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Speaker 1: Welcome to the Fearing Greed Business Interview. I'm sure in

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Speaker 1: Almar the world of fixed income investing has undergone a

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Speaker 1: seismic shift in recent years. What was once considered a

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Speaker 1: stable and at a predictable part of investor's portfolio is

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Speaker 1: now an evolving landscape, shaped by technological innovation, regulatory changes,

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Speaker 1: and rising financial costs. But this new landscape presents new opportunities,

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Speaker 1: especially for investors who embrace a more active, data driven approach.

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Speaker 1: Now remember this information in this episode is general in nature.

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Speaker 1: It doesn't take into account your own circumstances. Always look

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Speaker 1: for a financial advisor when making any investment decisions. WHIML.

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Speaker 1: Gore is head of fixed income and multi Asset at

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Speaker 1: Elliston Capital, which is working with SO Capital. It's great

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Speaker 1: supporter of this podcast. Most of what I've just said

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Speaker 1: a few moments ago is actually Wimble's words, which she

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Speaker 1: used in a piece in the fin Review. We're more

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Speaker 1: welcome to Fear and Greed.

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Speaker 2: Hi, San, thank you very much for having me today.

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Speaker 1: So, in the piece you wrote in the Finriom, you

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Speaker 1: talked about how much the fixed income market has changed

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Speaker 1: over the past fifteen years, and you talk about the

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Speaker 1: GFC as the start of that. What's the fundamental change

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Speaker 1: in fixed income markets that many investors probably haven't thought

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Speaker 1: enough about.

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Speaker 2: It all really does stem from the GFC, as you mentioned,

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Speaker 2: and the outcome of the GFC was regulators around the

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Speaker 2: world wanted to make the financial system more regulated and

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Speaker 2: a safer place to be, and so there was a

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Speaker 2: number of new initiatives that came on the back of

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Speaker 2: the GFC and the market dislocations we saw at that time,

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Speaker 2: and the largest one was around bank capital requirements and

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Speaker 2: bad three and that fundamentally changed the biggest player in

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Speaker 2: the market, which are the commercial investment banks, and the

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Speaker 2: way they operate, and that left lots of opportunity and

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Speaker 2: caused many changes in the markets. So if we just

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Speaker 2: step back and say what actually happen is if you

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Speaker 2: look at banks, they will investment banks they primarily have

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Speaker 2: two ways of making money. The first as they ride

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Speaker 2: the Yelk curve, and that's why they borrow short and

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Speaker 2: then long. So they take deposits in which are generally

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Speaker 2: at call, and they lend that money out to other

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Speaker 2: businesses like SMEs, or they lend it to people for mortgages,

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Speaker 2: which are generally quite long term, and they ride the

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Speaker 2: Yelk curve as they have a mismatch and they have

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Speaker 2: to provision against that, and that's a capital requirement. The

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Speaker 2: second way that investment banks make money is they trade securities,

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Speaker 2: whether they be bonds, equities, fx any securities, and they

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Speaker 2: make a bid off a spread on those securities. But

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Speaker 2: by virtue of the fact that they're not able to

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Speaker 2: run the same balance sheets, it means they're not able

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Speaker 2: to warehouse risk the same way they used to do.

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Speaker 2: Is their ability to make markets is massively impaired. So

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Speaker 2: you've seen banks go from effectively a warehousing facility which

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Speaker 2: provide a lot of benefit to the financial system, to

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Speaker 2: a model that's moll capital light and more transactional their nature.

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Speaker 2: So it meant they've stepped back from a number of businesses.

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Speaker 2: They've really stepped back from the lending business, and they've

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Speaker 2: stepped back from a lot for the market making business,

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Speaker 2: and that has enabled new entrants to come into the space,

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Speaker 2: which have fundamentally changed the way that fixed income markets work.

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Speaker 1: Okay, and I'm paraphrasing you here, but because of the

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Speaker 1: regulatory changes, they've actually had to step back because it's

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Speaker 1: just not profitable enough. They're not earning as much money

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Speaker 1: if they do some of these traditional things we think

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Speaker 1: about them doing. Ironically, you could argue then that the

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Speaker 1: post GFC rules around capital on the banks hasn't necessarily

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Speaker 1: made it a safer environment. It's made it and I

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Speaker 1: don't want to say a less safe, perhaps a less

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Speaker 1: transparent environment.

