George Vassos

When it comes to the outlook for bond investing, the Asian story continues to appeal. And the banks are playing a starring role, says George Vassos, Managing Director of specialist fixed income investment manager, Omega Global Investors.

“The Asian outlook is one we have favoured in general for some time, but what has attracted our particular attention is the strong performance in the financials sector, both in itself and also in the way it highlights the headwinds the European and US financials sectors face as they grapple with the recovery, new capital preservation requirements and other issues,” explained Mr Vassos.

“Analysis using our proprietary credit default model shows that despite intensive reforms, most developed world banks have a way to go before they turn the corner. Of course, the Australian banks are the exception to this rule. For various reasons they continue to be among the most profitable in the world, well and truly outstripping most in Europe and the UK. Whether or not that profitability translates to strong returns from a bond investment is of course, another matter.”

Mr Vassos went on to provide more detail about the contrast between the Asia Financials sector and that of Europe and the UK. He also stressed that the Omega ratings process provides different outcomes from that of the traditional ratings houses. This is due to the relatively slow moving nature of the ratings agency methodology – especially when it comes to assessing a fast moving environment which has dramatically changed in shape since events such as the global financial crisis and the surge in growth of the emerging markets’ middle classes.

“An example of this is HDFC Bank from India which we rate higher than Erste Group Bank from Austria. This is despite HDFC being rated lower than Erste by S&P. Our rating is on the back of HDFC having a better capital position and being more profitable. Bear in mind here that the relevant S&P rating was last updated in 2008,” said Mr Vassos.

He also pointed out that not all European banks score poorly, citing Komercni Bank from the Czech Republic as one of Omega’s highest rated banks.

Looking to the US, Mr Vassos called out Citigroup and First Republic, saying “We are happy with the capital position of both, however the poor profitability of Citigroup is cause for concern particularly when there are alternatives like First Republic, which has the same country risk, but is very profitable.”
What all this tells Omega and its investors is that, for the medium term at least, Asian banks are likely to be strong, stable performers. However, that doesn’t mean their European counterparts are out of the game for good.

“We’ll be keeping a close eye on those in the Eurozone and elsewhere because at some point it’s likely that the positive impact of outcomes from Basel III such as beefed up tier one ratios and capital preservation requirements will kick in to their bottom lines,” concluded Mr Vassos. “And we do want to be around to capitalise on it.”

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Andrew Cleeland

A credit default model that improves on conventional credit ratings, involves deep analysis of key financial ratios and gives as much weight to predicting negative events as positive ones, is delivering consistent positive returns for specialist investment manager, Omega Global Investors.

The process represents a refinement of the existing Omega Financial Health Rating, enabling Omega to effectively compare credit risk both within and – significantly – between sectors. It also enables effective comparison irrespective of geography, so developed and emerging market companies can be compared like for like.

To date, Omega’s process has proved more accurate in identifying mispriced credit than that of major ratings agencies.

“Mispricing spells opportunity for investors but is not always easy to spot except in hindsight,” explained Omega Investment Research Analyst, Andrew Cleeland, who has played a key role in developing and refining the Omega health rating.

“This is generally because of the complexities of comparing different issuers from different sectors from different regions – in other words, factors that that can change from moment to moment. Our model has been designed to capture this complexity, giving us a ‘top down’ approach that highlights where the opportunities are.

“We also benefit from the fact that the Omega credit default model is fast moving, while credit ratings are often tied up in red tape which slows their process down. We are able to cut through that tape so to speak.”

Mr Cleeland went on to cite examples.  In companies from the same sector – transport – for example, he pointed to Qantas and Kansas City Southern.

“Both are rated BBB by S&P, however our health rating give different results. While our health rating for Qantas is equivalent to the S&P rating largely due to higher than average leverage and poor recent earnings results, we rate Kansas City Southern better – largely due to its lower leverage and stronger cashflow.”

When it comes to cross sector comparisons, Mr Cleeland compared Kansas City Southern with consumer staples companies ConAgra Foods and Avon – both of which are also rated BBB by S&P.
“We would in fact rate ConAgra Foods somewhat higher and more on par with Kansas City Southern due factors such as its low leverage, strong cashflow and stable dividends,” he said.

“These two companies can be validly compared not only because they have strong financials for their respective sectors, but because their sectors also have similar low historic rates of default – also factors that are incorporated into our final rating.”

“Our process has been refined and developed over time to encompass a growing number of financial ratios including profit, leverage, market information and efficiency,” said Mr Cleeland.

