108. How to make money when everyone else is losing it

3 December 2020 (pre-recorded 30 November 2020)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

James Yardley (JY): Hello and welcome to the Investing on the go podcast, I’m joined today by Mike Riddell and Kacper Brezniak, the Elite Rated managers of the Allianz Strategic Bond fund. Guys, thank you very much for joining us.

Mike Riddell (MR): Thanks for having us.

Kacper Brezniak (KB): Thanks for having us, thank you.

[INTERVIEW]

[0:19]

JY: Now a few years ago you sat down with a clean sheet of paper to design this fund. So where did you start and what did you want to achieve and how have you differentiated it from other strategic bond funds on the market?

MR: So the background for this is, before I actually joined Allianz Global Investors in 2015, I worked at M&G and I was aware of what M&G’s fund was doing. But more specifically, what other funds were doing within the unconstrained fixed income sector – it’s called the strategic bond sector in the UK. And what I noticed really is that all funds in this sector were saying they were doing unconstrained investing, that they were flexible throughout the economic cycle, they were saying they could make money if interest rates went up or if they went down, or if inflation went higher or lower ,just by being flexible and moving the fund around, depending upon which stage of the economic cycle you were. However, what I noticed was something very different: that really almost all strategic bond funds – they behave like essentially equities. They have a lot of investments in credits, they have a lot of investment grade corporate bonds, they have a lot of high yield corporate bonds and, because they’re always highly exposed to corporate bonds, they behave a lot like equity funds and some of the really big funds in the sector have a correlation with equities of plus 0.7 – that’s basically like an equity fund.

So, when we came to launch a fund in this sector, we wanted to do something very different. First of all, we wanted it to behave, not like equities. We wanted to say we are a bond fund that behaves like a bond fund, so that you can be defensive and we can really be an anchor in the portfolio when things go wrong. So, when you see big ‘risk-off’ moves, when markets are very volatile, we should be at least preserving capital and ideally actually making money. So, we’re trying to be a diversifier. The other thing I noticed with a lot of funds in the sector is that they said they’re unconstrained and flexible, but they never really used it. So, what we’re trying to do with our fund is trying to take advantage of whichever economic scenario we’re in, where you can make money for investors in really any scenario, which is basically how it’s panned out in the last four and a half years.

JY: Yeah. I mean, it’s funny you say that. I remember going to M&G a few years ago and seeing a presentation from Richard Woolnough, who is a big fixed income manager at M&G for our listeners. And he showed the chart of the IA strategic bond sector versus IA corporate bond sector and they’re pretty much the same, almost exactly over 10 years. So, as you say, a lot of strategic bond funds are really just credit funds.

MR: Yeah and that’s fine if you want to have a credit fund or a corporate bond fund – if income is really important to you, then it does make some sense, but you just have to realise that corporate bond funds behave like equities. So, we wanted to do something very different and we wanted to be uncorrelated to equities. So, we say over a three-year period, we want to have a zero correlation to equities, for example.

[3:17]

JY: Well look, you certainly delivered this year and your fund is creating a lot of buzz at the moment because of your performance during the sell-off in March. I don’t think many funds, if any, performed as well as you guys did. So, whilst other strategic bond funds with those large credit positions were struggling, I think you did very well. So, can you tell us how you’re able to deliver that?

KB: Sure. Well, I think just to kind of add to what Mike said, so, you know, we designed this fund in a certain way, but when we think about what we do, part of it is the design of the fund: we want to give ourselves the best chance possible to perform well. But the other side of that is how you manage the fund on a daily basis. And so here we’re talking about things like process and philosophy. I mean, there’s a couple of things that in particular helped us in times like February/March. You know, part of that actually is flexibility. Again, you know, Mike had very strong feelings about, you know, this being a sector, you know, it’s an unconstrained sector, all these funds have a lot of flexibility, but they don’t really use it. Now we have a lot of built-in flexibility into the fund and we do use it. And that’s very important.

And I think there’s some aspects in terms of philosophy. One of those is asymmetry. We seek asymmetry and what that simply means to us is we want to be, we want to do better when we, when we get things right, than when we get things wrong. We want our up months to be bigger than our down months. We talk about having things like a value bias, for example, what that means is we don’t want to be buying things when they’re at the most expensive they’ve ever been.

So if you take that back into February, actually at the beginning of this year, we were positioned for global reflation. So, I think had we kept some of those positions on into March things would have looked very different, but again, we have a lot of flexibility. We focus on, you know, liquid asset classes, liquid products. And so you know a key thing was being able to turn the portfolio around when we, of course saw you know, Coronavirus was no longer just in China, it was spreading globally. So we, we turned things around very quickly, But actually, what you already saw in in January/February though, that even though we were positioned for global reflation, so we were positioned ‘risk-on’, if you will, directionally. Already at that point, we were, for example, short credit, short high yield in particular, we were long volatility in particularly in FX [foreign exchange] because these were two markets in particular that were pricing in perfection. Credit spreads were at incredibly tight levels. So for us, this was already something that we were positioned for. And of course, as things started playing out in February and March we of course changed positions and added to some of these you know, long volatility insured credit positions.

