2013.

Chart 2: Schroder Credit Securities Fund versus equities and cash: rolling 3 year returns

Source: Schroder Credit Securities Fund (gross of fees), Global Financial Data to 30 April 2013
Past performance is not a reliable indicator of future performance

While cash markets over the period have produced relatively stable returns averaging around 5% p.a., the impact of the GFC had markedly different impacts on investors depending on how much risk they were willing to take on. In the case of the Schroder Credit Securities Fund, the largest 3 year negative return was 2.0% p.a. for the period ending 31 March 2009. By way of contrast, the largest 3 year negative return for equities was 8.2% p.a. for the three year period ending 28 February 2009.

However, in terms of what matters to investors, it is not really sufficient to draw conclusions about the appropriateness of an asset class based on the largest 3 year negative return. Rather, it is perhaps more instructive to look at the longest drawdown period as well. In other words, if I invested $100,000 in the Schroder Credit Securities Fund versus $100,000 in equities (before the impact of fees and assuming I reinvest my distributions), how long would it take before I recovered the nominal value of my investment in the worst case? Again, the differences between the investment in the Schroder Credit Securities Fund and the investment in equities are striking and are summarised in the following table.

Table 3: Impact on investment value if $100,000 is invested at the peak of the market and maximum drawdown

Investment Peak Time to recover to peak
Schroder Credit Securities Fund October 2007 August 2009: 1 year, 10 months
S&P ASX 200 Index October 2007 Not yet recovered. After 5 years original investment value of $100,000 is approximately $98,495 at 30 April 2013

Through the GFC this Fund experienced a negative return, however this strategy is designed to take on more risk than defensive assets, but less risk than the equity market. When we look at this drawdown in the context of broader market returns, the strategy appears to offer the characteristics we would expect.

Because this strategy takes on more risk (to generate more return), investors need to consider a more appropriate (longer) timeframe for the strategy to recover from risk off periods. The stated timeframe required for this type of strategy is at least 2-3 years, notably shorter than is required for the typical equity market strategy.

Chart 3: Schroder Credit Securities Fund versus equities and cash: cumulative total return performance, since the equity market peak

Source: Schroder Credit Securities Fund (gross of fees), Global Financial Data to 30 April 2013

Looking at this period of extreme drawdown graphically since the GFC (i.e. since the October 2007 market high):

- Equity markets have been very volatile and are yet to regain their lost ground.
- Despite some short term volatility, less than 2 years after the peak the Schroder Credit Securities Fund regained its capital value.
- After 3 years the strategy had delivered a total return ahead of both cash and importantly term deposits.

What is a fair and acceptable margin over cash?

The analysis above has shown that the degree to which investors take on risk away from cash will heavily influence the total return on their investment. Most importantly not just by looking at the average outcomes but also by considering how potential drawdowns may be impacted by investing at the wrong time (a local peak in the market).

Over longer timeframes, if we are risk averse and seek to avoid unnecessary volatility relative to the objectives, we need to ask what minimum requirements we might have for a given investment. A very common objective in this regard is whether an investment keeps pace with the rate of inflation. Again, to illustrate the performance of investments carrying different levels of expected risk, we have shown the cumulative performance of cash and equities against the Schroder Credit Securities Fund over the last 10 years with a starting investment in each case of $100,000.

Chart 4: Schroder Credit Securities Fund versus equities and cash: cumulative 10 year total return performance

Source: Schroder Credit Securities Fund (gross of fees), Global Financial Data to 30 April 2013

An important assumption in the above analysis is that all income generated by each investment is reinvested. When this assumption is made, it can be seen that all three investments outperform the cumulative rate of inflation. The best performing investment over this particular 10 year period was in the Australian share market, however all cumulative outperformance was earned in the first 5 years. As we showed above, if an investor had invested halfway through this period, they would still be waiting to recover their initial investment.

But, what about income?

From the outset of this discussion piece, we referred to investors’ demand for income. If part of the demand for income is about drawing on the particular investment to produce regular payments, then does this change the behaviour of a particular investment’s performance relative to inflation? To answer this question we assumed that a constant 4.5% p.a. (approximately the return of cash over the period) of the initial value of the investment was withdrawn every three months. The cumulative return for each investment is shown below relative to the performance of inflation.

By operating in a high income universe and focussing on the total return objective, the outcome is a strong income distribution return profile.