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Speaker 2: That's correct. So it's definitely made it much safer for

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Speaker 2: the banks and the holders are bound because they're much

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Speaker 2: less capitalisal on the line or w risk adventures. But

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Speaker 2: if you step back and look at the whole system,

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Speaker 2: the financial system, I don't know if the systemic risk

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Speaker 2: has been lessons And you can argue the systemic risk

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Speaker 2: is higher is you've taken some of the activities that

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Speaker 2: traditionally within the banking system, which is regulated, and it's

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Speaker 2: gone out to the shadow banking system, which is much

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Speaker 2: lighter touch in terms of regulation.

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Speaker 1: And so you're talking and we don't mean shadow banking

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Speaker 1: in a negative sense, we're just saying to outside the

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Speaker 1: banking system. So we're talking about things like private credit,

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Speaker 1: private equity, those sorts of things.

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Speaker 2: Yeah, private equity, private credit. The growth in a lot

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Speaker 2: of the hedge funds new market maker operations that turn up.

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Speaker 2: So you know, you've got many new entrants into the

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Speaker 2: space who didn't who weren't really around. But pre the gfcs,

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Speaker 2: you've got all of these companies like Citadel Point seventy two,

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Speaker 2: Jane Street who are stepping in and acting as market

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Speaker 2: makers and picking up significant market share.

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Speaker 1: Say with me, we are We'll be back in a minute.

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Speaker 1: My guest this morning is we more go from Elliston Capital. Okay,

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Speaker 1: so what's that mean? Let's bring this to the fixed

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Speaker 1: income investors then, So we have all these new market

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Speaker 1: makers who are raising capital. That's where we come into

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Speaker 1: fixed income investors looking to put their money in different places.

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Speaker 1: So how has it changed and what does it mean

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Speaker 1: for being an institutional but even a high networth fixed

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Speaker 1: income investor.

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Speaker 2: Well, what it means is that the way the fixed

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Speaker 2: income markets has changed fundamentally, it's much more akin to

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Speaker 2: the way equity markets are now. And that's about much

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Speaker 2: more the amount of data you can get because obviously

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Speaker 2: the high frequency firms trade on ourgorithmic basis, generally using

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Speaker 2: a lot of AI. That what they've done is they've

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Speaker 2: disintermediated the space and pulled a lot of the alpha route.

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Speaker 2: So one of the market maker firms, but two the

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Speaker 2: high frequency hedge funds and the podshops who are much

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Speaker 2: more prevalent in this space than they used to be,

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Speaker 2: say pre GFC. They've sucked a lot of the alpha

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Speaker 2: that would traditionally accrue to the asset managers or the

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Speaker 2: end clients that's now been disintermedia and you can see

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Speaker 2: that for the profits of these organizations, and so the

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Speaker 2: ability to put on trades the way you would have

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Speaker 2: done pre the GFC is much lesson because there's just

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Speaker 2: less alpha going around because that's been taken away by

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Speaker 2: some of the whose new entrants.

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Speaker 1: So as an investor, how do I think about that? Then?

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Speaker 1: Do I think about fixed income in a different way

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Speaker 1: to the traditional sort of safety you know, sixty forty

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Speaker 1: whatever you want to play well?

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Speaker 2: The fixed income can still maintain that role and still

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Speaker 2: has a very strong role and a very relevant role

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Speaker 2: within diversified portfolios or sixty forty portfolios, but the nature

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Speaker 2: of the way you position with fixed income has to

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Speaker 2: change to get that benefit. There's no longer about just

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Speaker 2: having a fixed income fund. There's generally in a benchmark,

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Speaker 2: whether it be one of the global Agoga benchmarks or

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Speaker 2: the composite benchmarks in Australia are the like. You can't

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Speaker 2: just have one of those and then try to trade

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Speaker 2: around it to generate alpha. There's the ability to add

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Speaker 2: alfro onto those as much lessons. There's also a secondary

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Speaker 2: and that we can talk about in a minute about

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Speaker 2: the financing costs, which is directly linked to the official

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Speaker 2: interest rates that exist in the market. But generally it

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Speaker 2: means that when when you're looking at putting on fixed incompositions,

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Speaker 2: you need to be very clear about and very specific

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Speaker 2: about what you want that exposure to do for you.