“The fact is that in a market environment that’s characterised by shift and change – more often than not defying  convention – it’s up to investment managers to be aware responsive to the conditions environment rather than using backward-looking tools to make forward-looking decisions. And it’s the investors with the best tools who will be best positioned to gain.”

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“It’s our contention – supported by the numbers we’re seeing in our fund and its popularity among both institutional and increasingly, retail investors – that the right kind of global listed infrastructure assets can form a vital part of diversified income generating portfolio,” said Omega Managing Director, George Vassos.

“We’ve applied our strategy specifically to deliver an alternative for investors seeking defensive assets that also generate strong yields and certainty of income, minus the volatility associated with equities.”

Mr Vassos went on to explain that the listed infrastructure assets in the Omega fund have a low correlation with international equities. As such, they provide diversification benefits that may not necessarily apply to all infrastructure assets.

“Our portfolio is tilted to higher yielding securities, which means companies with strong balance sheets,” he said.
“The stable yield and high total return from the Fund is a reflection of the strength and monopolistic nature of the companies. What we mean by this is that they don’t have much competition, which translates into sustainable growth and predictable cash flows,” he explained.

There has been much written about the so-called ‘great rotation’, with investors switching from low yielding fixed income back into equities: but that does not tally with Omega’s experience.

“Since its inception in last September, the Omega Global Listed Infrastructure Fund has grown to over $160 million, moving from $95 to $167 million since March alone. The performance of the Fund has also been very strong, equating to 12.56% since inception.”

Mr Vassos attributed the strong performance of the Fund to the sub-sectors represented within it, including integrated regulated utilities, toll roads, water, transmission & distribution, all of which are defensive in nature and provide stable income streams.

“It’s important to understand that this Fund has been designed in line with Omega’s risk-controlled process,” he said. “Our portfolio construction is subject to tightly managing risk and volatility, and we invest in up to 200 global listed infrastructure assets.”

The fund has a major regional exposure to the US, with major sub-sector exposure to integrated regulated utilities such as The Southern Co, Duke Energy Corp and American Electric Power.

“In Australia, we like toll road companies such as Transurban Group,” said Mr Vassos.

In conclusion, Mr Vassos said that when his team was developing the Fund, they focused on the outcome they wanted and worked backwards.

“Investors were looking for liquid exposure to infrastructure, a low correlation to international equities and a consistent, high and stable income stream,” he said.

“And that’s what the Omega Global Listed Infrastructure Fund offers.”

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George Vassos, Managing Director of Omega, believes the last few years have seen a fundamental economic shift to the East – and that investors have finally recognised the fact.

“Asian corporations have strong balance sheets relative to their global sector peers and often with much less risk, which makes them an attractive option for investors looking for superior risk adjusted returns,” said Mr Vassos.

“Banks are just one example. The European and US banks have certainly had their issues over the last few years and those are continuing. On the other hand, their Asian counterparts, such as ICICI Bank and OCBC Bank, have experienced strong growth, strong balance sheets and have a far more positive long-term outlook with a lower probability of downgrade or default,” said Mr Vassos.

According to Mr Vassos, Omega is one of the few investment managers that saw the potential of Asian corporate bonds prior to them becoming more widely favoured.

“Omega’s Corporate Bond fund has had a 40 per cent allocation to Asian corporate bonds, excluding Japan, since its inception in 2009. Our proprietary risk-controlled methodology uses key criteria such as profit, liquidity, gearing and solvency to assess risk and allow us to identify quality securities for our clients.  Using this methodology, we were able to identify the quality securities well ahead of the pack,” said Mr Vassos.

Mr Vassos went on to explain that the corporate bonds Omega has selected are underpinned by strong fundamentals, and therefore have a strong, long term positive outlook.

“At Omega we expect to see an increased demand for Asian corporate bonds over the coming year as growth in the region continues.  We’re particularly looking at corporations issuing bonds in countries such as Malaysia, Thailand, Taiwan, Korea and Singapore that are showing signs of maintaining that growth over the next few years,” said Mr Vassos.

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On the contrary, the Omega research has shown that the application of its proprietary risk-controlled methodology is a highly reliable indicator of the likely performance of sovereign bonds issued by a range of nations.

The research is particularly significant because it provides guidance for investors in the face of the dramatic shift in the status of sovereign investing since major world events: the GFC, the actions of major governments in addressing it and the subsequent European sovereign debt crisis. 

“Not so long ago, sovereign debt from major developed nations was considered about as low-risk as you could get,” explained Mathew McCrum, joint head of investments at Omega.  “But post GFC, experience shows us that some of those assumptions no longer apply. The challenge for investors is how to make decisions according to information that’s accurate and relevant in the new environment.”

