Tomorrow’s Titans 2022: Christian Baylis

Multi-faceted fixed income and credit alpha

The Hedge Fund Journal
Originally published on 01 August 2022
  • Founder and CIO, Fortlake Asset Management Pty, Sydney, Australia

Fortlake fuses two words: fort, meaning strength and security, and lake symbolizing peace and calm, which also sums up the firm’s objective of generating strong risk adjusted absolute returns. Its hedge fund product, Fortlake Sigma Opportunity Fund (FSOF), is designed for equity refugees and targets returns of 7-10% with volatility of 5%, implying a Sharpe ratio of 1.5 to 2. The realized Sharpe since inception has been nearer to 4, and Christian Baylis’ prior track records at UBS also generated high Sharpes. Fortlake also offers lower volatility strategies, which can cater for retail investors.

Baylis previously managed billions for UBS, including inflation-linked mandates, ran currency reserves at Australia’s central bank and has also worked for S&P on structured products. His earlier PhD in inflation forecasting and option probabilities laid the analytical foundations for some facets of the strategy, and informs part of the investment philosophy, which ambitiously sets a target of keeping pace with inflation – even in June 2022 when developed market real interest rates were deeply negative. This encourages some investors to reach out into private and structured credit for illiquidity and other premiums, but Baylis does not believe this is necessary. He judges that the current strategy, focused on mainly investment grade government, inflation, corporate and mortgage cash and derivative markets, in the US, Europe and Australia, can meet investors’ return targets, and is also scalable to at least $10 billion of assets.

If you are siloed into one asset class...there is one degree of freedom. We are pulling more levers: we have multiple markets and instruments to choose from, which creates at least 30 sources of alpha.

Christian Baylis, Founder and CIO, Fortlake Asset Management Pty

Baylis’ vision for Fortlake is to create an alternative fixed income solution for both the Australian market and global fixed income, which generates alpha from multiple angles: “If you are siloed into one asset class like plain vanilla cash bonds and tied into one market, there is one degree of freedom. We are pulling more levers: we have multiple markets and instruments to choose from, which creates at least 30 sources of alpha, of which many are not correlated. The interposing philosophy considers relationships between all value buckets, including rates, inflation and credit, blending all value drivers. We see other fixed income and credit teams being much more siloed by asset class,” says Baylis.

Novel corporate structure and diverse team

Starting a brand-new firm from scratch with such a wide purview requires capital, balance sheets, infrastructure and relationships. To hit the ground running from day one, Fortlake conceived an unusual structure with three strategic partners and one seeder. JP Morgan prime brokerage’s incubation program provides clearing and repo lines; Tactical Global Management acts as outsourced middle and back office; and ASX listed firm IAM is the distribution partner, also handling administration and some investor relations functions. Seed capital comes from renowned Australian billionaire small cap and tech fund manager, Alex Waislitz.

The team is diverse. Three of Fortlake’s four investment professionals, including Deputy Chief Investment Officer and Chair of the Investment Committee, Dr Kylie Anne-Richards, are women. Baylis believes this is unique in Australia, particularly in roles involving trading, quantitative skills and coding, which are still heavily male-dominated to this day. It is partly a function of happenstance, while a deep bench of women also helps maintain diversity and improves diversity and inclusion more generally. “The most recent studies show that it will take another 111 years – or until 2133 – to close the gender equality gap globally based on the current rate of progress. Achieving gender equality isn’t just a moral issue – it makes economic sense. There has been considerable focus on women on boards, and whilst this is critical, we cannot rely solely on this and need to look at adopting a solid diversity strategy across all rungs of the ladder. Having three women on the team at different ages and stages bolsters the other women here and helps us retain the talent within the team. Women still bear the brunt of childcare responsibilities and home care duties. Having flexible working policies and a supportive and inclusive work culture goes a long way to ensure we retain the talent within the team and for the longer term,” says Baylis.

Relative value and directional

The strategy combines fixed income and credit arbitrage style trades with more traditional directional global macro style trades, and for all ideas, trade structuring can involve a variety of linear and non-linear instruments.

In relative value strategies, default arbitrage, between indices, tranches, and parts of tranches, mainly on CDX and ITRAXX in the US and Europe, has been an important driver of returns, and this strategy can even be offered on a standalone basis in customized mandates.

Ahead of the curve on inflation

Directionally, the inflation thematic has been a good call for Fortlake. “We have had a very bearish stance, well above consensus, since the firm started. We took the view that inflation was far from transitory, as it starts to permeate the psyche and ratchet up expectations. Covid wiped inventory clean while enforced savings created pent-up demand, and more money was printed over 18 months in the pandemic than in the prior 10 years. Less labour migration, China lockdowns, supply chain issues and the Russian invasion create a perfect storm. Anticipatory inflation is already seen in the consumer psyche, and this could lead to wage-price spirals,” says Baylis.

He is confident about the direction of travel – but also sees a huge margin of error in forecasting and has a different philosophical and statistical approach to many economists and investors. “After a one in one-hundred-year pandemic, there was going to be huge degrees of uncertainty in forecasting with a wide distribution of outcomes. Central bankers who look at the world stochastically, applying probabilities to previous states of the world, thought that forecast errors would remain tight and with historical mean reversion. But after a unique pandemic, with an isolated and totally variant outcome, it is really dangerous to get excited about forecasts. Rather than rely on mean reversion, it is better to be much more dynamic on monetary policy, like delta hedging a position. In a situation like this, we use Monte Carlo simulations rather than relying on a past viewpoint. We also employ risk-based forecasting, having authored a paper on the topic,” says Baylis. Baylis takes the view that basing monetary policy on a central base case path is risky given the huge errors entailed in estimating the natural rates of unemployment and inflation and the long- and variable-time lags before monetary policy takes effect. Therefore, it is better to iteratively adjust policy – and investment strategies – in response to events.

