This article was written by John Pattullo, Co-Head of Strategic Fixed Income at Henderson Global Investors prior to today’s reduction in the UK’s interest rate:
A few months ago I remarked to Jenna, my co-manager, how boring credit (corporate bond) markets were. Be wary of what you wish for, I hear you say! US credit markets were displaying late cycle behaviour and we were cognizant of this. Merger and acquisition (M&A) activity was high and it was not an environment in which credit investors were being well rewarded.
We had, however, a growing niggle that global bond yields may keep falling against mainstream consensual thinking (yields move inversely to prices), given the appalling global growth picture post the Global Financial Crisis. Hands up, we like many, did not call the Brexit 1
result, but over a month later we keep coming back to the same conclusion: "for the best risk adjusted returns in credit markets buy quality industrial, large cap. 2
, non-cyclical 3
investment grade bonds" 4
. We do not think this rather simple strategy will let you down. Let me explain.
Led astray by the science of economics
In 2010 we went short duration 5
in our funds, in other words reduced interest rate sensitivity 5
, partly due to overconfidence after a rather successful credit crisis, but also due to our orthodox university training in the dismal science of economics. Sterling fell very heavily in 2008, and we did import a lot of temporary inflation. The Bank of England saw through this and fortunately did not raise interest rates, as neither companies, nor individuals, had the power to pass these imported costs on in higher prices or wages. I would suggest a not dissimilar outcome will happen again.
Behavioural responses to traumatic events matter
It was after reading the economist Richard Koo’s book in 2011 that we completed a volte face in our duration thinking. Koo predicted that Europe would turn ‘Japanese’ nearly six years ago, and frankly he has nailed it. He coined the phrase “balance sheet recession” — whereby individuals or companies, experiencing negative equity post a financial crisis, only want to pay off debt and delever (reduce debt). Thus, lowering interest rates is a completely ineffective policy tool. Koo is highly critical of the economics profession as it completely ignores ‘behavioural’ responses to traumatic events.
Many commentators have likened Brexit to bereavement — something I felt myself. Our macro outlook remains realistic, but fairly dismal regarding growth and inflation. Aside from Brexit, we have serious concerns about falling Japanese bond yields, the strength of the yen and the almost inevitable threat of a Chinese devaluation, which will bring yet another wave of deflation. We have long been big fans of Larry Summers’ ‘secular stagnation' 6
theme, and Brexit has exaggerated this view.
Interestingly, in his recent speech, the Bank of England Governor spoke about “economic post traumatic stress disorder”. In his words “EU exit would bring about major regime change”. So, Mr Carney seems to agree that major events result in behavioural changes.
We expect interest rates to fall by 0.5% very soon, likely followed by a corporate bond buying programme and cheap funding schemes for the banks. We also expect a major fiscal response to the UK’s predicament, and only wish our European counterparts would follow a similar route. Fiscal expansion 7
has been tried in Japan of course, but with limited success, as the necessary structural reforms were not undertaken alongside economic reforms.
A ‘global titans’ strategy
Throughout last year, we suggested investors should not be tempted to ski off piste in the afternoon sun, such as getting into overly levered structured products 8
and peer to peer lending 9
. In addition, we materially reduced our high yield 10
book in favour of long dated US investment grade credit.
We continue to favour the refreshingly simple, reasonable to high credit quality names, and have focused entirely on large cap, non-cyclical, consumer facing, ‘reason to exist’ credits such as Kraft Heinz, Boots Walgreen and Verizon. Why? Because in 30 years’ time we believe these companies will still be paying reliable, dependable coupons to their bondholders. If anything, we may pursue this ‘global titans’ strategy even further.
Expect investment grade bonds to party on
Bonds returns will be all about ‘income’ in the future. We want to lock this in for as long as possible. We expect global bond yields in the high yielding countries of the UK and the US to fall further, and believe their yield curves will flatten even more as international investors seek out yield. We expect investment grade bonds to party on as the global grab for yield continues.
Brexit: UK’s decision to leave the European Union.
Large-cap: companies that have large market capitalisations (generally higher than £5 billion), are well-established with a strong market presence and are generally considered as safe investments
Non-cyclical: companies/industries that provide essential goods, such as utilities or non-discretionary consumer staples. While cyclical businesses produce goods and services that consumers buy when confidence in the economy is high, non-cyclicals produce items and services that consumers cannot put off regardless of the state of the economy, such as gas, electricity, food or non-durable goods.
Investment grade: companies that are deemed less risky by credit rating agencies, as they believe there is a strong likelihood that the company will be able to repay its debt
Short duration (reducing interest rate sensitivity): duration is a measure of the sensitivity of bond prices to changes in interest rates. It is a useful tool for managing risks in a portfolio. Bonds with longer maturities and therefore duration experience greater fluctuations in their value, falling more in a rising interest rate environment, and vice versa. If interest rates are expected to rise in the future, a portfolio manager would aim to reduce the average duration of the portfolio (go short duration). This could be achieved by simply increasing exposure to shorter maturity/duration bonds, or use of derivatives, such as selling interest rate futures. Alternatively, in a falling interest rate environment, the manager would extend duration 6
Secular stagnation: a concept that was first introduced by the economist Alvin Hansen in the 1930s where industrial economies are said to suffer from an increased bias to saving and a decreased tendency to invest. As a result, excessive savings act as a drag on demand, reducing economic growth and inflation
Fiscal expansion: An expansionary macroeconomic policy seeks to increase the money supply in the system to encourage economic growth. One form of expansionary policy is fiscal policy, which comes in the form of tax cuts, rebates and increased government spending.
Levered structured products: synthetic fixed income instruments that use derivatives to create specific risk-return profiles. The products allow ‘leveraged’ exposure to a market or an underlying instrument and react disproportionately to price movements in that underlying instrument, which can be shares, indices, currencies or commodities; for example a structured note whose payoff is based on five times the return on an index. Leverage means that large percentage gains can be achieved by putting only a modest amount of capital on the line
Peer to peer lending: this is where cash-rich investors bypass banks and lend directly to borrowers, often through online peer-to-peer lending platforms 10
High yield: companies that are deemed to have a higher risk of default on their debt by credit rating agencies, who assign them a lower credit rating than investment grade corporate or government bonds. To compensate for the increased risk the debt of these companies pay a higher yield.
The fund manager’s views at the time of writing may differ from those of other Henderson fund managers. The information should not be construed as investment advice. Before entering into an investment agreement please consult a professional investment adviser.
Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
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