126. Rising inflation: We’re on the brink of something different for the first time in decades

8 April 2021 (pre-recorded 6 April 2021)

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]

Juliet Schooling Latter (JSL): Hello and welcome to the Investing on the go podcast. I’m Juliet Schooling Latter and today I’m joined by Chris Bowie, manager of the TwentyFour Absolute Return Credit. Chris, thanks for joining us today.

And as a quick note, I need to just mention that TwentyFour is authorized and regulated by the FCA to engage with professional clients. Right, let’s get started.

[INTERVIEW]

[0:24]

JSL: Chris, bond markets have had a shaky start to the year. What has been going on?

Chris Bowie (CB): It’s been a really challenging start to the year for bond markets. It’s probably been the worst start for government bond markets that I can remember in my career, I’d be managing bonds for three decades now. What’s been going on is really the reflation story after COVID and what that has meant has been very strong government spending and also a commitment from central banks to keep interest rates very low. And the combination of these factors means that the bond market is getting more concerned about inflation in the future than it has really for the last 20 years. So we’ve started to see the bond market at the longer end of yield curves, meaning longer dated bonds selling off quite significantly. And if we look at UK government bonds, which are normally regarded as a very safe investment, they are down more than 7% year to date. So that’s actually a surprisingly large loss for what’s considered to be a very safe investment in most times.

[1:25]

JSL: That’s interesting, and presumably this is linked to inflation expectations? Do you think inflation and higher interest rates are a real possibility? Or do you think the market is getting ahead of itself here?

CB: I think there’s two interesting questions there Juliet and I’d say the first one inflation, yes, there is a threat of inflation. I think we are at the brink of perhaps something different for the first time in many decades, because we’ve had a supply shock because of COVID, we also have huge government borrowing and government spending, through the furlough schemes and other schemes to support the real economy. That’s good for the economy, but it does also bring about some additional inflation risks. And we haven’t really had that. We’ve had globalization now for many decades, which has generally driven prices down and wages have stayed relatively low. I think we’re potentially on the brink of something different, where we might have inflation closer to say 3% than 1% over the next 10 years. Of course there will be differences every year.

I don’t think we’re going back to a 70s style inflation, but I think, possibly, we will have slightly higher inflation than we’ve seen in the last 20 years. And that that will put pressure on the bond market because the absolute level of yield of the bond market, the income from the bond market, is at the lowest level it has ever been. And so I think it’s natural that the bond market recognizes some additional risks now, and then has sold off a little bit to make the yield or the income from the bond market more appropriate for the risk we face.

[3:00]

JSL: So do you think higher interest rates are a real possibility?

CS: That’s a great question and normally I would say yes, in an inflationary environment, you would expect interest rates to go higher. But one of the interesting features of this economic cycle has been that central banks have been at great pains to tell us that they are not going to be raising rates anytime soon. The federal reserve, which is the US central bank have said quite recently, we will not be raising rates at least until the end of 2023. And if we look closer to home in the UK, the Governor of the Bank of England has said negative rates could still be a possibility for the UK. So we have this unusual scenario, perhaps where inflation could be going slightly higher, growth could be coming back very strongly and yet central banks will be sitting on their hands, keeping rates very low. And that means, in fact, the selling pressure for the bond market will most likely be felt in very long dated bonds.

[3:58]

JSL: And you tend to invest in bonds that are due to mature shortly. Why is this? What are the benefits for investors? And what are the risks, or the opportunity costs with this?

CB: Yes, I do tend to prefer shorter dated bonds for funds where volatility is a key concern, i.e. where keeping our capital preserved is the number one objective. And then the second objective is to return as much income as we possibly can. Short dated bonds are better at doing that, they tend to be far less risky. And it’s for a number of different reasons, some of them are mathematical to do with some of the concepts around the bond market, but some of them are because you have much more predictability over the short term than you do over the long-term. If you invest for the long-term of the bond market, you really do have to be concerned about inflation, whether the company will ultimately default, for example, as well. Whereas for shorter dated bonds, inflation is not really a big driver of the prices of those bonds. And you can generally invest in companies with a little bit more risk because you have more visibility on their earnings over the next one to two years than you would have over the next 10 to 20 years, for example.

So in my shorter dated funds, I am a little bit more tolerant of credit risk, i.e. I can buy companies that are perhaps a little bit more risky in terms of their earnings profile, because I have the certainty of knowing that I’m going to get my money back in the next 12 months or 24 months, rather than having to take a view on whether that sector or that business will exist in 20 years’ time. We all remember Tesco, you know, it was high in terms of market share, it was the darling of the stock market for many years. It then got into trouble, its bonds were downgraded, and it’s the longer dated bonds that tend to underperform in those scenarios. If you stay in short dated bonds, you don’t have the same risks. You do give up a little bit of income, but you’re more than compensated, I believe, in terms of the lack of volatility. So they’re safer investments and a steadier return profile is enjoyed by owning these assets.

[6:05]

JSL: Right…so in what parts of the market are you currently finding opportunities?

CB: It’s actually mostly banks and insurance companies. One of the features of last year following COVID was that sectors that were receiving explicit government support, such as transport for example, those bonds rallied very hard. They went up in price terms and they became very expensive. By contrast, some banks and insurance companies became cheaper. So I like things like, for example, the Nationwide Building Society or the Coventry Building Society, where we can loan them money through the bond market and enjoy a nice income from those bonds.

But one of the differences with the bond market, compared to equities or shares, is that once you’ve decided to buy the bond of a company, you have many more choices after that in terms of how much risk you want to face. You can loan them money for a riskier investment, which will pay you a higher rate of interest, or you can loan them at the more solid end of the balance sheet, if you like, where you get a lower rate of interest, but you have more security. And within the banking sector of the bond market, you have a lot of choice here in terms of, do I want the lowest risk bond possible, or do I want the highest risk one. I tend to favor banks where the bank itself is so secure, it has such high capital ratios, that I am tolerant of their junior bonds, meaning they’re riskier bonds. So I would rather own the junior bond of a strong bank rather than the senior bond of a weak bank. If that makes sense.

[7:39]

JSL: Yes, it does, yeah. So perhaps you could tell us about one or two of your top 10 holdings.

CB: Of course. So I particularly like Nationwide and Coventry, really because they’re mutual building societies. So because they’re mutuals and they don’t list on the stock market, they have to essentially be a safer business through the cycle. They don’t have the option of tapping the stock market to raise money. So their balance sheet tends to be stronger than other banks. So for example, Coventry or Nationwide have a very high capital ratio of more than 30% core tier one. That might sound like a strange number, but if you compare it to something like a Barclay’s or an HSBC, their capital ratios will be less than half of that. That means you have incredible protection against any unexpected events, such as losses, for example.

And more than that, the Coventry and Nationwide, they really only do residential mortgage lending. And the average loan to value of their mortgages is reasonably low. So their balance sheet is actually in my view, a very safe one, safe as houses almost. And therefore I can be tolerant buying their more junior bonds, which are still yielding about 3.5% today, which is very attractive when you compare that to say the senior bonds of something like an HSBC or Barclays, which might be yielding closer to 1%. So you can get much higher income if you pick your spots carefully and also pick the banks that you’re invested in carefully.

JSL: Right, that’s all interesting stuff, that’s great. Chris, thank you so much for your time today.

CB: My pleasure.

JSL: If you’d like more information about TwentyFour Absolute Return Credit, please visit fundcalibre.com and don’t forget to subscribe to the Investing on the go podcast.