194. What do Birkenstock, eBay, recycling and litigation all have in common?

19 May 2022 (pre-recorded 12 May 2022)

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]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re looking at the fixed income market, the potential for stagflation and a few hidden gems in the Baillie Gifford High Yield Bond fund.

Ryan Lightfoot-Aminoff (RLA): I’m Ryan Lightfoot-Aminoff and today I have the pleasure of being joined by Lucy Isles, the Elite Rated manager of the Baillie Gifford High Yield Bond fund. Lucy, thank you very much for your time.

Lucy Isles (LI): Thank you for having me.

[INTERVIEW]

RLA: Bonds have had a pretty tricky start to the year. Can you just explain what has happened and how high yield bonds have fared versus sort of maybe government and investment grade bonds?

LI: Yeah, you’re right. Bonds have had a really tough start to this year, and we’ve seen negative returns across all fixed income asset classes. The US treasury index has had the largest six month fall in over 40 years. I think this reflects a big shift in headline inflation and the market’s view on inflation. So, previous market consensus was that this inflation was short-term, transitory in nature, and the result of, you know, supply chain bottlenecks and base effects – mostly COVID related – that would quickly dissipate. The surge in inflation we’ve seen in 2022 has really caught the market off guard. Central banks have moved away from that transitory narrative, and the market is pricing in sharp rate rises. The two-year treasury yield – the measure of short-term interest rate expectations – has moved from 0.2% a year ago to 2.7% despite less severe rate hikes in Europe.

The performance across the two markets has broadly been similar as credit trends for European corporates are starting to diverge from their US equivalents following the Russian/Ukraine conflict. For most European high yield corporates, direct exposure to operations and assets in Russian and Ukraine is immaterial. The most significant issue for Europe relates to energy and input prices particularly dependence on, Russian gas versus the US being benefiting as a net exporter of energy. High yield has not been immune from those sharp repricing of interest rate risk. And the market is down 8.6% this year. Investment grade bonds are also down around 8.2% and government bonds are down 7.2%. I think it’s important to recognise that thus far, the underperformance in high yield is mainly related to government bond sell-off. So, the spread moves have been relatively small – so, inside a 100 basis points, which is not much when you consider the kind of 400 basis points spread widening in 2020 or the financial crisis.

Defaults are also, you know, 20% lower relative to this time last year or a third of the levels that we saw in 2020. So, this is really a government, inflationary sell-off, not a recessionary sell-off – yet. I guess, wider context, the economy is transitioning into this new phase in which businesses, consumers and investors will have, you know, far less government support and the prices in many asset classes are weakening. And one thing to keep in mind, I think, is that the market is now pricing in a lot of interest rate risk. So even if interest rate expectations were to rise further, the capital loss on bonds would be offset by the coupon income provided.

RLA: Thank you for that. And a couple of things that you spoke about that we’ll just touch on. You said that economies are going through transition. You also said the US is doing quite well, but we actually had a surprise contraction in the first quarter. Are you worried about a thing called stagflation where we get sort of very high and rising inflation, but growth that’s very low or slowing. And what impact could that have on the high yield bond market?

LI: Sure. So yeah, I mean a recession would not be good for any risky asset class. To get there, the Fed would have to tighten too quickly and cause a growth shock. Generally, we think that’s unlikely as the Fed should get on top of inflation and managing the reduction in monetary support carefully and effectively. Prolonged high inflation and recession are significant risks for high yield. Having said that, credit fundamentals have remained roughly in good shape. So, you have high yield issuers with plenty of cash. And after taking advantage of monetary stimulus over the last two years, they have longer maturity profiles than, than is typical. Finance at attractive rates, defaults – despite increasing over the last month – remain below long run historical average. The most recent earning season has been better than expected with the ratio of beats to misses improving and companies appear to be passing on inflation, you know, but I’m conscious this is backward looking, and you don’t know you’re in a recession until after the event.

As an asset class, high yield bonds are typically less sensitive to interest rate risk. This is because increase in interest rates are normally offset by the high coupon over the long term. And the duration of the asset class is low. In terms of inflation, bit of inflation is usually good for high yield companies because it inflates away their typically high debt loads. So, I think high yield is reasonably well-positioned for a rising rate environment where there is short bout of inflation. But you want to be invested in the quality, resilient end of the spectrum. We think our approach to high yield is attractive at present because of that focus on resilience. It typically means that companies in the fund have a meaningful margin of safety against rising input costs and eventual rises in financing costs. Lower quality portfolios may find the coming environment tougher.

And in terms of kind of how I run money, I spend practically all my time thinking about company fundamentals and the resilience of the companies that we lend to. I don’t spend a huge amount of time, you know, thinking about which macro tail risk event might impact portfolio positioning, because I want my portfolio to be resilient all of the time.

