Review of 2019 for Acre Fixed Income - Acre Capital

2019 has been an exceptional year for fixed income, Acre Fixed Income Managed Accounts are up +14.0% vs the iBoxx USD Asia High Yield Total Return Index returning 13.0%. The strong rebound is due to global central banks lowering interest rates in tandem as economic conditions continue to decline after the US-China trade war escalation from mid-2018. This factor of lower interest rates contributed 6% to returns, while coupons contributed 7.5% and tightening spreads at 0.5%.Acre’s managed accounts are not strictly tied to a benchmark, but rather the aim is to achieve a consistent 6-8% net return pa. regardless of market conditions according to each investor’s needs and risk profile.

Factors of Outperformance

The good performance was due to us avoiding Indonesian and Indian high yield bonds which fared poorer. Another reason for outperformance was selling Investment Grade (IG) holdings that were richly priced in 2H and diversifying into Fixed Coupon Notes which are structured and priced by Acre.

These bespoke investments yield 8-10% with a risk profile that Acre is well equipped to manage. Despite the strong showing, there were missed opportunities as well – namely being too cautious on China property bonds due to policy headwinds and governance concerns. Unfortunately, they were one of the top sector performers of 2019 as lower interest rates spurred more flows into the sector in 1H, followed by the relaxation of policy headwinds in 2H.

Fig 1: Acre FI MA +14% vs HY Index at +13%

Fig 2: Yields have come down since end 2018

Cautious in 2020

Looking ahead to 2020, we are more cautious as yields (YTW) have come down significantly since end 2018 (Figure 2). There is less room for even lower interest rates as we’re already at a low level. Nevertheless, central banks are expected to maintain low rates for longer. Should the trade war cool-off continue, an improving economic environment with continued low rates would be conducive for fixed income. I am also expecting more fund flows moving from a richly valued IG space to HY in search for yield. Therefore, the outlook for HY bonds from a broad fundamental and technical perspective seems to be benign.

That being said, the HY bond market is also fraught with risks. Business fundamentals could change quickly, causing stress to the ability of the issuer to make payments. Weak governance can lead to defaults, regardless of business fundamentals. Increasingly relaxed covenants also do not give sufficient protection and recovery for bondholders. Therefore, there is a need to understand these factors in detail, where the team at Acre can do on behalf of investors.

“Why not invest in a fixed income fund?”

Given the complexity of bonds, it is only natural to pose the question: “Why not invest in a fixed income fund?”. There are many advantages of investing in a fund, the best of which is diversification. But the downside is that fund managers and banks promoting such funds take a fixed 1.5-3.0% pa. of total AUM in expenses, management and sales fees. In an era of low interest rates, these equate to a large percentage of the total return to investors. For example, the coupon for the HY market is around 6%. After fees, a client’s net return would be significantly reduced to 3.0-4.5%. Therefore, it makes more sense to buy individual bonds to avoid such hefty fees, provided that the account size is large enough.

Alternatively, clients could also seek to invest with advisors with a performance fee-based model. Acre employs such an approach and charges fees based on a % of profits rather than a fixed fee. We believe that this is fairer to our investors and provides for a more sustainable long-term relationship.

Funds tend to do very poorly in a crisis

In addition, fixed income funds often need to track the index and yet show a high headline coupon over the index. This limits their flexibility and leads to over-exposure to risky sectors, as well as concentration in risky names that have a high coupon rate. This means that when the market turns bearish or if there’s crisis, many funds are likely to underperform. In addition, mass redemptions in a crisis means that funds are forced to sell at an unfavourable price when the right thing to do instead is to buy when prices are unreasonably low.

In contrast, Acre is nimble and active

In contrast, Acre is able to be flexible in portfolio management, taking risks when the returns make sense and avoiding them when it does not. The goal is to deliver a 6-8% net return regardless of market conditions and in taking risks in accordance with our clients’ mandate.

Overall, I remain optimistic on being able to achieve the target return in 2020 while being aware that the fixed income market is starting to look crowded. Even so, low interest rates and an improving credit environment should bode well for our portfolios.