5th March 2021
As covered in recent blogs, our Funds are managed very actively and with little regard to benchmarks or to what peers are doing. Rather than working within the confines of a top-down asset allocation framework our unconstrained, valuation informed approach means that exposure to certain asset classes can change significantly over time. The recent evolution of our exposure to vanilla corporate credit hopefully brings this crucial aspect of our investment process to life.
At the start of 2020 our corporate bond allocations were close to the lowest levels in the Funds’ history. This was not due to any great prescience regarding the coming pandemic and the dramatic impact that would have on risk assets. Instead it was a reflection of extremely elevated valuations where historically tight credit spreads (the additional return investors require over the risk free rate for taking on greater credit and liquidity risk) were providing investors with little margin of safety.
For us, credit at that point was a negatively asymmetric trade where available returns as represented by yield to maturity, were far too low given potential downside risks. This positioning proved to be beneficial with credit spreads blowing out aggressively in February and March as investors came to realise the potential consequences of the pandemic and as market liquidity evaporated. As corporate bonds continued to sell-off we began engaging with our trusted managers in the space (i.e. avoiding the perma-bulls who always talk their own book), helping deepen our understanding of what was fast becoming a compelling valuation opportunity. With credit spreads aggressively decompressing to levels that implied an unprecedented level of defaults we quickly built conviction positions recognising that higher yields and spreads were, even in light of the prevailing uncertainty, overcompensating us for the risks involved.
In short, the margin of safety offered by the valuation of the asset class was back. Our exposure to developed market vanilla corporate credit in both the Vanbrugh and Distribution Funds moved from a low of 5% at the end of February 2020 to 16% and 19% respectively by the end of April.
A lot has happened since the first quarter of last year, including vast injections of liquidity by the world’s largest central banks. This combined with extensive government support packages has helped soothe corporate bond markets and has seen most subsectors retrace much of the widening that had occurred, leading corporate bond yields and spreads back to almost rock bottom levels. With spreads evaporating so does our margin of safety, resulting in the Distribution Fund’s exposure to vanilla investment grade and high yield rattling back to 5%, with what allocations we do have very much focused on high alpha managers who are well positioned to exploit ongoing valuation dispersion within the market.
Against this backdrop of fluctuating corporate bond spreads, government bond yields, from which all other fixed income assets are priced, have been trending close to all-time lows with vast swathes of this market offering negative inflation-adjusted returns. Bearing in mind the overriding objective of our Funds is to deliver positive returns net of all costs and inflation, it will come as no surprise that our exposure to these ‘return free’ government bonds has been very low for some time. With yields continuing to fall, this positioning has been a headwind to our relative performance in recent years, particularly when assessed against passive vehicles that have significant exposure to long duration sovereign debt.
The tide has turned recently however, with market expectations regarding growth and inflation picking up markedly to levels well above those currently priced in by sovereign yields. We recognise the difficulties of macro forecasting, especially when it’s about the future (namecheck Yogi Berra) so have no strong view regarding whether we are entering a new regime of sustained inflation or not. Instead we don’t own government bonds because the real return potential is poor and also because we worry that the traditional hedging qualities of the asset class are not what they used to be with starting yields so low.
We are of course, however, multi-asset investors with a commitment to managing sensibly diversified portfolios. Furthermore, with regards to the Vanbrugh Fund we are required by the IA Sector rules to allocate at least 30% of the portfolio to fixed income and cash (the Distribution Fund sits in the IA Mixed Investment 40-85% Shares Sector so has no such constraints). So, bearing in mind low government bond yields, tight credit spreads and the capital losses that come with rising yields, the big question is: What should one own in this space?
Fortunately for those willing to go off the beaten track, fixed income opportunities offering reasonable levels of return and low sensitivity to interest rates do exist. Residential backed mortgage bonds for example have seen credit spreads retrace less aggressively than mainstream credit and due to their floating rate coupons tend to have lower duration. Asian credit is another area of interest, offering material yield pick up over and above European and US markets for the same level of credit risk.
Our extensive use of investment trusts also gives access to the alternative debt space. This is something of a mixed bag in terms of quality and outcomes, but for the discerning investor it is possible to identify good quality managers with strong underwriting track records. These are managers who have built sensible portfolios of well-structured bilateral, asset backed loans whose coupons are often floating (mitigating interest rate risk) and which offer a material yield premium over mainstream credit markets. Our investment in BioPharma Credit, whose 8%+ coupon loans to established US pharmaceutical companies are secured against the cash flows of approved life science drug sales, is a wonderful example of this type of lending.
Finally, we believe certain property sectors can offer investors bond-like returns, particularly those with long leases and credit-worthy counterparties. Supermarket Income REIT for example, operates in a non-cyclical sector, leasing large supermarkets to the likes of Tesco and Sainsbury’s on lengthy terms (average lease of 16 years) at c.5% yields, almost double the rate these companies borrow at in the corporate bond market. In the face of low bond yields, our exposure to property and particularly these sorts of defensive sectors, remains high.
Beyond property and the more niche areas of the bond market, we are also finding lots of idiosyncratic opportunities which deliver attractive levels of income and exhibit low correlation with equity markets, and so fulfil much of the portfolio role traditionally played by fixed income. These include things like battery storage, ships and song royalties. In many cases we are further assured by the relatively high discount rates used to value these assets which provides scope for yield compression and additional growth in the future. This is a subject we intend to revisit in more detail in a future blog.
Paltry returns and the risk of rising government bond yields certainly make navigating fixed income markets today incredibly difficult. Fortunately, our investment process means that we do not have to own these large, problematic asset classes, whilst our willingness and ability to access harder to reach parts of the market means that we can still identify fixed income investments that we believe have the ability to deliver acceptable returns in the years ahead.
Ben Mackie – Fund Manager
This financial promotion is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. HA4280.