I’m looking to lend to businesses with unique prospects, that are compatible with the sustainable economy and have an appropriate capital structure. So, Birkenstock, for example, you know, the iconic German footwear brand – it has enough pricing power to pass on rising costs to their customers. You know, Ocado the UK online grocer has customers who are highly dependent on their services or Paprec, you know, an innovative French recycler, that’s increasing, you know, demand and regulatory support for its green solution. So, building deep knowledge of the companies that we lend our clients capital to, I believe is the way in which we can add most value over the long term.

RLA: Now I’m just going to switch gears a little bit. We’ve discussed like the three main areas you invest in Europe, US, UK. But you’ve got an Indian company in your top ten Bharti Airtel. Maybe you could start by telling us a little bit about that company. And then also the Asian region as a whole, is that sort of a new area of opportunity for you in the high yield space?

LI: So, I might answer your question in reverse. So, at Baillie Gifford, we run a unconstrained portfolio that reflects the best ideas within the asset class. So, I don’t take a top-down view on regional allocation. Our portfolios are constructed on the basis of offering diverse portfolio of the most rewarding opportunities we can find and any macro considerations form part of our portfolio construction thinking. So, we’re seeking to avoid thematic risks. Asian high yield has underperformed other EM [emerging market] regions year to date. And this has been led of course, by Chinese high yield where spreads are, you know, over 600 basis points wider year to date. This has been driven by issues in the property sector, as well as ongoing issues by COVID 19 and the pressure on Chinese tech companies. India, Bharti’s home market, on the other hand, has outperformed in the Asian context this year. I think this bond is attractive in the context of the whole high yield market.

It’s one of our high conviction ideas. So, we have a 1.7% position. It’s a BB subordinated hybrid bond from an investment grade issuer offering a 6% yield. Through our framework, we consider Bharti to have solid prospects. It has a leading market position in the high growth Indian mobile market. It survived a grueling price war and has become one of two companies that dominate the Indian telecommunications market. It puts it in a great position to improve pricing in a, in a growth market with insatiable appetite for data. From a sustainability perspective, we consider this to be an enabler. So, it’s our highest score for sustainability given the social role in bridging the internet divide and giving people access to services. And then in terms of capital structure, we believe this to be appropriate. It’s profitability’s expanding as it’s reducing leverage. It has a very supportive shareholder base and ultimately, it’s actually on positive outlook and it may be upgraded to investment grade at Moody’s, which would be the only rating agency to which it remains high yield at the moment. And in addition to that, you really get a good yield pickup relative to similar issuers in the UK, like Vodafone, demonstrating the advantage of having a global opportunity set.

RLA: Thank you. And then maybe we can talk about some of the other holdings you’ve got in there. I mean, Adevinta is see is in your top 10, it’s got eBay and Gumtree amongst its customers, well-known names to our listeners. And then perhaps if we’ve got time, just another little hidden gem you’ve got in the portfolio that you’re, you are really pleased about?

LI: So yeah, Adevinta, it’s a holding we share with our equity colleagues at Baillie Gifford. Actually, it’s a pure play online classified group business. We hold a 1.7% position in a five-year BB- bond offering a 5.5% Euro yield. By our framework, we consider this to be a company with outstanding prospects, leading market positions, benefiting from the flywheel network effect with higher listings, driving higher customers, creating a winning marketplace. We think it’s an enabler of a sustainable economy, or again, our higher score. It’s a very its very proposition is really fueling the circular economy, championing ‘reduce, reuse, repair, recycle’. And then in terms of its capital structure, you know, even despite the 50% drop in market cap, it still has a very low to loan value at 35%. So, a significant equity cushion. It’s a very cash-generative business, with a long-dated debt structure.

I think another business that demonstrates the value, our, of our approach, which is one of my favourite companies in the portfolio, is Burford Capital. It’s a founder-led litigation finance company, which provides capital against the future value of legal claims for a share of the eventual proceeds. It’s one of our largest positions in the fund. It’s a 3% holding offering a 6% US high yield. I believe Burford is an investment grade company in disguise. So, it has optically high losses, inherent illiquidity and uncertainty in the legal cases. And they weigh heavily on the rating agency scorecards. So, and it completely undervalues the very high barriers to entry, exceptionally skilled underwriters that work for Burford. The lack of correlation to the financial cycle, as well as the significant cash from outsized returns, which ultimately lead us to consider this to have a business with outstanding prospects and a very strong capital structure. And unlike a fossil fuel company, Burford, doesn’t have to do anything differently to earn its social license to operate. So even though the social values could be argued either way, we consider this to be neutral from a sustainability perspective. This company has held up well in a weak market, is outperforming the sell off, and it’s still offering upside with investment grade potential over the long term

RLA: As expected Lucy. That’s been really interesting. Thank you very much for your time today.

LI: Thank you

SW: This fund offers investors access to a portfolio of predominantly UK, US and European high yield bonds. The team believes its extremely selective approach to investing in high yield bonds is the key to the fund’s success in this market. To learn more about the Baillie Gifford High Yield Bond fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

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 the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.