July-August 2013

INSIDE VIEW: Of bonds and celebrity footballers

FootballThe momentum in the credit market has sharply reversed in recent months. Jamie Hamilton of M&G Investments, says this has created opportunities in high yield and junior financial bonds that underline the importance of patience. There was a time when bonds were boring, left in the “sleep at night” corner of the portfolio. Now, bonds have become rather like the celebrity footballer: accustomed to making back-page headlines for the right reasons but making the front pages for the wrong reasons. The problem is that pension schemes need the steady, predictable income streams that corporate bonds can offer. Many have also spent the best part of a decade selling down riskier equities in favour of lower risk assets, such as corporate bonds. They are now left with an asset class that has not only been more volatile than expected but, thanks to low interest rates, also offers meagre yield. Yield is about 3% above government bonds, in the case of investment grade, 5 % or 6%, for high yield bonds. In such uncertain and confusing times, pension schemes with benchmarked corporate bond allocations face two options. They can either play wholeheartedly, frantically chasing such yields that remain, or they can sit on the sidelines and be more selective. Being selective, seeking value when it offers itself, is the only way to play a market like this. Anything else is folly. The obvious place to turn to when seeking to boost yields and match return expectations might be the high yield market. In simple terms, yield would be improved. But are you really being compensated for the extra default risk you are taking on? It might be the highest yield on offer today. But is it good value? It is tempting to think that a higher yield will improve returns, particularly over a longer time. Historically, however, buying high yield bonds at these yield levels gives you a no better than even chance of making more money than you would in better rated investment grade bonds over a three year period. If you are prepared to accept a slightly lower yield today, you can wait for better opportunities to buy risky assets, giving you much better chances of positive returns. STRIKE A CHORD
In a world that still contains many obvious sources of risk and volatility, from Europe’s fiscal woes to Chinese economic risks, there is every chance of such opportunities being delivered. One example strikes a chord: the care home operator Bupa recently issued a subordinated bond. Its terms said that, in the event of corporate restructuring, a holder would rank in front of any equity investors but well behind senior or secured lenders. You would normally expect a high level of compensation here, perhaps a double-digit coupon, but the yield was around 5%, some 3.5% over government bonds at the time. That also looks wholly wrong. Yet many institutional investors feel compelled to buy at these levels – they fear that it will be the only chance to secure a yield. The Bupa bond was about ten times oversubscribed. Investors who participate in such volumes at these levels may be encouraged by data saying that the US economy is improving. Such a momentum view of corporate bond investing can embolden investors to play irrespective of valuation. A more sensible strategy is to ignore momentum signals, look solely at valuation and ask if the price of each individual bond offers compensation for the risks on offer. Anyone taking this approach would surely conclude that investment grade credit as a whole offers no better than average compensation for risk and any portfolio should be very close to its benchmark. Wholesale allocations to high yield would also look poor value against investment grade. Were a pension fund investor to take such an approach, they could do two further things: keep some dry powder and ignore the macro-economic noise. Dry powder – in this case cash – is essential in any market but particularly one such as this. That is because choppier markets throw up more opportunity, whether these are mis-priced or misunderstood assets. Before anyone had heard of Deepwater Horizon, BP’s bonds looked expensive. This blue chip company with quality assets offered no toe or footholds for the value investor. As the company descended into crisis, so the price of its bonds fell. And that was the time to buy. At no time was the company’s ability to service its debt affected in any material way. Who knows when the next BP might occur? The only thing to be said is that you would rather sit on the sidelines and pick up good bonds at beaten down prices when they happen. Misunderstood assets can also present opportunity, provided you understand them yourself. Back in 2009, few wanted to touch European mortgage backed securities with a barge pole. To most, they just looked tarnished. That superficial view belied the reality – many bonds subsequently proved to be unbreakable – and this market can still offer misunderstood bonds at good prices. If it takes nerve to wait for pricing to become attractive, the same can be said for shutting out macro-economic noise. As I write, markets are digesting the possibility of the Federal Reserve’s tapering – jargon for a possible end to quantitative easing in the US. PATIENCE
This has sharply reversed the momentum in the credit market, and is throwing up the sort of individual opportunities in high yield and junior financial bonds that underline the importance of patience. The benefit in buying these assets at yields sometimes several percent above where they were two weeks ago massively outweighs the income sacrifices by a relatively short wait in cash. True, the Fed might eventually be turning off the liquidity tap, but this will happen eventually. If we keep focused on buying assets when they offer fundamental value, we do not need to worry about predicting what potential Fed action might do to short-term supply and demand. The history of investing is littered with decisions based on unfulfilled hope or expectation. Long-term investors will always be better served by looking at the number on the price tag and asking whether it offers compensation for all the risks on offer. Jamie Hamilton is senior credit fund manager at M&G Investments ©2013 funds europe

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