January 2013
For Professional Investors only
Schroders
Credit where credit is due
Chris Durack, Head of Product and Distribution and Oliver Trusler, Investment
Specialist
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.
Issued by Schroder Investment Management Australia Limited
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ABN 22 000 443 274 Australian Financial Services Licence 226473
January 2013
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Chart 1: T
The Perform
mance of Te
erm Depos
sits
Source: RBA to 31 Decemberr 2012, Term De
eposit rate for b alances >$10,0
000 over 12 mon
nths
− Term deeposits have outperformed institutionaal cash markkets since the
e GFC. Overr the last 12 months
m
term
depositss have outperrformed by a margin of b
between 90 and
a 100 basis
s points. Hoowever in late
e 2009, the
margin o
of term depossits over cas
sh exceeded 200 basis po
oints. Prior to
t the GFC, tterm depositts typically
offered rrates consistently below institutional
i
ccash markets
s. It is proba
ably reasona ble to expec
ct term depossits
will rema
ain competitivve relative to
o cash marke
ets but mode
erating in term
ms of their m
margin to cash from this
point goiing forward.
− However, in absolute
e terms, 12 month
m
term d
deposit rates have decline
ed from overr 6% in 2011 to around 3.54% now (December 2012).
− As thesee rates declin
ne investors may require higher return
ns than is likely to be avaailable from term
t
deposits.
Is the “De
emand for Income” really deman
nd for safetty and sustainability?
?
In the “post retirement” market wherre investors a
are more reliant on their investment pportfolio (as opposed
o
to
employmen
nt income) to fund their co
onsumption n
needs, it is still
s the total return
r
that m atters most where
w
investtors
primarily seek:
− a reliablee return strea
am; and
− avoidancce of severe downside ou
utcomes.
As a proxy ffor these objectives, inve
estors and th eir advisers often expres
ss a desire foor income ba
ased
investmentss. But if an in
nvestor is en
njoying retire ment and the
erefore draw
wing on their iinvestment portfolio,
p
their
tax position is often such that there is
i no differen
nce between income and capital (an iinvestment th
hrough an
allocated pe
ension attraccts a 0% tax rate on both its income and
a capital co
omponent). Moreover, iff an investor is
still subject to tax, there may well be
e arguments to seek capital returns given they maay attract discounted
treatment re
elative to inco
ome. It is for reasons su
uch as these that it may be
b instructivee to “look thro
ough” the
income and
d capital components to th
he total returrn and evalua
ate what type
es of total reeturn meet the objectives
outlined abo
ove.
Analysis o
of a sustain
nable returrn profile
If sustainability of a total return is a primary
p
objecctive, how ha
ave the returrns from inceeption for cre
edit stacked
up? The Scchroder Cred
dit Securities
s Fund investts in corporate debt and other
o
incomee producing securities
s
across the w
world and with an Australian investorr in mind and has a targett of outperforrming the RB
BA cash rate
e
+2.5% (grosss of fees) ovver rolling three year perriods. The sttrategy has been
b
operatinng for over 11 years sincce
October 200
01, including
g through the
e GFC, where
e the fund re
emained liquid and open tto client rede
emptions. Th
he
table below shows the returns
r
of the
e Fund comp
pared with its
s objective off outperformi ng the RBA Cash rate
+2.5% overr rolling three
e year periods.
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January 2013
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Table 1: Performance of the Schroder Credit Securities Fund
1 year
%
3 years
% pa
5 years
% pa
10 years
% pa
Since inception
%p.a.
Fund (gross)
10.8
8.6
6.4
6.9
7.2
RBA Cash rate
3.7
4.3
4.2
4.5
4.8
Excess (gross)
7.1
4.4
2.2
2.4
2.4
To 31 December 2012
Source: Schroder Credit Securities Fund (gross of fees) inception: 23 August 2002, strategy inception 18 October 2001 − 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
1 year
%
3 years
% pa
5 years
% pa
10 years
% pa
Since inception
%p.a.
