For much of the year, as we have met fixed interest investors, we seem to have been following hot on the heels of other fund managers advising people to buy duration (as presumably they have been in their funds).
We have not agreed with this for several reasons but mainly that rates were likely to go higher than expected and then to stay there for longer than expected. This we felt would lead to a steepening of developed market yield curves as yields moved to discount higher rates further out (i.e., the longer-dated end of the market was high risk).
This has proved to be the case and we have seen some significant losses down the long ends of both US Treasuries and Gilts. To put this in context, both 30-year bonds returned to levels of yields not seen since before the Global Financial Crisis of 2008/9. In price terms, the 30-year Gilt sank 22% year to date which, rather starkly, speaks for itself.
Recent ECB, Federal Reserve and Bank of England rate decisions have all been to hold (and they look more and more to be finished in this hiking cycle), so we have seen some rallying in the bond markets. In US Treasuries, the long end had probably got a bit ahead of itself and so it has seen a bigger reduction in yields. The Bank of England’s was the most downbeat but hawkish of the meetings as UK economic activity is weak (their forecasts are for very little growth out to 2025) whilst our inflation numbers are still taking longer to moderate than other developed markets.
The Gilt curve has therefore seen more of a parallel shift where short, medium and longer dated yields have moved by similar magnitudes. This means that the belly (mid part) of the curve has become more interesting and we have added risk here (and will continue to do so) which has pushed our duration out a little. However, when we can still find such attractive all-in yields from the front end to the belly of the curve, offering tremendous carry with no degradation of credit risk quality, we still see little, to no, compensation for embracing more volatility in longer-dates.
CH Investment Grade (CHIG)’s positioning has been relatively short; our duration was under three and has been close to that all year. This has been a significant driver of the positive performance of CHIG over the year. For others, who have held too much duration over the year, many are in negative territory and one look at passives sees the same result, UKCO, the sterling corporate bond ETF is still down over 3% (it has a duration of over 6).
The quality of our credit positioning has also stood us in good stead. We have maintained our 25% AAA weighting, which has been rock solid in the face of some recent credit spread volatility (felt the most in weaker credits). Sterling spreads have also outperformed euro spreads materially over this period, especially corporate non-financial spreads which comprises around 40% of the Fund. A good example here is Heathrow Funding who recently had strong results and we had added to our 6.75% 26’s holding at around 6.4% yield in late summer, which has tightened/rallied to around 6%.
We do have a significant weighting to financials, but as ever these are the highest quality banks, Bank of America, Goldman, Lloyds, NatWest, Barclays, Credit Ag, RBC to name a few. From a credit perspective these have remained very steady in comparison to second tier banks, which we do not own. Bank equity has been volatile recently as results have been seen as slightly disappointing, but this has not been reflected in their credit which continues to be a major beneficiary of a higher interest rate environment. The ‘over’ focus on Net Interest Margin, seen recently in NatWest shares’ overreaction as their NIM goes to a forecast 3% from 3.15%(?), we think has the potential to distract investors from their more important underlying credit fundamentals such as solid Common Equity Tier 1 capital ratios (NatWest at 13.5%).
We, as ever, have been active in the primary and secondary markets. The primary market has seen a steady stream of quality issuers including some very attractive foreign names issuing into sterling. We bought a new issue from Caterpillar, 5.72% 26’s issued at 97bp over Gilts and now trading at 74bp, a 1% capital uplift. We also took the new John Deere 5.125% 28’s at 95bp over Gilts, now trading at +78bp. Credit Agricole issued a 5.75% 27 bond at Gilts + 260bp, now trading at Gilts + 175bp, a 250bp uplift in capital. We also took a new 6-year issue from Virgin Money paying a 7.625% coupon. Most of these are short dated (which is where the bulk of the issuance has been) and most have performed strongly after the break in the secondary market. CHIG’s unconstrained and non-benchmarked mandate means we can own all of these names.
Some more examples in the secondary market; we added Bayerische Landesbank 3-year Covered AAA paper on a yield of 5.5%. We added to our existing Deutsche Pfandbriefbank 7.625%’s, now 2-year risk, paying over 8% redemption. We added Barclays sub 1 year risk on a yield of 6%. We also added to our RAC 8.25% 28’s, bought at issue at Gilts + 390bp, on a yield of 7.87% adding to a capital uplift of over 1.5% in less than a month.
In summary: to have a high-quality fund such as CHIG paying out 5.3% income yield with a GRY of 6.7% and a duration just over 3 more than justifies it as the allocation in the asset class for a sterling UK based portfolio. The investment opportunity for the asset class is as good as it gets, but still we have to limit associated volatility, which is what CHIG does, especially in the current environment of global growth fears and geopolitical uncertainty.
The above article has been prepared for investment professionals. Any other readers should note this content does not constitute advice or a solicitation to buy, sell, or hold any investment. We strongly recommend speaking to an investment adviser before taking any action based on the information contained in this article.
Please also note the value of investments and the income you get from them may fall as well as rise, and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.