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Speaker 2: Is it about a return generating exposure. Is it to

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Speaker 2: give you diversification, Is it give you downside protection? You

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Speaker 2: can't just now buy global government bond portfolio and have

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Speaker 2: it provide all of those roles. You arguably need to

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Speaker 2: disaggregate each of those components that you need and build

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Speaker 2: them up from a different way of approaching it.

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Speaker 1: Yeah, so we'll get under the rates. But just before

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Speaker 1: you do that, the point there is that it's actually

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Speaker 1: harder in a sense to be a fixed income investor

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Speaker 1: now because you really need to know what's going on,

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Speaker 1: because actually what's underlying what you're buying is potentially far

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Speaker 1: more diverse than it ever was before.

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Speaker 2: Correct, it's harder because there's many more entrants in the space.

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Speaker 2: But that said, it's also you can argue it's somewhat easier,

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Speaker 2: and there's a lot more data as well. So yeah,

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Speaker 2: data gives you an information, it gives you transparency, and

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Speaker 2: therefore increases your ability to generate alpha. So the more

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Speaker 2: data you have, the better it is. But you obviously

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Speaker 2: have to have the tools and the skills to be

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Speaker 2: able to process that data and to glean information out

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Speaker 2: of them.

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Speaker 1: Okay, so what we've been talking about has been the

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Speaker 1: result of regulatory change. It is kind of not to

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Speaker 1: do with the fact that interest rates have been so

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Speaker 1: low for the last fifteen years. I mean, that's kind

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Speaker 1: of a of course they're related, but mostly this is

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Speaker 1: about regulatory change and capital positions overlay the interest rate

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Speaker 1: environment of the last ten fifteen years on that. How

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Speaker 1: does that fit into it?

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Speaker 2: Yeah, so it goes hand in hand that. Yes, the

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Speaker 2: regulatory change means that the way the market operates has

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Speaker 2: morphed since the GFC, but part of the new entrance

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Speaker 2: and the changes in the ATTIC class exposures we're seeing.

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Speaker 2: For example, the biggest one is that is the massive

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Speaker 2: influx of money into private credit is because of the

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Speaker 2: low interest rates around for so many years when you're

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Speaker 2: able to generate called it ten to twelve percent of

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Speaker 2: our private credit or interest rate was zero for many

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Speaker 2: many years. It was very compelling. But now interestrates are

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Speaker 2: called it four to five, and your private credit return

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Speaker 2: hasn't moved and it's still ten to twelve. Well, it's

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Speaker 2: a much less appealing masset class. So I would argue

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Speaker 2: you've probably had you've had the rapid growth in this move,

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Speaker 2: and you've had the markets repositioning itself for the regulatory

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Speaker 2: change and also the interest rate environment. But I'd argue

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Speaker 2: that change is largely done now and if anything, there's

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Speaker 2: a chance it goes a little bit into reverse.

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Speaker 1: Okay, So regulatly, we've done plenty on that. Just the

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Speaker 1: way that a higher interest rates are hitting the market.

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Speaker 1: Can you kind of explain that a bit.

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Speaker 2: Yeah, So there's two parts of this. One is the

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Speaker 2: standard cyclical nature of interest rates. Obviously, as we go

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Speaker 2: through cycles, which are generally in four to five your

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Speaker 2: time horizon, interest rates go up and then interest rates

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Speaker 2: go down. That's a normal functioning of economy, and we've

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Speaker 2: seen this for millennia now. But the problem is when

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Speaker 2: you're running out for positions and a lot of leverage

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Speaker 2: in a book, which is the way that you know,

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Speaker 2: it's typical throughout a number of fixed income funds. The

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Speaker 2: problem is as interest rates go up, it makes it harder,

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Speaker 2: increases the hurd rate to put trade on. Because if