Fund (gross)
10.8
8.6
6.4
6.9
7.2
RBA Cash rate
3.7
4.3
4.2
4.5
4.8
Excess (gross)
7.1
4.4
2.2
2.4
2.4
To 31 December 2012
Subtract 125 basis points p.a. to allow for wholesale fees and assumed TD premium
Excess (net)
5.9
3.1
0.9
1.2
1.2
Source: Schroders. Fund Inception: 23 August 2002, strategy inception 18 October 2001 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 3% p.a. (and 1 year term deposits now offering around
3.5-4%), 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.
1
For direct investments >$50,000 or available via platform, >$500,000 investments into the institutional share class attract a
fee of 0.54%
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The followin
ng chart show
ws the rolling
g 3 year retu rns over the 10 year period to Decem
mber 2012.
Chart 2: S
Schroder Credit Securrities Fund
d versus eq
quities and cash: rolliing 3 year returns
r
oder Credit Securities Fund (gro
oss of fees), Glo
obal Financial Data
D
to 31 Dece
ember 2012
Source: Schro
While cash markets ove
er the period have producced relatively
y stable returrns averagingg around 5%
% p.a., the
impact of th
he GFC had markedly
m
diffferent impaccts on investo
ors dependin
ng on how muuch risk they
y were willing
g to
take on. In the case of the
t Schroder Credit Secu
urities Fund, the largest 3 year negattive return wa
as 2.0% p.a. for
the period e
ending 31 Ma
arch 2009. By
B way of co ntrast, the la
argest 3 year negative retturn for equitties was 8.2%
%
p.a. for the tthree year pe
eriod ending 28 Februaryy 2009.
However, in
n terms of wh
hat matters to
o investors, iit is not really
y sufficient to
o draw concl usions about the
appropriateness of an asset
a
class ba
ased on the largest 3 yea
ar negative return. Ratheer, it is perha
aps more
instructive to look at the
e longest draw
wdown perio
od as well. In
n other words
s, if I investeed $100,000 in the Schroder
Credit Secu
urities Fund versus
v
$100,000 in equitiies (before th
he impact of fees and asssuming I rein
nvest my
distributionss), how long would it take
e before I reccovered the nominal
n
value of my inveestment in the
e worst
case? Agaiin, the differe
ences between the invesstment in the Schroder Crredit Securiti es Fund and
d the
investment in equities are striking an
nd are summ
marised in the
e following ta
able.
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Table 3: Im
mpact on in
nvestment value if $1
100,000 is invested att the peak o
of the mark
ket and
maximum drawdown
n
Investmen
nt Peak Schroder C
Credit Securities Fund October 200
07
S&P ASX 200 Index October 200
07
Time to
o recover to peak
August 2009: 1 yearr, 10 monthss Not yet recovered. After
A
5 yearss original inve
estment valu
ue
of $100,000 is appro
oximately $887,119 at 31 December
2012
Through the
e GFC this Fund
F
experien
nced a nega
ative return, however
h
this strategy is ddesigned to take on more
e
risk than de
efensive asse
ets, but less risk than the
e equity mark
ket. When we look at thiss drawdown in the contexxt
of broader m
market return
ns, the strate
egy appears to offer the characteristic
c
cs we would expect.
Because thiis strategy ta
akes on more
e risk (to gen
nerate more return), inves
stors need too consider a more
appropriate (longer) time
eframe for th
he strategy to
o recover fro
om risk off pe
eriods. The sstated timefra
ame required
d
for this type
e of strategy is at least 2-3 years, nota
ably shorter than
t
is required for the tyypical equity market
strategy.