And obviously that worked out very well. I think, you know, for us, when we talked to investors, this is exactly what we want to be doing. We want to be able to change things around. We want to be a diversifier in a portfolio. And that’s very important. Although of course, I will say, you know, that the stars sort of aligned for us in terms of volatility and positioning. We’re unlikely to repeat that sort of performance in the future. But nevertheless, I think the design of the fund and the way we managed it were clear you know, contributors to that performance.

[6:45]

JY: I think what was also impressive with your performance is that, you know, that you continued on often in the recovery, you also did well during that period as well in April and as we moved into the summer. So how were you able to deliver that? Because most, very few funds were able to do well in both the sell-off and the recovery.

MR: The view we had about the economy changed very rapidly in March. So as Kacper said, we were very worried about Coronavirus and we can see very simply it wasn’t priced in to financial markets at the end of January. Markets were completely complacent and expecting a great global economy. And we could see some material risks of a big crisis and particularly recession. So were defensive and very worried in January, February because markets weren’t pricing in anything bad happening. By the time we got to the middle of March, it was a complete opposite – where markets were in complete panic mode and they’re essentially pricing in a great depression forever. So we had to look at what’s going on. What’s the response been. We saw huge monetary stimulus, interest rates being slashed, loads of QE. We saw record fiscal stimulus, so much more government spending than we saw in the ‘08/09 crisis. And other things as well made us very bullish on the economy and we expected a V-shaped recovery. For example, oil prices had collapsed. That’s normally great for the economy about six months later. And even Coronavirus, of course, COVID was the big risk for markets that was already starting to improve by the end of March in countries like Italy. So we became much more bullish on what’s going to happen to the economy. And yet you can see markets are pricing in a great depression. So for us, that was opportunity.

What we did with the fund was we moved from being very defensive, to actually being very risk-on. And we did that by actually buying corporate bonds in particular. We thought corporate bonds were pricing in the most distress of any of the global fixed income asset classes that we look at. And the other one, which we really liked was actually inflation. So I remember at the end of March, the market for the US for example, it was pricing in deflation for two years and we thought that was completely wrong. So we were buying a lot of, going with US inflation. Not actually using bonds, but we did it inflation swaps, basically the same trades, just long of US inflation. And that worked very well as the market started practicing in higher inflation. Ie that global reflation narrative really kicked on in Q2.

So yeah, as we said, you know, we move, we used the flexibility of the mandate. We were very defensive in Q1 because we were worried about the economic outlook. In Q2 we were very bullish on the economic outlook and were buying risky assets because they were incredibly cheap and unjustifiably so in our view.

KB: And I think that just really highlights again what Mike was saying there, it just really highlights the flexibility that we have, the toolkit that we have, one of the things that we always say is that we have a lot of flexibility because different markets price in different things. So we, when it comes to expressing a view, whether it’s a bullish view or bearish view or something, that’s maybe more market neutral, having that flexibility and using liquid products as we do, really allows us to move things around. I think again, that was a really good example of that.

[9:47]

JY: If we look at your latest factsheet, you seem to have a lot in US treasuries and US government bonds. Are these not very expensive at the moment given the incredibly low yields or is there more, more to the portfolio sort of below the surface which we can’t see?

MR: Yeah, there’s a lot more to the portfolio. So, what we’ve been doing actually since the summer is, whereas in the second quarter of this year, we thought corporate bonds were pricing in a very high risk of recession, or essentially pricing in a depression. Our view did change over the summer. So what we’ve been doing is selling down our corporate bond exposure and actually buying government bonds. We’re generally buying shorter dated government bonds. So we weren’t very exposed to interest rates going up at any point. So I wouldn’t say that means that we really bullish on government bonds. It’s just that we wanted to move out of so some of the corporate bond holdings that we had.

Where we’ve been rotating as well is buying emerging market debt. And this has been a big change for us since the summer is that when we look at all of the fixed income asset classes and what’s lagged in this global reflation trade, you know, as people start thinking about vaccines as the growth outlook, it looks much rosier. And the things that hadn’t moved as much as they should have done, firstly, was emerging market debt. So we’ve been buying a lot of emerging markets bonds, but local currency. So in other words, in the currency denominated, for example, South Africa, Rand denominated government bonds, the same thing for Brazil, for Mexico, for Russia, et cetera. And we’re not hedging it back. So we’re taking the currency positions and we like those bond markets because the yields are much bigger than what you get in developed markets…

JY: And that’s as opposed to hard currency bonds. So emerging markets, of course, they can either issue bonds in their own local currency or in say US Dollars, for example. So you’re taking on both the currency exposure and the bond risk.

