Stuart Steven

Two themes for 2018 – steeper yields and avoiding expensive CoCos

Stuart Steven

Amid growing focus on bond yields, we believe last year’s theme of curve flattening has run its course.

Looking back at history, when the US Federal Reserve has increased interest rates, the spread between Treasuries of different maturities changes, resulting in a flattening of the government yield curve. In essence, this occurs because short-dated yields are typically more sensitive to rising policy interest rates than longer-dated yields. Moreover, if the market ultimately believes that rising rates will push the economy into recession, it can even result in an inverted yield curve where long yields are lower than short.

As things stand, the spread between five and ten-year Treasuries is just 20 basis points and the market also looks to have finally woken up to the fact the Federal Reserve will deliver on its guidance. As evidence of the latter, five-year Treasury yields are up almost 100bps from last year’s low of 1.62%.

For yields to continue flattening however, you have to believe the Fed will continue to hike rates (which we do) and that these hikes (three are expected this year) constitute a policy error that will choke off economic growth and push the US into recession (which we don’t).

We see a number of reasons why interest rates will continue to rise. Essentially, the US economy remains robust, amid a period of co-ordinated global growth. The vast majority of commentators are predicting growth will remain around long-term trend levels over the coming years, highlighting factors such as strong and broad-based Purchasing Managers Index (PMI) surveys, healthy consumers – with household balance sheets in good shape – and robust corporate earnings.

Wage growth is also picking up and employment (and underemployment) is back to pre-crisis lows.

At policy level, we have a Fed committed to orderly normalisation, in terms of both interest rate rises and unwinding quantitative easing, while President Trump’s tax cuts and planned infrastructure projects should extend the economic cycle.

Beyond this healthy backdrop, we would highlight several other reasons for curves to steepen: they are currently far too flat and failing to price in the risk of inflation, with real yields at the long end too low.

Having missed the start of the bond sell-off, many in the market are looking for ways to put on a short. Given that two and five-year yields have done much of the heavy lifting to date (hence the flattening), the longer end of the curve offers better risk/reward opportunities for those looking to implement a short.

Within our Liontrust SF Corporate Bond and Monthly Income Bond Funds, our US duration short is now expressed through 10-year bond futures, whereas last year we used five-year. We also have a US five-year/10-year steepener in place, initiated in January.

Another key call across our funds centres on contingent convertible (CoCo) bonds, which delivered great returns during 2017 and remain popular with investors. To give a quick recap, CoCos are fixed income instruments that can be converted into equity if a specific trigger event occurs. The concept became particularly popular in the context of risk management in the banking industry post-financial crisis.

This is deeply subordinated debt, which means it ranks below other loans and securities when it comes to claims on a company's assets or earnings. CoCos tend to have short call periods and are therefore seen as high-yielding with a short time to maturity.

While that is true, we believe total returns are limited and volatility and downside risk significantly underpriced.

We have benefited from holding CoCos in the past, buying when yields were around 8% or higher and prices were 100 or lower. Today, the vast majority of sterling and euro denominated CoCos issued by high-quality banks yield between 3 and 4% and many are priced well above par.

At such prices, capital upside is limited or non-existent and these bonds typically fall with equities during market sell-offs. Yields on CoCos are also now typically lower than the equivalent equity, with similar risk: if capital levels fall below predefined levels, coupons are switched off and the bonds can be converted to equity or written down.

Looking at the sector more broadly, the price dispersion between high and lower-quality banks has massively compressed and we see that as a big warning light. Technicals are a further concern, with much of the CoCo market owned by non-traditional holders of this type of bond. This means significant risk of a liquidity-led sell off, with investment banks unable or unwilling to warehouse these bonds as there is no hedge and capital requirements are penal.

With all this in mind, we believe investors are not compensated for the risk in this asset at current valuations and have trimmed our exposure from around 5% last year (versus our internal limit of 7.5%) to virtually nothing.

Less subordinated bank bonds currently offer a better risk/reward profile but we would re-enter the CoCo sector if valuations improve in the event of a significant sell off. Given the nature of this asset class, we would only focus on high-quality national champion banks.

Discrete years performance* (%), to previous quarter-end:

 

 

Dec-17

Dec-16

Dec-15

Dec-14

Dec-13

Liontrust Sustainable Future Corporate Bond 2 Inc

7.2

10.5

0.5

9.8

1.8

iBoxx Sterling Corporate

5.0

11.8

0.6

12.3

1.9

IA Sterling Corporate Bond

5.1

9.1

-0.3

9.8

0.6

Quartile

1

1

1

3

1

 

 

Dec-17

Dec-16

Dec-15

Dec-14

Dec-13

Liontrust Monthly Income Bond B Gr Inc

8.9

9.4

1.4

7.4

2.6

iBoxx Sterling Corporates 5-15 years

5.7

10.8

1.2

12.6

1.9

IA Sterling Corporate Bond

5.1

9.1

-0.3

9.8

0.6

Quartile

1

2

1

4

1

 

* Source: Financial Express, primary share class, total return (net of fees and interest reinvested), to 31.12.17


Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in Funds managed by the Sustainable Future Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. The Monthly Income Bond Fund has a Distribution Yield which is higher than the Underlying Yield because the fund distributes coupon income and the fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining the fund’s capital appreciation. The Distribution Yield and the Underlying Yield is the same for the SF Corporate Bond Fund.

Disclaimer

This content should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, February 8, 2018, 3:20 PM