114. A masterclass in interest rates, inflation and fixed income

14 January 2020 (pre-recorded 12 January 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]

Darius McDermott (DM): I’m Darius McDermott from FundCalibre and this is our Investing on the go podcast. Firstly, happy New Year to all our listeners. And let’s hope we can have a slightly more positive year. I’m delighted to be joined today by Gary Kirk, who is one of the co-managers on the TwentyFour Dynamic Bond fund.

This is a fund which we’ve followed since FundCalibre’s launch and I think it’s particularly interesting that TwentyFour just do fixed income. They’re a multi-channel fixed income business, but that’s what they do, that’s what they’re good at, and they stick to it and I actually applaud, applaud that. So thanks Gary. Thanks for taking the time to talk to us today.

[INTERVIEW]

[0:46]

DM: When we think of bonds, there’s always two things. There’s credit and there’s duration, ie interest rate sensitivity. Let’s start with credit. I mean, what a year 2020 was, how does you know that risk of lending to companies and governments look at the moment or are there any minefields or areas to avoid?

Gary Kirk (GK): Yeah, happy New Year to you as well Darius, good to be here. Yeah, it is the multi-billion dollar question. I don’t think it ever in my working lifetime and most people who’s listening to this, in their working lifetime, have we seen a cycle that’s actually moved with the momentum that we’ve actually had over the course of the last 12 years – over the last 12 months, sorry – a cycle normally like 10 years, but originally we have gone from late cycle at the beginning of 2020, into a full blooded recession. You know, with the catalyst we all know about. And we have rapidly gone into the recovery phase of that cycle and to the point where we’re actually now seeing corporate credits testing historical tights over what has been a very, very short period of time.

And that obviously raises questions and does raise concerns with some investors, quite rightly so. Have we moved too quickly? You know, and is there a question mark, I guess over the very solvency of some of these corporates that have been supported in the markets. And I guess you have to look at three things in credit really, where we are at the moment. You have to look at the level of the actual level of the debt, the volume of debt and I guess the amount of support from investors, you know, how much is that pent up demand, is that investor demand for income? And you know, we all look at fixed income market for what is yield and an income for, you know, for investment portfolios.

And then on the corporate side, I mean, just looking at Moody’s data, gross issuance in 2020, $5.4 trillion, that’s up 22% on the previous year. So in terms of absolute volume, you know, it’s higher and truly large, albeit 90% of that, or approximately 90% was actually in investment grade.

[3:20]

DM: But there is, there is a buyer on the other side of that trade though isn’t there? In the ‘buyer of last resort’ [central banks].

GK: Absolutely. There is the buyer of last resort and that was going to be obviously, you know, my, the caveat to that large number is, but we’ve never had such a large investor or investors, you know, sort of taking the other side of that particular trade. And so therefore you can understand why corporates have issued into that backdrop because rates have been driven lower, you know, of course, because of the you know, the stimulus packages that we’ve seen and the support mechanisms from central banks. And it’s not surprising to see banks and corporates front-load in their issuance needs. So I would expect, and I think if you speak to the main investment banks that are out there in our space, they all sort of expect that the issuance in 2021 will be lower than it has been in 2020.

So in terms of the net interest charge, the burden that has on borrowers, that’s obviously lower because, you know, historically rates are as low as they’ve ever been. And they’re, if you, if you listen to the rhetoric from central bankers, then rates are going to remain low for a prolonged period of time. You know, they’ve all said, you know, be it the Bank of England, the ECB, the Fed have all said that they’re prepared to let economies run hot, whilst leaving rates unchanged, meaning that they’re going to see inflation go beyond the sort of the 2% sort of, you know, level for a prolonged period of time before they even begin to sort of consider adjusting rates. So I think in terms of the timing for corporates to actually refinance, or to you know, sort of, you know, restructure their for their financing needs, I think we’ve got time on our hands. Certainly with rates remaining low for a prolonged period of time, that means that investors are going to be forced into credit. It’s the only place that they can actually find any yield. So therefore I think that the concerns that we are testing historical tights in terms of credit spread, I can understand it, but I think that we are going to not just test those historical tights. I think over the course of the next year, we’re going to go through them because fundamentally and technically the support is there.