The desire to pinpoint the factors most relevant to sovereign bond investors in today’s environment has driven this latest Omega research, which back tests the efficacy of the ‘Omega Financial Health Rating’. This is one of a number of risk control tools that’s been used by Omega since its inception in 2008. It is focused on limiting exposure to losses resulting from sovereign defaults and downgrades.

The Omega system assesses both the financial strength and political risks associated with the country it is rating. The financial strength measures focus on a government’s ability to repay debt, and are currently based on the net debt to GDP ratio.  Political risk measures, on the other hand, address a country’s willingness to repay it.

More recently, Omega wanted to explore the potential benefits of enhancing the rating by including additional financial health measures.

“Within a fluctuating financial environment we wanted to see if certain additional measures will help provide a more robust account of a country’s financial health and are therefore a valuable indicator of the likelihood of default,” said Mr McCrum.

Those additional measures include the bonds’ cost based on ten-year-yields; length judged by average maturity; and momentum as assessed bysix-month changes in net debt to GDP.

The research and its findings
The research involved testing the existing Omega Financial Health Rating to see whether it limited exposure to downgrades; and whether it supported improved returns. Proposed additional health measures were also then tested. The benchmark used was the JP Morgan GBI Broad Index.
Ratings downgrades findings: 45 investment grade countries were split into quintiles based on the Omega Financial Health Rating for each year since 1999. The findings show a clear correlation between the resulting rating and future downgrades. For Omega’s investors, this translated to zero exposure to any of the 22 countries that experienced downgrades during the relevant period.

Returns findings: The yearly quintiles created from the Omega Financial Health Rating were compared with the one year forward total returns. The findings show that countries with a superior Omega rating had both larger average returns and reduced volatility of returns. For Omega’s investors this translated to increased return of 9% which was 1.10% over the performance benchmark.

Additional health measures findings:  The next step was to back test performance in relation to each of the proposed additional financial strength measures. For all four measures, the countries with the superior financial health rating tended to have lower volatility of returns, with all but the maturity measures also delivering higher average returns.

“One of our real concerns at Omega was that the current extreme risk aversion in the market would result in an approach that placed all sovereign debt into one basket, irrespective of its quality – and that investors would miss out as a result,” said McCrum.

“However our research clearly shows that using a comprehensive risk-control tool that’s built on a strong platform of objective economic and political measures gives us an accurate picture of the true risks that apply, and helps us make investment decisions accordingly. We’ve had some very good results in our funds this year and one of the key motivations for undertaking this research is that we are keen to maintain the high performance.

“We want to stay in front of changes to help us continue offering investments that deliver both maximum upside potential and protect on the downside. Because that’s what fixed income investing should be all about.”

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The appointment strengthens Omega’s risk-focused asset management capabilities and adds further depth to the firm’s proprietary research and credit analysis.

Omega‘s joint Director of Investments, Andrew Gruskin welcomed Andrew Cleeland’s appointment. He said the firm’s core belief is that superior investment outcomes can be achieved through understanding and controlling investment risk.

“Andrew’s significant experience in the research field is invaluable and will further enhance our business and investment team on behalf of institutional clients.”

Andrew joins Omega with over six years financial markets experience, specialising in quantitative research and analysis, valuation modelling and system development. In his most recent role, Andrew was a Quantitative Analyst at Austock Securities for five years, where he built and managed the quantitative research and construction of research reports. Andrew holds a Bachelor of Mechanical Engineering and a Graduate Diploma in Applied Econometrics.

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The strategy was co-developed by Omega with Local Government Super (LGS), a leader in sustainable investment. With over $3 billion in funds invested in responsible strategies, LGS’s commitment to sustainable investment is by far the largest of any Australian super fund.

LGS has awarded an initial $170m mandate to the Sustainable Global Government Bond Fund, to be managed by an investment team jointly led by senior Omega investment executives Mathew McCrum and Andrew Gruskin.

“The strategy is leading edge – in fact we believe it to be an Australian first, and one of just a handful created around the world. It was co-developed over nine months between Omega and LGS, which is an industry super fund with deep commitment to ESG and a signatory to UNPRI principles on sustainable investment practices,” Omega Director of Investments, Mr McCrum said.

“The strategy integrates with Omega’s existing risk-controlled approach to fixed income investing, built upon our proprietary financial health rating filters,” said Mr McCrum.

“Our aim is to choose global government bonds derived from fiscally robust and politically stable nations but which also pass meaningful ESG filters. These include nations with strong environmental awareness and governance standards, and with sound score cards in the areas of regulation and human rights.