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Speaker 2: you're able to borrow at very low rates, your universe

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Speaker 2: of acceptable trades is very large. As the interest rate

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Speaker 2: goes up and the borrow either borrowing cost goes up,

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Speaker 2: it makes it much higher, increases the hurdle to actually

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Speaker 2: put trades on, so the universe of trades you can

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Speaker 2: actually express get smaller and small and smaller. Now, obviously

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Speaker 2: that will go well, that will change as interest rates

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Speaker 2: come down and with you know, at the start of

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Speaker 2: a rate cunning cycle across the globe, and it's likely

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Speaker 2: the RBA is going to be cunning rates early next

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Speaker 2: year that will start. That impact will start to lessen,

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Speaker 2: but it's one that's pretty much at its peak now.

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Speaker 2: And there's a secondary impact as well well, because obviously

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Speaker 2: infrastrates are cyclical, but there's a structural impact, and that's

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Speaker 2: really to do with credit cost for balance sheet. So

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Speaker 2: one that the bank will charge you the interest rate

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Speaker 2: and then they'll charge you a credit cost on top

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Speaker 2: of that. And that credit cost has increased because of

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Speaker 2: the Archaeus hitch fund closed down last year. Effectly, what

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Speaker 2: happened is that the investment banks offered a lot of

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Speaker 2: credit lines with minimal investigation or knowledge of what went

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Speaker 2: on with those lines. And there's a significant hit for

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Speaker 2: the investment bank and community of around ten billion dollars.

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Speaker 2: And so to recoup those losses and to make sure

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Speaker 2: they don't happen again, banks are now charging a higher

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Speaker 2: fee by a credit spread above the financing rate. So

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Speaker 2: you've got this double whammy that now you've got a

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Speaker 2: higher financing rate, which makes the hurdles on your trades higher,

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Speaker 2: and you've got a higher credit spread, so it's making

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Speaker 2: it doubly hard to actually run out for trades on

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Speaker 2: a leveraged book. And so you've had both of these

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Speaker 2: these changes happen in conjunction with each other.

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Speaker 1: Okay, we're out of time. But finally, how then, given

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Speaker 1: everything you've said, with more do we think about fixed

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Speaker 1: income in a portfolio. It does still have some of

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Speaker 1: those traditional traits, but it's a little bit more complex.

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Speaker 2: Now it does. I mean, fixed income is still my

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Speaker 2: favorite asset class. It gives you the two things you

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Speaker 2: want in any asset class, and certainly as part of

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Speaker 2: the diversified portfolio. It gives you a positive return and

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Speaker 2: it gives you a negative correlation to equities in times

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Speaker 2: of stress. But as I mentioned earlier, just relying on

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Speaker 2: a buy and hold portfolio to give you those characteristics

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Speaker 2: is much less efficient and effective than it was in

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Speaker 2: the past. And so now you need to think about

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Speaker 2: fixed income assets in a very idiosyncratic manner. Do you

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Speaker 2: want funds that have high leverage? Do you want to

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Speaker 2: have funds that have very high credit exposures? And if

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Speaker 2: you do, that's absolutely fine, But how are you blending

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Speaker 2: those products? And how are you making sure you're getting

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Speaker 2: your yield and your negative correlation? And those are the

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Speaker 2: two key things you need out of fixed income, and

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Speaker 2: you can still get them. It's still easy to get them,

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Speaker 2: but you need to approach it a different manner.

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Speaker 1: We will thank you for talking to fear and greed.

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Speaker 2: Thank you.

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Speaker 1: Sure that was w will go ahead of fixed income

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Speaker 1: and multi asset at Elliston Capital, which is working with

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Speaker 1: sale Or Capital and great supporter of this podcast. Remember

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Speaker 1: information in this podcast is general in nature and you

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Speaker 1: should get professional advice and make sure a product is

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Speaker 1: right for you before proceeding. This is a Fear and

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Speaker 1: Greed business interview. Join us every morning for the full

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Speaker 1: episode of Fear and Greed, daily business news for people

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Speaker 1: who make their own decisions. I'm sure Alma enjoy your day.