Chart 3: S
Schroder Credit Securrities Fund
d versus eq
quities and cash: cum
mulative tottal return
performan
nce, since the
t equity market pea
ak
urities Fund (gro
oss of fees), Glo
obal Financial Data
D
to 31 Decem
mber 2012
Source: Schroder Credit Secu
Looking at tthis period off extreme dra
awdown grap
phically since
e the GFC (i.e. since the October 200
07 market
high):
− Equity m
markets have been very volatile
v
and a
are yet to reg
gain their lostt ground.
− Despite some short term
t
volatility
y, less than 2 years after the peak the
e Schroder C
Credit Securities Fund
regained
d its capital value.
v
− After 3 yyears the stra
ategy had de
elivered a tota
al return ahe
ead of both cash and impportantly term
m deposits.
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What is a fair and ac
cceptable margin
m
ove
er cash?
The analysis above hass shown that the degree tto which inve
estors take on risk away ffrom cash wiill heavily
influence the total return
n on their inv
vestment. Mo
ost importantly not just by looking at tthe average outcomes but
also by considering how
ay be impacted by investting at the wrrong time (a local peak in
w potential drrawdowns ma
n
the market).
Over longerr timeframes, if we are ris
sk averse an
nd seek to av
void unneces
ssary volatilityy relative to the objective
es,
we need to ask what minimum requiirements we might have for a given in
nvestment. A very comm
mon objective
e in
this regard iis whether an investmentt keeps pace
e with the ratte of inflation. Again, to illlustrate the performance
e of
investmentss carrying diffferent levels
s of expected
d risk, we hav
ve shown the
e cumulativee performance of cash and
equities aga
ainst the Sch
hroder Creditt Securities F
Fund over the
e last 10 yea
ars with a staarting investm
ment in each
case of $10
00,000.
Chart 4: S
Schroder Credit Securrities Fund
d versus eq
quities and cash: cum
mulative 10 year total
return perrformance
Source: Schro
oder Credit Securities Fund (gro
oss of fees), Glo
obal Financial Data
D
to 31 Dece
ember 2012
An importan
nt assumptio
on in the abov
ve analysis iss that all inco
ome generatted by each iinvestment is
s
reinvested. When this assumption
a
is
s made, it ca
an be seen th
hat all three investments outperform the
t cumulativve
rate of inflattion. The be
est performing
g investmentt over this pa
articular 10 year
y
period w
was in the Au
ustralian sharre
market, how
wever all cum
mulative outp
performance was earned in the first 5 years. As w
we showed above, if an
investor had
d invested ha
alfway throug
gh this period
d, they would
d still be waitting to recovver their initia
al investmentt.
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But, what about inco
ome?
From the ou
utset of this discussion
d
piiece, we refe
erred to inves
stors’ deman
nd for incomee. If part of the demand for
f
income is about drawing
g on the particular investm
ment to prod
duce regular payments, thhen does this
s change the
e
behaviour o
of a particular investment’s performan
nce relative to
o inflation? To
T answer thhis question we assumed
d
that a consttant 4.5% p.a
a. (approxima
ately the retu
urn of cash over
o
the perio
od) of the inittial value of the
t investme
ent
was withdra
awn every three months. The cumula
ative return fo
or each inves
stment is shoown below re
elative to the
e
performance of inflation.
By opera
ating in a high
h income un
niverse and fo
ocussing on the total retuurn objective,
the outcome is a stro
ong income distribution
d
re
eturn profile.
