A professional investor tells us where he’d put his money now. This week, Bryn Jones, investment manager, Rathbone Ethical Bond Fund
Investors are faced with a now familiar dilemma: what is the greater menace to global economic stability – higher inflation or slowing growth? The Bank of England surprised markets by raising rates to 4.75% to bring inflation in line with the 2% target. The futures cash market suggests that rates will rise to 5.25% in the next 12 months. But markets are now pricing in a pause or peak for the US. Central banks have been criticised in the past for tightening too aggressively, so the US Federal Reserve now seems comfortable with slightly higher inflation while expecting slower growth to subdue near-term inflationary pressures. The market continues to scrutinise monthly US employment figures, which might point the way for rates. The tense geopolitical backdrop could mean more safe-haven buying of government bonds – although this can distort investors’ perceptions of future monetary policy by driving down yields.
Should US growth disappoint – in particular, if the housing market weakens further – then we would expect to see ramifications in the UK and globally. Overall, credit spreads – the difference in yield between bonds carrying varying degrees of risk – have remained stable; however, default rates are more likely to rise because firms have taken on more debt. Credit agency Standard & Poor’s recently revealed that investment-grade firms have a 3.32% chance of defaulting over a 15-year period; this figure is nearly 31% for speculative grade bonds over the same period.
Our focus on higher-quality credit and cash-generative firms – in the form of asset-backed securities, building societies and banks – acts as a defence against this. Where we are exposed to riskier sectors, such as telecoms, we have bought into companies that are not highly geared. We remain underweight compared with the iBoxx Sterling Non-Gilts Index and favour holdings such as Telefonica, where leverage is unlikely to rise significantly.
The threat from leveraged buy-outs (LBOs) remains high. The re-leveraging of balance sheets can damage the quality of a bond, although bondholders are now negotiating revised financing structures on new issues, such as the London Stock Exchange. The LSE has strong covenants that protect the bondholder in the event of a downgrade resulting from a private-equity bid or takeover, as has retailer Next. Mergers and acquisitions activity has paused, but weexpect it to resume later this year. Our exposure to asset-backed bonds and financials provides some insulation from LBO risk, and we have avoided cyclical assets, which are structurally prone to LBOs.
In April, we bought CRC Breeze Finance, a compelling ethical story in German and French wind-farm securitisation, yielding 5.29%. This is our first Euro-denominated bond, a position we are comfortable with as the Euro continues to strengthen. We have added to Fresh Finance, a mortgage-backed security (MBS) that invests in residential social housing in the UK. This is one of the strongest AAA (the highest rate of corporate debt available) fixed-rate, MBS structures available, and is highly attractive in this uncertain environment. Citigroup is another quality position that we have built this year. The bond is AA-rated across a range of maturities, but we believe that the company should attain AAA status over time.
Finally, we have initiated a new, Sterling-denominated holding in Resona Bank as a play on the Japanese recovery story. We believe that any bank that has survived the zero interest-rate era can only benefit from a higher interest-rate environment, and should have the ability to drive some margin out of its loan and/or deposit book.