Aitken Ross

Where is the value in bond markets as rates rise?

Aitken Ross

With the end of the bond bull market proclaimed yet again in recent months – and interest rates edging upwards – investors are understandably asking where the value currently lies in credit.

Corporate bonds have performed well for the last decade and within that, European high yield and subordinated debt* issued by banks and insurance companies have been standouts, producing returns in the region of 88% and 101% respectively (Source: Bloomberg to 31.01.18).

Within the Liontrust SF Fixed Income team, we are long-term advocates of subordinated financial bonds and while our conviction has lessened, we continue to believe these offer strong risk-adjusted value. In contrast, we see the high-yield asset class as generally lower credit quality and at the current yield and credit spread levels, we do not believe it compensates investors for the level of risk taken.

We have always had a preference for quality and our overweight positions in bank and insurance bonds, as well as stock selection within these sectors, has been a key driver of performance of the SF Corporate Bond and Monthly Income Bond Fund over recent years.

Looking at the contrast between subordinated financials and high yield in more detail, quality is a key differentiator: not only is the debt itself generally higher quality, it is issued from even higher-quality parent companies.

Comparing insurance company Axa and industrial company ArcelorMittal makes this point: Tier 2 bonds (the most senior subordinated debt) from Axa are A3 rated by Moody’s, with a credit spread (the level of yield over government debt of similar maturity) of 180 basis points. Senior unsecured bonds from ArcelorMittal are lower rated, Ba1 from Moody’s, and the spread is 70 basis points less at 110.

Seniority

Axa

ArcelorMittal

Moody’s rating

Credit spread

Moody’s rating

Credit spread

Senior unsecured*

A2

56 basis points (bps)

Ba1

110bps

Tier 2*

A3

180bps

n/a

n/a

Tier 1*

Baa1

210bps

n/a

n/a

Source: Bloomberg, as at 20.02.18. 100 basis points=1%.

Apart from the significantly higher spread and better quality, the Tier 2 Axa bonds only have a modest level of subordination relative to the company’s senior debt and there is very little risk of the term being extended or the coupon being turned off.

As for ArcelorMittal, the bonds have a tight valuation for a sub-investment grade issuer and the wider sector is exposed to high levels of cyclical risk. More generally, industrial companies are vulnerable to Environmental, Social and Governance (ESG) pressures including environmental disruption and poorer health and safety records.

Stepping back a level, we also see superior fundamentals and technicals for financials over high yield in general.

Credit fundamentals within banks and insurance companies have been on a broadly positive trajectory since the financial crisis. Under ever-increasing scrutiny from regulators, many financial companies, especially higher-quality names, have significantly improved their balance sheets. Coupled with higher levels of capital held, the inherent risk within these entities has dramatically reduced.

As for high yield, many of these issuers have also seen improvements in their credit metrics but more recent trends have been negative, with leverage picking up. High-yield names are also more exposed to refinancing risk, the credit cycle is nearing its later stages, and spreads are historically tight and barely compensate for the default risk.          

On the technical front, a key driver of investment grade spread tightening has been the government bond buying programmes and this has incentivised investors to move down the credit spectrum to pick up yield and spread within high yield. When policy technicals begin to unwind, these “yield tourists” may exit the high-yield asset class, moving back up to investment grade and providing support for that part of the market.

Finally, we are all having to get used to a rising interest rate environment and we feel that also favours banks and insurers over high-yield names. Banks should benefit from rising net interest margins (NIMs), the differential between lending and borrowing rates, while insurance companies should generate higher yields on their investment portfolios. Meanwhile, high-yield companies could be more exposed in a rising rate environment as the availability of cheap funding declines and valuations are already stetched.

Considering all these factors, we continue to believe subordinated financial bonds can offer attractive opportunities in a tougher environment and remain overweight across our portfolios.

 

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

 

*Company debt is structured like a ladder: senior secured bonds are at the top and have the strongest claim on assets or earnings if a business falls into liquidation or bankruptcy. Next comes senior unsecured and then subordinated debt, which typically has a number of tiers.

** 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.

Monday, February 26, 2018, 10:28 AM