245. Forget emerging markets – invest in a Barclays Bank bond

9 March 2023 (pre-recorded 1 March 2023)

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. I’m joined this week by George Curtis, portfolio manager and member of the Multi-Sector bond team at TwentyFour Asset Management. Today we’re going to be talking about the whole fixed income spectrum from high yield through to government bonds. Hopefully, by the end, we’ll have given a through overview on market conditions and what bond investors are seeing at the moment. So George, thanks for joining us today.

George Curtis (GC): Thanks for having me, Staci.

[INTERVIEW]

SW: So, let’s start a bit broad and then we’ll get into some specifics. What is your outlook for the global economy today, at the beginning of March 2023? And how might that impact bonds in the next 12 to 18 months?

GC: Okay, good question. Let’s start quickly by saying, well, 2022 was obviously, you know, one of the worst years on record for global bond markets. We had inflation that was at multi-decade highs, and we had central banks that had been at zero lower bounds for much of the last decade. So, we had a sharp adjustment from the central banks. Towards the backend of the year though, we did get clarity on some of the issues that had driven markets last year. So, inflation started to roll over. That gave us better visibility on where the central banks were going to end up. It gave us better visibility on the central bank reaction function. We had better clarity on how European economies were going to deal with the war in Ukraine. And more specifically, gas prices helped, fortunately by a warm winter, so, gas prices declined significantly. And we also had, rather surprisingly to us at the time, China – at the end of the year – hastily got rid of the zero-Covid policy that they had been utilising for the years before, which, you know, obviously improved growth forecasts for China. 

So, you know, all told, our probability of a hard landing has reduced. So, we see, you know, three main scenarios. Our probability of a hard landing has reduced to somewhere around 20%, and we see equal probability weightings of a soft landing and a softish landing; a softish landing being one where we do see a recession, but where we think the unemployment rate and where we think default rates will stay lower than they have been [in] the previous recessionary cycles. In a large part because we think, you know, corporate balance sheets and consumer balance sheets are in a very strong place.

Where does that leave us for fixed income? Well, fixed income’s a very interesting place at the moment. And starting yields at the beginning of this year were the highest in over a decade across both high yields and investment grades, and indeed, government bonds. So, you know, while we expect volatility to remain elevated in the coming 18 months, while we expect the data, … it’s not going to move in a straight line, we think the outlook for fixed income is positive given those elevated all-in yields.

SW: And then if we can just look at some of the different areas within the bond market, and we’ll start with high yield, you mentioned it there. So high yield are these companies that are deemed the most risky to lend to, but which compensate investors for that risk with a higher level of income. So, why is this area interesting you today? What level of income are investors getting? What’s to be expected?

GC: Yeah, it’s a good question. So, you are right to say that companies in the high yield sector are deemed the most risky across the credit spectrum. This is where the vast majority of defaults happen – 99% of defaults happen in the high yield sector. So, in order to be invested in this sector, you have to have a good idea on your default outlook. And also you have to do rigorous bottom-up analysis. Interestingly, given all of the tensions we’ve had in the macro side of things, the default rate forecast, the default rate outlook has remained very benign. And that’s for one of the reasons I mentioned earlier: corporate balance sheets are in a very strong place. Leverage is at the bottom of the decade low, at the decade range. We have interest coverage, which is a metric measuring earnings over interest, at all-time highs. And we have cash as a percentage of debt on balance sheets, at record highs. So European high yield, let’s take the default rate for 2022, given everything that’s happened – there was a war in Europe – the default rate ended the year at 0.4%. And forecasts for default rates this year are for it to remain below historical averages, both actually in Europe, the UK, and the US. So, the default rate outlook is benign. And you are getting, as I mentioned, yields that are the highest they’ve been really since the sovereign credit crisis in Europe, since 2012. 

Having said that, we don’t think this is the time to be reaching for yields. So, within our portfolios, we have been reducing our exposure to high yields, just particularly given the yields that we are seeing in higher quality areas of the market now. But also, we want to reduce our exposure to those names that are most sensitive to recessions, and the names that we have been invested in, we want them to have strong pricing power, so our overall allocation to high yield has reduced. And within the high yield bucket, we have moved up in quality.

SW: And so, you said you’re reducing your exposure to high yield, and you slightly mentioned the kind of threat of recession. Are these high yield companies more at risk if a recession does come through? And does that, I guess, vary by the regions that you’re looking at, whether it’s US versus Europe versus UK, they all [have] kind of different outlooks depending on geographies as well?

GC: Yeah, so this is a good point. You’re right. Companies in the high yield sector are most vulnerable to recessions, there’s no doubt about it. For reasons that I’ve mentioned, we think even in a recessionary environment, we’re not going to go to the default levels that we saw in 2008. We’re not going to go to the default levels we saw in 2000. We will be significantly below that. 