Inflation instruments and inter-relationships

The firm has been actively trading zero-coupon inflation swaps and caps in the G7, and paying close attention to the inflation curve. “The front end of the curve has already repriced, so we are moving along the curve to areas where it is inverted, implying market expectations of inflation being transitory and mean-reverting. Around the five-to-seven-year part of the curve, we can get positive carry and some roll down, which helps to fund inflation hedges,” says Baylis.

There are different opinions about how the flat yield curve balances growth and inflation expectations, and Baylis is biased towards inflation: “We expect that yield curves could steepen toward the belly of the curve as inflation expectations rise further out the curve, and not necessarily due to higher expectations of economic growth”.

The inflation trades also dovetail with other parts of the book, including credit and nominal rates. “We also use the inflation risk premium at the front end of the curve to help fund our credit book, based on the cointegration between inflation and credit,” says Baylis. Inflation views have also been expressed through nominal rates curves, including front-end steepeners. There has also been some short-duration exposure, within the tight range of plus or minus three years, implemented through a volatility strategy involving straddles.

High yield, swaps and cross-asset class trades

High yield can be played through high yield indices and tranches or total return swaps when they offer better value. “There has also been some short volatility exposure on the credit side, selling receiver swaptions on high yield and crossover. Swaps spreads are another potentially uncorrelated source of alpha,” says Baylis.

Other asset classes, including currency and equity, are monitored for implied volatility signals, and sometimes the equity VIX index can be traded as a substitute for credit hedges. Relative value between equity and credit volatility can also be traded.

FSOF could trade structured credit such as RMBS, CDO, CLOs, but Baylis does not think it currently offers a sufficient illiquidity premium. In any case, such positions would be sized small.

There are a wide variety of trades, which can typically involve 3 or 4 legs, but the 800-position tally overstates the number of line items since it includes underlyings of indices. Derivative relative value trades can entail substantial notional leverage, but this is capped at 400% for FSOF.


Fortlake excludes some sectors such as thermal coal and controversial weapons from both long and short books. ESG is also integrated into the investment process as a source of alpha and risk management. Fortlake calculates an ESG rating from the worst score of zero to a best of five, and this also translates into an estimated credit spread measured in basis points, which could be positive or negative. “That, in turn, allows overall credit spreads to be bifurcated between an ESG risk premium and a pure credit risk premium,” says Baylis. He has observed “green bonds” with tighter spreads, and reckons this is because their investor base tends to be more stable and long-term. Fortlake has invested in some green bonds and is open-minded about social, sustainability-linked and carbon-linked bonds where costs of capital can be linked to ESG performance, though he has not yet seen many such issues in Australia. “Poor ESG can contribute to short investment theses, such as baskets of airlines, or other positions which have challenges around governance or social factors,” he adds.

Macro outlook

Baylis sees consumer preferences for sustainability as one source of inflation, and he does not think it will be easy for central banks to engineer a soft landing. He sees a high risk of central banks making policy errors, with negative outcomes for inflation, the economy, or both. He draws some parallels between 2022 and the 1970s and sees no reason why inflation could not go higher, given the very large bounds of uncertainty: “UK inflation calculated using the 1970s methodology would already be in the teens. Real interest rates are deeply negative, by 7% in the US and 4% in Australia. Europe is still stimulating the economy despite inflation. It has real interest rates of minus 8.6%, more than 10% below the neutral rate of 2.5%. Recession or slower growth is mathematically a higher probability since we have brought forward future consumption”. He does not however necessarily expect a stagflation scenario of recession and inflation but rather foresees slower economic growth combined with inflation as most likely, as inflation itself is already starting to dent demand in the economy.

Meanwhile, central banks do not have much ammunition to stimulate the economy. “Previous crises were easier to deal with because they were all disinflationary, whereas the current situation is inflationary, with real interest rates already well into negative territory,” says Baylis. The financial market impacts of the economic environment could also be exaggerated due to a reversal of central banks’ role, from captive buyers to forced sellers of financial assets. “In developed markets, they have gone from being non-commercial buyers with a huge impact on rates, inflation and credit, to effectively being non-commercial sellers,” says Baylis. In emerging markets, some of which have huge pools of capital, geopolitics adds another dimension where fear of potential sanctions could encourage divestment of western assets that might be vulnerable to freezes or confiscation for political reasons. “The US freezing of FX reserves makes it harder to fund current account, fiscal and trade deficits. Sovereigns and wealthy individuals in emerging market countries may think twice about buying US Treasuries if their security depends on Western ideology,” says Baylis. These forces are already driving up risk premiums and dispersion thereof, especially for sovereign spreads in Europe.

A compelling sandpit

Fortlake’s distinctive risk management approach demands that incremental risk taking needs to improve forecast risk-adjusted returns. “This means we normally get less busy as the Sharpe goes up. Running a Sharpe of 4 sets a very high bar for any new trades, but in June 2022 the opportunity set was compelling. There has been a huge repricing and total recalibration of interest rate risk by 5 or 6 standard deviations. Credit spreads and their volatility have also doubled. Sharpe opportunities are now much greater. The sandpit is full of toys at the moment,” says Baylis.

Customized mandates

The investor base was wholly Australian on day one, but now 60% is from outside Australasia, and Fortlake is in contention for allocations to its comingled funds and customized strategies. Customized mandates could calibrate the strategy to credit beta targets; focus exclusively on sub-strategies such as default arbitrage, or concentrate on geographies and segments such as European investment grade.

Full Report

Tomorrow’s Titans 2022