MR: Yeah, exactly. And we did actually own some so-called external debt, which is US dollar denominated or Euro denominated bonds as well. But we were selling those down through the summer because again, they were becoming more expensive. So it really was the currency play that was looking very attractive to us because the EM currencies had really lagged. And we could see that they were very cheap, firstly, which made us quite interested in them. And secondly, one of the big changes in the last few months has been the Asian economy and the Chinese economy in particular have been incredibly strong. So we thought emerging markets were a very good way to tap into the stronger Asian narrative, which we’ve had in our fund for a few months.

So while it looks like we have a lot of developed market government bonds in our fund, and that’s true, you know, there are a lot of other things going on in the portfolio. Currencies are one of those. We still like some long inflation positions actually, which you wouldn’t see in the top 10 bond holdings in the factsheet. We are still long of US inflation a small, long in Euro inflation just because it’s so cheap, it’s pricing pretty much zero inflation over the short term. And you know, various other trades that were using derivatives as overlays, which wouldn’t necessarily appear on the factsheet.

[12:46]

JY: And I noticed a couple of Japanese bonds in your top 10 as well. Is that another theme you’re playing?

KB: Well, I mean, you know, obviously one thing that’s important and again, one thing that’s a big feature of this fund by the way, is that, you know, we have a benchmark – global ad- and we chose that very deliberately. And so, you know, it is worth highlighting. You know, whenever we think about positions in this fund it’s always relative to the benchmark. And so, you know, the benchmark has around two-thirds government bonds, one-third corporate ones. So when we think about, you know, positioning, it’s always relative to that position. So I think there’s two things worth to say then on Japan or first of all, you know, it’s part of our benchmark. So, you know, unless we’re taking a massive underweight, then there’s naturally going to be some things in there, but actually one of the things with Japanese government bonds, that’s really, really interesting is that while it looks like you’re buying a negative yielding bond, once you hedge that back to sterling, which we naturally would do, actually you end up with quite a positive yield and especially, you know, at the front end, if you’re looking at sort of cash instruments then Japanese government bonds or Japanese T-bills provide actually one of the best yields in the global universe. Similar to Italy, for example, and so, you know, that should be a really good example of how big that yield is, because obviously, you know, when you’re buying Japan, you’re not taking the credit risk you are, if you’re buying you know, Italy, but ultimately hedged back to sterling, those two provide quite a similar level of yield.

[14:19]

JY: And the yield on the fund is quite low. I think it’s one around 1.5% at the moment. So would you always expect it to be that level or is that likely to change in the future?

MR: The yield can move around a lot which is a function of basically how our views change. So when we had a lot of corporate bonds and you know, some of those were very high yielding back in March and April, the yield on the fund was very high. I mean, it was probably more than 4% at one stage. But when we think that it’s not so attractive to take credit risk and we don’t want to lend to those worst rated companies or governments, then the yield will naturally go down. So you have to remember within bonds, the higher the yield, the more risk you’re taking. So what we’re, what we’re doing is we’ve been de-risking, we’ve been selling down some of our corporate bonds buying some lower yielding government bonds, you know deliberately because we think those corporate bonds aren’t so attractive anymore – they’re not pricing in enough risk of default and we think there are still some significant risks of default over the next few months. We’ve been deliberately de-risking that part of the portfolio and, as a result, the yield’s gone down, but we always say we don’t try to maximise yield. You know, if you go for the highest yielding bond portfolio you can have, you’ll end up with a very high beta equity fund, and that’s not what we do.

So, we care about total return. That is our objective. We’re trying to outperform our benchmark. And we’ve managed that. We are trying to be uncorrelated to equities. And again, that means we’ll generally have a lower yield, but we don’t really care about that. It’s all about total return. It’s not about the income from our fund. And I guess you have to really start off and think what’s the point in a bond fund? In the old days, a bond fund was about generating some income for people. And it was about being a diversifier in a multi-asset portfolio. The income bit clearly – given where interest rates are now – is not dominant. The main reason we think to own a bond fund is to be a diversifier. And, as a result, that’s the most important thing for us being uncorrelated to equities. But also, if we get our macro views right, generating a decent total return, and that’s what we’ve done particularly this year.

JY: Mike and Kacper, thank you very much for joining us and congratulations on a fantastic year.

MR: Great, thank you very much.

KB: Thank you very much.

JY: And if you’d like to learn more about the Allianz Strategic Bond fund, please visit our website fundcalibre.com and please don’t forget to subscribe to the podcast as well.