Chart 5: S
Schroder Credit Securrities Fund
d versus eq
quities and cash: cum
mulative 10 year total
return perrformance after 4.5% p.a. quarte
erly withdra
awal of inittial investm
ment
Source: Schroder Credit Secu
urities Fund (gro
oss of fees), Glo
obal Financial Data
D
to 31 Decem
mber 2012
The key poiint here is tha
at if investors
s are seeking
g to fund the
eir lifestyle ne
eeds (i.e. connsumption) using
u
predominan
ntly cash bassed investme
ents, then the
e real purcha
asing power of
o their remaaining investm
ment is likelyy to
decline ahe
ead of other asset
a
classes
s with the po
otential for hig
gher total retturns. If this situation is to
t be mitigate
ed,
investors ne
eed to consid
der that some tolerance o
of volatility is
s required to avoid significcant reductio
ons in
purchasing power. Ove
er the last 10 years the eq
quity market has significa
antly outpaceed cash. However, the cost
of this outpe
erformance over
o
the perio
od was seve
ere underperfformance inc
curred duringg the GFC where cash
performed m
more stronglyy. The addittional cost off holding equ
uities was the
e reduction inn total returns over the most
m
recent 5 yea
ars of the pe
eriod meaning
g the return o
of equities ov
ver the perio
od was heavi ly dependen
nt on the entrry
point. Howe
ever, the Sch
hroder Credit Securities F
Fund has ke
ept pace with or outperforrmed the rate
e of inflation
over the lon
ng run (before
e the impact of fees), witth much lowe
er volatility th
han the equity
ty market.
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Expectatio
ons for cre
edit markets moving fforward
There is a lo
ot of focus on bond mark
kets at prese nt given the low yields on
n offer in govvernment bonds across
major marke
ets. While this is having an
a impact on
n yields in cre
edit, we belie
eve that creddit spreads are still
attractive an
nd provide ad
dequate com
mpensation fo
or credit risk. Taking this into accountt, together with
w the
prospects fo
or further sprread compre
ession, return
ns in the orde
er of 5-7% pa
a from the Scchroder Cred
dit Securitiess
Fund over the next coup
ple of years are
a possible (2-4% ahead
d of expected returns froom 12 month term deposits
over a similar timeframe
e).
Credit lookss attractive frrom a valuation perspectiive, although
h credit sprea
ads (credit rissk premium)) have come
down and w
we have seen
n a moderating in the cre
edit risk prem
mium closer to
o long run avverages. As can be seen
n
from Chart 6 below, cred
dit has move
ed from being
g cheap (pos
st GFC) to fa
air value, but credit is still offering solid
yields in a b
broader declining rate env
vironment.
Chart 6: V
Valuation - Australian
A
corporate bonds rem
main relativ
vely stable and a source of yield
d
mberg
Source: Bloom
− The Ausstralian marke
et is primarily
y an investm
ment grade market
m
and ha
as not seen tthe same vollatility as
offshore markets.
− Australiaan spreads have
h
been reasonably sta
able and trad
ded in a tighte
er range, desspite global volatility.
v
− We belieeve the Austrralian market to be arounnd fair value in terms of credit
c
risk preemium, offeriing a 100bp
premium
m over swap.
Concludin
ng remarks
s
Investor objjectives are really
r
the onlly meaningfu
ul benchmark
k against which to judge tthe appropria
ateness of a
particular in
nvestment. Our
O view is th
hat for investtors seeking a sustainable and reliablle return ove
er shorter as
well as long
ger periods, cash
c
based investments are unlikely to provide su
uccessful stra
rategies. This
s becomes
particularly acute over lo
onger periods given the p
potential eros
sion of purch
hasing powerr relative to inflation and
where invesstors require a drawdown
n from their in
nvestment to
o finance their consumpti on. Therefo
ore some
degree of vo
olatility risk needs
n
to be accepted.
a
Fo
or those inve
estors unable
e to withstannd high degre
ees of volatiliity,
again becau
use the total return is relied on over sshorter period
ds, equity ris
sk needs to bbe treated with a high
degree of ca
aution. By way
w of contra
ast, the Schro
oder Credit Securities
S
Fu
und balancess the need to
o ensure a real
return is ma
aintained ove
er longer periods of time a
against the importance of
o avoiding seevere drawdown events.
Schroder Invesstment Manage
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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.
Disclaimer
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.
Investment in the Schroder Credit Securities Fund may be made on an application form in the Product Disclosure Statement
(PDS) dated 1 February 2011 which is available from Schroders. 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.
2
The 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.
Schroder Investment Management Australia Limited
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