When constructing the portfolio, Mr McCrum explained the aim was to manage risk without compromising alpha generation.
“We also understand through our performance track record that it is possible to construct high quality, well-diversified bond portfolios that also deliver a strong sustainability dividend above benchmark,” he said.

LGS Chief Investment Officer Craig Turnbull said risk minimisation across the spectrum of investment and operational risks has become a critical component of effective asset allocation.

“We are looking to develop innovative strategies that manage or mitigate our ESG risk exposure, and to capitalise on investment opportunities across all asset classes to achieve solid returns for our members. The sustainable global government bond strategy is a great example of our principles in action.”

“We welcome the partnership with Omega, and value the ability to co-produce innovative approaches that allow us to continue leading the way in investing wisely and responsibly in a world that is rapidly changing,” Mr Turnbull said.

7 June 2012

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Omega has timed the release to capitalise on a renewed interest from institutional investors looking for a high quality investment grade bond portfolio with a stable return profile.  The fund will predominately invest in a combination of Australian government and corporate bonds.

 “Australia is in an enviable fiscal position compared to many other developed nations and Australian government bonds provide an attractive yield, especially on a risk adjusted basis. Australian corporate bonds also compare very favourably to their European and US counterparts, especially in the current market. This gives investors access to increased diversification and higher yields,” said Mathew McCrum, Omega’s Director of Investments. “All in all they carry much lower downside risk than those in almost any other developed country.”

The fund’s diversified portfolio invests in a range of quality Australian corporate, government, semi-government and mortgage backed security bonds, enabling access to issuers such as Rio Tinto, Woodside, BHP, Stockland and ANZ. 

While the domestic bond market is generally dominated by government issued bonds, Mr McCrum stresses the importance of a proactive approach to purchasing securities to avoid the pitfalls of following the herd. 

“It’s important to remember that there are still risks associated with bonds, so simply following the benchmark is inefficient.  At Omega we use a risk-controlled approach specifically controlling return volatility and we undertake a stringent screening process to identify high quality securities for our clients,” said Mr McCrum.

According to Mr McCrum, Australian bonds represent a great opportunity but are currently underrepresented in portfolios.  McCrum says Australians tend to have a total asset allocation to bonds of approximately 13 per cent compared to 50 per cent allocation to shares.  In other developed markets such as the G20 nations, the allocation is around 20-30 per cent.   

With market volatility and demographics of superannuation members migrating from accumulation to retirement phase, investment strategies have shifted focus to defensive assets.  Mr McCrum believes the Australian Bond Fund enables investors to tailor their asset allocation to best suit their investment strategies.

The Australian Bond Fund will be open from 9th September and will start with a $200 million FUM with a view to gradually increase its portfolio size.  The $200m investment into the Australian Bond Fund brings Omega’s total FUM to over $1 billion.

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“Institutional investors increasingly want access to both the domestic and global inflation-linked bond markets, allowing them to make tactical decisions regarding allocations between the two based on their views of global market conditions,” Omega Managing Director George Vassos said.

“This value proposition for investors is supported by strong growth, with both domestic and international inflation-linked bonds returning more than six per cent over the last six months, in a time of high volatility in the global markets.”

Omega began managing mandates for both Australian and global inflation-linked bonds in the past 12 months as the institutional market looked to increase allocations to this asset class.

“The increasing number of baby boomers heading into retirement this decade has shifted the focus from investment strategies relevant for the accumulation phase of a superannuation plan to those that are more in line with the objectives of a retiree – a concentration on income and a return on investment over the rate of inflation,” Mr Vassos said.

“This market wants to increase their exposure to asset classes that deliver consistent income and don’t diminish the purchasing power of their retirement pool.”

Mr Vassos said the growth of both domestic and international inflation-linked bonds is linked to the global demographics of superannuation members and the expectation that inflation will generally increase in the next 5-10 years.

“Inflation is definitely at the forefront of the Reserve Bank’s mind in Australia, plus there is the broad expectation that it will pick up around the world – for example China recorded an annualised inflation rate of 6.4 per cent in June,” Mr Vassos said.

Mr Vassos said Omega is one of the few boutique managers to have a mandate for both domestic and international inflation-linked bonds, enabling investors to tailor their allocations between the two to suit their needs. 

He said the increasing appetite for Australian inflation-linked bonds would likely grow the supply and depth in the marketplace, with more issuance expected from Australian governments, both at federal and state level.

“Increasingly, investors are looking for asset classes which are CPI linked or fixed income as a total asset class, and this really fits with our capability across the defensive asset spectrum,” Mr Vassos said.

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