[5:50]

DM: So I would like to come back to inflation. But as we’re on opportunity set, let’s talk about where you see the value and where you can get some income for income investors in the fixed income market; which geographies, or which sectors I know, because I have to, when we do these things, I had a little look at the factsheet and you’ve got a decent weight in both Europe and financials. Where are you seeing the best return opportunities as we sit here today?

GK: Yeah. Your first question then on inflation you know, do we see inflation you know, picking up? Yes, we ultimately – inflation will come through. I mean, we’ve had an unprecedented level of stimulus and an unprecedented sort of level of central bank you know, keeping rates anchored at, or through zero. So, that over the course of time, you would expect to see the pent up demand and the buildup of inflation gradually building. But I think what, we’re some way off, I think that the market will move in anticipation of inflation before inflation actually embeds itself into the system. And I think that we need to see a number of key fundamentals improve before inflation does become a real concern for the central bankers.

DM: So, maybe not your case based case, then that inflation is a worry on what a 12 month view? But at a period sometime after that, when you’ll need to protect us from those rising potential rising rates?

GK: Yeah, no, you know, I’m not saying that inflation isn’t going to happen, but I think we need to see some fundamental changes first of all. Look, it needs to come from the consumer. Now the consumer has increased their savings, we know that. There’s pent up demand. I’m sure, you know, all of us have been sort of, you know, locked down. We haven’t been going on our annual holidays like we did. We haven’t been out going to eat in restaurants, there’s pent up demand there. So, you know, you can see that that will actually feed into inflation eventually, but just taking it really back down to the very, very basics, just look at the non-farm payroll, you know, there was the classic monthly data that we get on unemployment in the States, you know, unless you’ve got full employment, you know, that is going to be a drag on inflation, less people earning money means that there’s going to be less price inflation in the system.

2008, 2009, you know, the last time we had a serious, serious economic shock. 2008, I think the job destruction in the United States was about three and a half million people. In 2009 it moved up to about five and a half million people. So in combination about 9 million. 2020 job destruction, 9 million people. So actually, in combination, you know, we’re pretty much like we were back in 2009. That took inflation sometime to sort of, you know, to begin to build up again. And I think that whilst we can’t ignore the inflationary impact, I think that it is not going to be a 2021 issue. It’s going to be a 2022 issue at the earliest.

DM: And as you rightly said, some of the central banks are loosening their focus on the inflation target, as opposed to looking at the overall wellbeing of an economy, taking that into account or not having to raise rates at the first sniff of a very positive inflation month, or quarter.

GK: Absolutely. They’ll let the economy run hot for a period of time before they start to get concerned and then start to adjust the base rates. So I think inflation is something that the market will sort of actually focus on before the reality. And we’ve seeing that already in the treasury curve. I mean, I wrote a blog this morning, funny enough, you know, hot off the press, just going to be released this afternoon, talking about, you know, the steepness of the curve. It’s the first, the twos tens is a classic, I’m an old fashioned trader, you know, twos tens is a classic shape of the yield curve. You would look, at the long end…

DM: That’s the two year treasury and the 10 year treasury.

GK: That’s the yield of the two year treasury vs the 10 year yield of the 10 year treasury. And that, that gives you the steepness of curve. Today was the first day since 2017, that it actually went over a hundred basis points [100bps or 1%]. So the curve is steeping. And just for those that are not rates traders amongst this you know, for the listeners here, the short end is typically driven by base rates – by central policy. And the longer end of the curve is typically driven by the perception of inflation. So as the perception of inflation increases, the steepness of the curve it gets steeper. And so we are beginning to see the first little concerns of that happening. And of course, this has been driven by the election in the US the Democrats have come into power. They’ve now got control of the Senate, and the market is putting two and two together and saying, there’s going to be more stimulus, which is going to be more long-term inflationary, and then seeing the steepening of the yield curve. So that’s something that we need to consider, but I’m not going to get too concerned about it quite yet.

[11:04]

DM: So where are you putting our money to work today then? What areas are interesting you? Geographies, governments, EM [emerging market] debt, what are you looking at?

