Expert: Scott Freedman, Newton – Portfolio Manager Facilitator: Mark Rushton
Headlines:
- The pressure that the market put on the UK Government would not have been as potent if the global backdrop had not already been one of liquidity withdrawal
- The New Chancellor is more orthodox, though the question, “Why would foreigners invest in UK?” remains valid as there is still no clarity
- Non-discretionary inflation in Europe, e.g., energy and food, persists. What should governments do about energy infrastructure? Germany will probably be the weakest link in Europe given their economy has thrived on the low cost of energy from imported Russian gas and then exporting manufactured goods to China
Context:
UK Bond Views (prevailing on 20-11-22).
Gilt yields have settled down, but BoE had to step in to stop the LDI-led sustainable sell-off.
At the height of the recent troubles, gilts looked ‘fair value’, but now Scott is not that keen within a global context. Some multi asset managers have been underweight gilts and have begun to close that underweight.
Generally, expect big Government with more intervention, both on the fiscal side and from an independent central bank.
Gilts were looking to be fair value at recent peaks, but the Bank of England has been behind the curve.
UK peak rate expectations at 5.2% in May 2023 vs 4.9% US in July and EU at 3.1% in July 2023.
UK investment grade has been cheaper than US and EU, but UK is less popular, and investing has been opportunistic, and focussed on finding shorter maturity bonds at high spreads and yields.
Index linked exposure in UK:
- Looking at the 2073 Index linked, the price declines have been huge. Some of the shorter dated index linked bonds are looking more attractive, but investors should be aware of the duration effects in the index -linked market
- Newton’s Govt Bond exposure was net zero in duration earlier in the year, being careful over US, though it is comfortable now to be averaging into some US duration
- Investors need to be nimble, but not to fiddle with portfolios day to day; and Newton is tactically managing duration, including with some government futures and options
What might be the next event?
Some LDIs had c. 4x leverage, but there could be other situations of which we are unaware where leverage is lurking, given the regulatory constraints since the Global Financial Crisis.
Sweden, New Zealand and Australia are vulnerable, given their shorter dated mortgage markets, but some countries have been more on the front foot with regards to interest rates where yields are close to peaking, However, while that doesn’t mean a pivot point is following, it may mean more of a plateau perhaps with core inflation remaining sticky.
The most prone exposures are private credit funds, but if the underlying business is good and there is little in the way of covenant triggers then should be safe for now.
The Leveraged Loan market is bigger and attracts poor covenants with high leverage and very poor liquidity (and to some extent in High Yield). There is a risk of liquidity concerns spreading to better quality.
Scott had not heard of any problems with ETFs, while Alternatives unit trusts in UK have suffered.
In general, investor sentiment as in the BoA survey is very negative, meaning a fair amount could already be priced into the bond market. In the US the Fed is selling many bonds into the market.
Cash has credibility now that it has a meaningful yield, though questions still remain regarding what is the genuine risk-free rate.
Emerging Markets continue to be a concern while USD stays strong. Newton has kept Emerging Market Debt exposure low – 8% in Covid, now at 13% and the majority is local currency. USD exporters of commodities will benefit. Newton is avoiding Central & Eastern Europe and looking at low beta exposure to government debt, taking care over IMF involvement.
To take advantage of the prevailing conditions, Newton uses calls and puts for duration hedging, though it is more expensive to be short as yields rise. It holds some short-dated Government bonds that it can sell easily for liquidity when needed to recycle into better opportunities (e.g., Short Dated Treasury Floaters).
Fiscal Stimulus and Quantitative Tightening
Fiscal stimulus will help to take the worst case out of recession scenarios, but it will be inflationary and Central Banks will need to continue to raise rates, particularly as wage inflation remains one of the main risks.
Banks are merely ‘flow traders’, meaning that there is less market liquidity and are still trying to work out the risk-free rate.
One of the concerns is who are the buyers for US Government Bonds, especially with Quantitative Tightening under way.
Additionally, deglobalisation has resulted in trade friction and rising costs, while politicians focus on relatively parochial issues.
There is a potential opportunity to lengthen duration and then ride rates down when growth weakens materially.
To the question whether a plateau of rates is more likely than pivoting down, there might be two phases. Yields could go higher from here if inflation remains very sticky and unemployment does not rise enough.
Consider convexity and a move from e.g., 2% to 4% yield is worse than e.g., 4% to 6%?
Companies should buy back their own issues of bonds if the cash price has dropped significantly.
US Investment Grade duration is >6 years. Newton Global Dynamic Bond stands at 2.4 years duration.
High Yield – spreads and default potential?
Investment Grade spreads are attractive at 170bps in US; yield = 6.1%. Europe is at 214bps; yield = 5.4%. UK is 192bps; with High Yield yields 9% in US; and 8.6% in EU.
And what should governments do about energy infrastructure? Germany will probably be the weakest link in Europe given their economy has thrived on the low cost of energy from imported Russian gas and then exporting manufactured goods to China.
The primary market offers an attractive new issue premium, as there is not enough issuance so buy in the secondary market. However, high yield is vulnerable with weakening growth and bond market reaction to equity volatility.
Banks are usually first to recover their capital. Default rates could rise to 5-6%. 40% recovery is the usual recovery rate but there are few covenants so no near-term triggers to restructure debt. However, the recent LBO Citrix issue still proposed very weak covenants to allow a c. $2bn dividend to be taken out per year through a loose restricted payments test. 70% of the EU High Yield index has been issued since Covid started.
Additional Tier 1 bank large issues are more liquid. Banks are not going to be stronger than today, but they hold strong capital buffers and yield 20% Yield to call or 11% to maturity (they may not call - COCOs suddenly priced YTM as happened during Covid).
ESG
It is worth looking at Government and Corporate Bonds differently, more bottom up and with a focus on greenwashing.
Fixed income investors have more avenues through which to allocate capital to better outcomes e.g., not For Profit and Social Housing issuers. Consider: Governance; Carbon tax; engagement as a Bondholder though not perceived as such as disclosure can be poorer in Bond markets than Equity markets, postponing any demonisation of a company or sector or country without considering the ESG transition or trajectory.
There are many opportunities due to ESG funding and frameworks, starting in the public sector, acknowledging that disclosure is only as good as the issuers themselves.
Financial returns will benefit through better preparedness re Sustainability & ESG and as conventional credit ratings agencies (Moody’s/S&P) more explicitly link ESG quality to their ratings.
Equity and Fixed Income fund managers do not work together re ESG but should do.
Key takeaways:
- Message to the IA: please produce a unified IA message covering FI and Equities (and other assets) regarding ESG & Sustainability ratings and descriptors so that the IA and its industry message can be a major influencer (NB - following this MoM event, the FCA announced on 25th October the FCA consultation CP22/20: Sustainability Disclosure Requirements and investment labels).