The way we think about regions is we look at things on a fundamental basis. We look at things on a valuation basis. Fundamentally, you’d probably want to be in the US, right? Because, you know, you’ve got a labour market that’s at record lows, you’ve got inflation that’s coming down faster than it is in Europe, faster than it is in the UK, but dollar high yield is more expensive than euro high yield or sterling high yield, for example. So, valuations in Europe are cheaper. Dollar high yield – the index is trading at a dollar yield of 8.5%. If we take the Euro yield on the euro high yield index and swap it into dollars, so we can measure apples to apples, the yield on the Euro high yield index is 1.3% higher than it is in the US. And it’s worth saying that the US high yield index is lower quality. The average credit rating, which is a measure of risk, is Single B+ versus BB- for European high yield. So, European high yield is more highly rated. So, we view these things on both the fundamental and a valuation perspective. We have a relatively equal weight within the portfolios of US high yield and European high yield at the moment. But both, as I mentioned, have reduced over the last 12 months.

SW: And then just before we move out of a high yield, you’ve talked about US and Europe, where – as I’m sure listeners will be wondering – where is the UK high yield market sitting on kind of this spectrum that you’ve just explained?

GC: Yeah, it’s a good question. So, look, the sterling high yield market is much smaller than both the euro high yield index and the dollar high yield index. The dollar high yield index is 2 trillion dollars; European high yield index is 500 billion Euro; Sterling high yield index is 60-70 billion pounds. So, it’s significantly smaller. It’s maybe a slightly more illiquid market, and generally trades at higher spreads than both Europe and the US. Interestingly, and you’re right to point it out, actually the spread between sterling high yield and euro high yield, is the highest that it’s ever been. It was at its 99^th percentile at the back end of last month. So, we certainly think there are interesting in the sterling high yield space with all in yields over 9%.

SW: Excellent. Well, we’ll kind of move on then from high yield and maybe go into investment grade. So, these bonds are for more reliable companies. Is investment grade presenting new opportunities? Is that kind of, you mentioned reducing exposure to high risk. Are you going into investment grade or something else? Can you tell us a bit more about that?

CG: Absolutely. So, investment grade is, you know, more attractive than it’s been in a long time. Of course, you know, in Europe we’ve had, as I mentioned, we’ve had a decade of negative rates, almost a decade of negative rates. But now, given the move we’ve seen in government bond curves, given the spread widening – the spread, remember, is a measure of credit risk – we’ve seen in credit, yields are significantly above their longer-term average. So, euro IG [Investment Grade] for example, is yielding you approximately 4% in euros. If I swap that back to sterling – and we are not FX experts, we swap everything back to the base currency of the fund – that’s a sterling yield of 5.5% for an index that is rated A-. So, yeah, absolutely no default risk. These are, you know, the largest companies in the world. The 10-year average for that index is 1.2%. So, we are over three times higher the 10-year average. The 20-year average is 2.6% – and that obviously includes the financial crisis where yields went to over 7% in euro IG.  

So, we view euro IG as attractive. We have, as you mentioned, rotated some of the high yield exposure we have had, into the investment grade market. Our preference within that space, is to invest in the financial space. You know, banks have, since the financial crisis, had a decade of capital generation, building capital at the behest of the regulator, but it has meant that they have rock solid balance sheets, which ultimately protect us as bond holders. And we just saw during 2020 and 2021 how solid these balance sheets were, with many of the banks generating very solid profits. And they are, you know … there is a lot of protection for us as bond holders, even in the more subordinated part of the capital structure within a bank’s balance sheet. So, we can take subordinated bank risk of investment grade companies, so take a Barclays [bond, for example], one of the biggest banks in the UK, they issued an investment grade-rated, subordinated financials bond yesterday at a yield of 9.25%. This to us, seems like very good risk to hold throughout the cycle, whatever your view on the macro is. So, this is what we’ve been doing in investment grade.

SW: And then another area to touch on is obviously government bonds. Listeners might know them as UK gilts or US treasuries. And, you know, since these loans are backed by governments, we like to think of them as less risky. Obviously emerging markets would be slightly different. But what opportunities are you seeing in government bonds, either in the last few months or even kind of looking forward? How are you viewing the government bond opportunities?

GC: Yes, so in line with what I’ve been saying in terms of yields in the investment grade market and the high yield market, government bonds now offer you yields, they offer you protection, and they offer you flexibility. We have a preference for [US] treasury curves – for US government bond curves – because we have better clarity on what we think the FOMC [the Federal Open Market Committee], the Federal Reserve, is going to do. And inflation is coming down faster than it is in Europe and the US, but also it’s a much more liquid market. And we want that flexibility in our government bond bucket. We want flexibility to go from short-dated government bonds to long-dated government bonds, which we’ve been doing over the last 12 months. 