Chart 5: Schroder Credit Securities Fund versus equities and cash: cumulative 10 year total return performance after 4.5% p.a. quarterly withdrawal of initial investment

Source: Schroder Credit Securities Fund (gross of fees), Global Financial Data to 30 April 2013

The key point here is that if investors are seeking to fund their lifestyle needs (i.e. consumption) using predominantly cash based investments, then the real purchasing power of their remaining investment is likely to decline ahead of other asset classes with the potential for higher total returns. If this situation is to be mitigated, investors need to consider that some tolerance of volatility is required to avoid significant reductions in purchasing power. Over the last 10 years the equity market has significantly outpaced cash. However, the cost of this outperformance over the period was severe underperformance incurred during the GFC where cash performed more strongly. The additional cost of holding equities was the reduction in total returns over the most recent 5 years of the period meaning the return of equities over the period was heavily dependent on the entry point. However, the Schroder Credit Securities Fund has kept pace with or outperformed the rate of inflation over the long run (before the impact of fees), with much lower volatility than the equity market.

Expectations for credit markets moving forward

There is a lot of focus on bond markets at present given the low yields on offer in government bonds across major markets. While this is having an impact on yields in credit, we believe that credit spreads are still attractive and provide adequate compensation for credit risk. Taking this into account, together with the prospects for further spread compression, returns in the order of 5-7% pa from the Schroder Credit Securities Fund over the next couple of years are possible (2-4% ahead of expected returns from 12 month term deposits over a similar timeframe).

Credit looks attractive from a valuation perspective, although credit spreads (credit risk premium) have come down and we have seen a moderating in the credit risk premium closer to long run averages. As can be seen from Chart 6 below, credit has moved from being cheap (post GFC) to fair value, but credit is still offering solid yields in a broader declining rate environment.

Chart 6: Valuation - Australian corporate bonds remain relatively stable and a source of yield

Source: Bloomberg. As at April 2013.

- The Australian market is primarily an investment grade market and has not seen the same volatility as offshore markets.
- Australian spreads have been reasonably stable and traded in a tighter range, despite global volatility.
- We believe the Australian market to be around fair value in terms of credit risk premium, offering a 100bp premium over swap.

Concluding remarks

Investor objectives are really the only meaningful benchmark against which to judge the appropriateness of a particular investment. Our view is that for investors seeking a sustainable and reliable return over shorter as well as longer periods, cash based investments are unlikely to provide successful strategies. This becomes particularly acute over longer periods given the potential erosion of purchasing power relative to inflation and where investors require a drawdown from their investment to finance their consumption. Therefore some degree of volatility risk needs to be accepted. For those investors unable to withstand high degrees of volatility, again because the total return is relied on over shorter periods, equity risk needs to be treated with a high degree of caution. By way of contrast, the Schroder Credit Securities Fund balances the need to ensure a real return is maintained over longer periods of time against the importance of avoiding severe drawdown events.

With credit remaining reasonable value and corporates having strong balance sheets, in a falling interest rate environment the Schroder Credit Securities Fund has the potential of delivering income and capital growth greater than on offer from term deposits, but with less risk and lower volatility than the equity market, by investing in a diversified portfolio of Australian and global corporate credit and other income securities.

About the Schroder Credit Securities Fund

The Schroder Credit Securities Fund invests in a range of domestic and international credit and income securities. The Fund has an absolute return focus with an objective to outperform cash +2.5% (pre fee) over the medium term whilst minimising capital volatility. Actively managed by Schroders’ experienced fixed income team, investments within the portfolio are dynamically managed with the aim to ensure we are in the right assets at the right time to maximise return with lowest achievable risk.

Key characteristics:

– Absolute return focus with an objective to outperform cash and minimise capital volatility.
– Well diversified portfolio of credit and other income securities.
– Dynamic investment process that aims to ensure we are in the right assets at the right time.
– Focus on risk adjusted returns where there needs to be appropriate reward for risk taken and the flexibility to be very defensive.
– Strong domestic and global credit research teams, giving investors access to a broader opportunity set and the resources to analyse and monitor credit risk.
– Transparent portfolio of assets with daily liquidity.
– Distribution policy2 closely aligning the distribution payments more closely with the underlying income yield of the credit universe without adverse consequences to the Fund or unit holder equity, providing regular income while maintaining the flexibility to be very defensive when appropriate.

1For direct investments >$50,000 or available via platform, >$500,000 investments into the institutional share class attract a fee of 0.54%
2The fund distribution policy changed commencing with the March 2012 quarter distribution. The previous practice was to pay a distribution on a quarterly basis referencing the expected total taxable net income of the Fund for the relevant financial year. The total taxable net income of the Fund generally comprises both income generated from securities in which the Fund invests and gains and losses from investments held within the Fund. As a result of this practice, distribution amounts fluctuated and on occasion were low reflecting realised losses from investments which offset the income generated.

Important Information:
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.