GK: Yeah, I mean, you know, we are definitely in transition, we’re in the recovery phase of the credit markets, we’ve seen that. I mean, that’s been helped obviously by all the stimulus packages. That’s going to continue. That’s what we’ve already seen that you know, the ECB had their sort of at the tail end of last year, had the pandemic emergency purchase program the PEPP for, you know, shortened too. And so you know, that’s now you know, up to around a [euro]1.85 trillion mark and the US stimulus package is obviously, you know, is going to be going through the Senate over the next hundred days or so. So that support in the general marketplace is going to continue. And as we’ve already said, base rates are going to be kept low by the central banks. They’re going to remain unchanged, anchored close to zero.

So that gives you a very, very good back position for credit. And, even though credit spreads do look tight, you know, I think that where those corporates are focused purely on the credit spread and are not sensitive to interest rates, because as we said you know, there’s this inflation bubbling under the center, under the surface, rates are unlikely to go any lower, therefore only likely yields on government bonds are only likely to creep higher. They’re not likely to sort of, you know, significantly go lower here. Therefore, you want to be avoiding duration at this point in time, focus on the credit spread. And I think at this point where we are in the recovery phase, in the cycle, you really want to be embracing more pro-cyclical names than you would do otherwise. And that brings me around perfectly to where you say the opportunities. I think that those corporate credits particularly on the more pro-cyclical ones are around the around the crossover type rating. So ones that are just below investment grade, you know, the strong double B’s.

DM: So lets just then for our audience, crossover is that area just below where it goes from investment grade into high yield.

GK: Exactly. Exactly. So it’s where the default rate is historically fairly slim. So, there’s not like not the default rates actually sort of take place in a sort of single B-, you know, unsecured and CCC’s. This is typically the crossovers typically seen as a BB to BB- type entity. They’re normally more liquid, so in an index, a crossover index will contain the most actively traded names just below investment grade.

DM: Right, okay.

GK: For want of a better term. And I think that this is probably the sweet spot for the market because they’re less sensitive, they trade on a price, not on a spread, less sensitive duration, and they’re going to be supported by the measures that we have discussed already. So I think that’s a sweet spot for the market. And one way that you can actually obtain a collective group of those types of names is in the CLO market, the European ABS market, or CLO’s in particular – collateralised loan obligations – for want of a better term. I don’t know why they use all these terminology but that’s one area where we do see some opportunities, and the other opportunity which always raises an eyebrow, but we think more justification at this point in time, in terms of relative value than any other, is the subordinated banking sector. Yes it’s…

[14:50]

DM: What does that mean? What does subordinated banking mean? What does that mean to our listeners?

GK: Subordinated banks is that when you look at the capital of a bank, this is the lowest point in the…

DM: the capital structure?

GK: the lowest point in the capital structure that is just above equity.

DM: So you get extra yield for that though, don’t you Gary?

GK: Well, you get extra, there’s pros and cons. I mean, an equity holder obviously has a right of vote on the actual, the very sort of how a bank actually operates, the key elements that sort of dictate how the bank operates. You know, if you’re an equity holder, you’ve got a right to vote on that, you know, you can vote the directors in and out, et cetera. A bond holder doesn’t have that, but in terms of their subordinated bonds, they are typically, they will, they will offer you a better yield and a better spread then the senior bond holders. So you are taking more of a risk, so if a bank does go into default than the subordinated bond holders take a capital loss before the senior bond holders, but we believe that you are being rewarded for it for a number of good reasons.

DM: That’s the main issue is it’s, you understand the risk you’re taking for that extra reward. And, and clearly at this stage of the cycle, you think that’s a good trade.

GK: I think it’s a very good trade. Now, you know, I don’t invest in equity from this fund, but from a personal point, you know, there’s nothing to stop me from actually investing in equities. I would not be investing in the equity of a bank at the moment, but I am certainly investing in the subordinated banks.