So, 12 months ago within our portfolios, all of our government bond bucket was in one year government bonds. But as yields rose through the year, we extended the interest rate durration of that bucket ie. we were buying longer and longer bonds. So, we, at the moment, we think there are very few scenarios where you lose money in a 10-year US treasury at 4%, over a kind of medium to long-term view. So that’s what we’ve been doing in government bonds. And that bucket, that allocation to government bonds, acts as the balance to the credit in the portfolio. 

I would maybe just add there that, you know, as the cycle changes, when I say that government bonds offer liquidity, offer flexibility, and these cycles are changing very quickly – you know, just think how quickly things have changed over the last 12 months – we want to be able to remain nimble. So, if the fundamental outlook changes, we want to be able to, you know, move into less credit, we want to be able to move into more credit, or we want to move into different parts of the rate curve. And that liquidity and that flexibility is … you’re able to do that quite easily when you hold treasuries.

SW: Great. So just lastly, I wanted to finish with emerging markets, and specifically I noticed that the TwentyFour Dynamic Bond fund has been reducing its exposure to emerging markets. So maybe tell us a little bit more about what’s happening in the emerging market bond space, but also why this reduction in the Dynamic Bond fund? What’s been happening with that fund specifically?

GC: Yes. Okay. Good question. So, you know, coming into 2023, there were probably good reasons to be optimistic about emerging markets, right? We had the Fed who had started to slow their pace of rates, we had the dollar started to weaken versus a very strong 2022, and these things are usually positive for emerging markets. That coupled with obviously very high yields. But I would say that, on a relative value basis, developed market yields are also significantly higher than they were 12 months ago. And the relative value of developed markets … if we can get a triple B, an investment grade bond of a Barclays, a big UK bank, at 9% or 10%, then you don’t need to, as I mentioned, reach for yield. You don’t need to go into a small Latin American telecoms producer or whatever the company is, because there is a significant yield on offer, and developed markets usually lead the recovery. So, that’s the first point.

I would say the second point is the ESG landscape of emerging markets has become much more difficult to navigate, with the likes of Russia and Putin invading Ukraine, with the likes of China, who essentially allowed their property market – which is generally almost 25% of their GDP – a large part of those bonds had to default. So, you have to have a very thorough view on the political environment, and it just makes the analysis of governance within your ESG calculation, much more difficult.

So, we have significantly reduced our exposure to emerging markets over the last 18 months, let’s say. I wouldn’t see it increasing much in the short-term from here.

SW: And then you just mentioned ESG there, so just a quick question. How much are you seeing the ESG kind of space change within the bond market? We hear those things, you know, green bonds, blue bonds, and all of these very niche examples, but when you’re looking at the broader market, how much is ESG becoming an influence for what you’re seeing when looking at bonds, but also within the funds and analysis you are doing?

GC: Yeah, so we very much take an integrated approach, and we do that because we think ESG is a credit risk. We think that, as part of your credit analysis, you have to integrate an ESG analysis because these are where flows are going, this is where flows are going, and this is where investors are going to put capital to work. So, we are seeing lower interest rates, companies are able to issue at lower rates if they have a good ESG score versus if they have a bad ESG score. So, it’s something that we are very conscious of. 

You know, obviously as fixed income you know, bond holders, we don’t have a share in the company, we’re not shareholders, we don’t have voting rights. So, for us, engagement is very important. And focusing on engaging with companies, focusing on momentum and helping them move to a more sustainable company. These are all important things, but no doubt, as you say, it’s becoming increasingly more important. So, I would be very surprised if a company came to the market and did not have a [powerpoint] slide on  ESG. Even the lower rated, private, high yield deals, they are building out ESG teams. Most of them now have sustainability reports; most of them report on scope one, scope two, scope three emissions, and other key ESG data. That’s something that we would expect to continue of course. And we’re seeing much more green issuance, sustainability-linked issuance, et cetera. I think it’s important not to get wrapped up in the title of a lot of these bonds. You still have to do the ESG work and not take it for granted. But yes, absolutely no doubt that this is becoming very important and will continue to remain important in the coming years.

SW: George, thank you so much. That was an excellent overview of a lot of different things happening at the minute. Thank you so much for joining us.

GC: Thank you for having me, Staci.

SW: TwentyFour Asset Management is an independent firm specialising in fixed income investments. The TwentyFour Absolute Return Credit, TwentyFour Corporate Bond and TwentyFour Dynamic Bond fund are all Elite Rated by FundCalibre. The TwentyFour Dynamic Bond fund is the most flexible of the three and may invest across the whole range of fixed interest assets. To learn more about any of the Elite Rated products from TwentyFour 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.