And there’s a very good reason. Now a lot of people will say, the most deeply subordinated bank bonds are at risk like equity. Well, they’re not, there’s a big, strong differentiator between the equity and the subordinated bank now. Subordinated bank coupons are effectively are being paid and the regulator wants those to be paid. The regulators have actively curtailed banks from paying dividends and…

DM: Yes, this is that contractual income versus discretionary income and dividends obviously a discretionary and payments on coupons are contractual.

GK: Absolutely. Well, they are. And the AT1, the language is a little bit more equity like, but the regulator has actually given very strong indications over the last year that they want the AT1 coupons to be paid where they can. To the point where even when the capital goes below certain thresholds, that in the past were concerns, the regulators are happy to look through that at this point in time during this, during this crisis period, whereas they’ve guided banks to refrain from any dividend payments until at least September 2021. And even when they are turned back on, there are very strict covenants about the level of capital that a bank has to hold in order to be able to pay that dividend. So we think that equity income from a bank sort of equity is, is not, is not encouraging at the moment. So therefore the subordinated bank debt is the one area where you can get attractive income for the risk you’re taking.

[18:10]

DM: And another function or feature, I would say of the Dynamic Bond fund, but also a feature of TwentyFour Asset Management, which is, your specialty in something called asset backed securities. Would you give me a one or two minutes intro to what asset backed security is and why they’re nice to have in a multi-strategy bond fund such as yours?

GK: Yeah, I mean, it’s the asset backed securities is a strange pneumonic that has been sort of adopted by the financial industry. It just means asset backed securities, and it covers a multitude of products. So you can have income streams from credit cards. You can have income streams from car loans. You can have income streams from household mortgages, commercial mortgages, and also from leveraged loans from those corporates that are sub-investment grade, you know, the lows so anything that has an income stream, you can collectively put it together and then issue bonds dependent on the amount of credit enhancement each tranche has above or below it.

And we like, here I’m just talking about European ABS. There are legal and structural differences between US and European. Here we are only really active in the Europeans for good legal reasons, which I won’t go on to here, but there are reasons why we prefer that particular geographical region. The CLOs, which we do like, is just a way of having a collective exposure to corporate loans. And once again I think we’re fortunate at TwentyFour that we have probably one of the most highly-regarded asset backed security teams looking at these.

There is a, there’s definitely a complexity premium in terms of the spread for having, for investing in this particular type of product. But once you have the know-how and you have the internal sort of stress test models to actually analyse these products, you quickly begin to realise that like all these things, yeah, there are good ones and there are bad ones and the good ones you are being very, very well rewarded for investing in these, when you have the time and the expertise to do the due diligence, to feel comfortable with the investment.

And to give you an example, a classic, a typical BB rated CLO, which is a collateralised loan obligation type ABS, the ones that we prefer, a European one, you can easily find these in the market at about 600 basis points over LIBOR. So about 600 basis points, 6% of yield. Compare that to a current BB European high yield borrower which you’d be lucky if you can get more than 2.5% at the moment. So the spread differential, if you’re prepared to do the due diligence and have the skillset in order to analyse them is quite significant in an environment like we find ourselves where yield is becoming an ever scarce commodity. So it’s one area where I think that when you’re you know, our team live and breathe it every single day of every week, and they understand where the pockets of liquidity are. They’re very comfortable with the due diligence of the actual independent sort of CLO managers. And we’ve also, I think the other thing about CLOs and ABS’ in general is that they lend themselves very, very well to quantitative analysis. So you can, your ongoing due diligence, your ongoing sort of monitoring is that much better than a typical high yield that may be you only get sort of an annual or biannual sort of release from the company when you can analyse the balance sheet. Here, you can probably look at them, most of them on a monthly or quarterly basis in detail. So it’s an area we do like, yeah.

DM: Gary, thank you very much for taking us through the world of fixed income. And I’m glad we got a chance to talk about asset backed because I know, I know it’s an area of specialty for the firm, but also a bit of a differentiator in the TwentyFour Dynamic Bond fund, because you do have that within your firm that you can add an allocation into that part of fixed income. So thank you very much for your time.

GK: Thank you very much.

DM: If you’d like more information on the TwentyFour Dynamic Bond fund, please visit fundcalibre.com and don’t forget to subscribe to the Investing on the go podcast.