290. Defensive plays: how to thrive in a market full of surprises

23 November 2023 (pre-recorded 16 November 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. Today’s guest gives us a cautious yet optimistic outlook on the bond market and tells us where he believes the value lies in the current environment.

James Yardley (JY): I am James Yardley, and today I’m joined by Dillon Lancaster, the fund manager of the Twenty Four Dynamic Bond fund. Dillon, thank you very much for joining us today.

Dillon Lancaster (DL): Thank you very much for having me.

[INTERVIEW]

JY: Now, Dylan, I mean, it’s a really interesting time for bonds. It feels like the bond market is just leading everything at the moment. I think you said recently that you’ve been increasing your exposure to government bonds, so, why is this and and what’s the attraction now?

DL: Yeah, I suppose the main story that’s been dominating not only the bond market, but also the market at wide over the last 18 months, has been the rapid raising rate cycle from central banks across the world. And that’s been to fight the very high inflation that we saw last year.

As they’ve been raising rates, we’ve been gradually increasing our government bond exposure. And the reason for that is, well, the reason central banks have been raising rates is to slow down the economy. And we think, as they carry on increasing their rates and probably have pretty much done the job now, that slowdown of the economy, that slowdown of growth which we’ve begun to see in certain sectors globally, and expect to see as interest rate raises carry on being passed through to the real economy through some sort of lagged time period, we think as that growth slows down, investors will want to be in the safe havens when investing, and for us, government bonds are the safest place to put your money. And so we think as growth rolls over and continues to do so, that then government bonds can definitely protect you and should perform well.

However, we think that even if growth doesn’t considerably slow down, government bonds can also perform well as inflation falls. So, as I said, central banks have been increasing their rates to reduce inflation. We’ve seen some encouraging signs of this over the last few months. And if we annualise the last few months of, for example, US inflation, they’re actually not too far away from their 2% target. Now, as inflation falls to target, central banks are still in very, very restrictive territory.

So, the Fed [Federal Reserve] at the moment at 5.5% is probably about 3% higher than their neutral rate, the rate at which they’re not in restrictive or expansionary territory. And so, even without growth rolling over, you can see cuts coming through as that inflation target is met and they actually just reduce the restriction of their territory, of their rate environment at the moment. So, we think that, if growth rolls over, people will go into government bonds for protection, or if we hit inflation targets, then central banks will start cutting, and again, government bonds will perform well. And so for us, we think that government bonds, and for us in particular, we think US Treasuries are a very, very good investment at the moment.

JY: And do you worry about the large fiscal deficits which we’ve seen in the US? I mean, because that I guess is the concern from the bond bears at the moment, is the bond vigilantes are back and that governments everywhere are just, they’re just spending more money than they’re taking in and they’re having to issue all these bonds and somebody’s got to buy them all; and, of course, market supply laws – supply and demand, the price has to go up – sorry, the price has to go down, yields have to go up. So, what do you think of that?

DL: Yeah, I think that’s definitely something to be cognisant of and aware of as we go forward. We obviously saw the debt to GDP of developed nations balloon massively during Covid. And if we look at the US for example, usually a very fiscally conservative country, it’s run in a deficit of above 6% at the moment, [which is] something you haven’t really seen outside of a wartime environment since the second World War. And so that supply/demand dynamic is definitely something to look at.

I think in the shorter term, the main driver of those government bonds is going to be growth and going to be any slowdown that we see. And so, really, cyclicality will still be the main driver in the short term. And I think, if people are expecting and pricing in a recession, you’ll see those government bonds perform, regardless of that supply dynamic. Whether on the other side of a recovery, we get structurally higher yields as a result of the supply dynamic <inaudible>, I think it’s definitely something that we are looking at and definitely something that is a possibility. However, in the short term as people position for a slowdown and a possible recession, I think that will be the main driver rather than technicals.

JY: And you prefer government bonds at the moment? I think you’ve also been reducing your high yield exposure and moving up the credit spectrum into investment grade. Is that a part of your broader thesis of we’re going to see a slowdown in the economy – a potential recession – you’d rather be in the safer areas like government bonds and investment grade?

DL: Yeah, I think an increase in quality definitely makes sense here. I mean, this is probably with the rapid raising rate cycle probably one of the most well-heralded slowdowns in economic history. And so, when seeing a slowdown, quality will outperform and also you want to, as a fund manager, be confident that from a bottom-up perspective, every name that you hold is robust, and again, that means increasing the quality.

So yes, I like government bonds here. I like government bond exposure. I like investment grade exposure. We have been reducing high yield definitely across the fund. However, there are still areas where, if you are highly selective, you can be paid very well in the high yield market as well, so on the whole increasing credit quality, but that doesn’t mean that you necessarily have or need to have zero exposure to high yield. It’s about really just being highly selective in that environment.

JY: And on that recession which has been so talked about for so long, I mean, it hasn’t materialised yet, is it still your view that we are going to see a recession in the middle of next year? Or have we all just misread this completely? <laugh>

DL: Yeah, so I mean, the last few months, there’s definitely been a growing narrative that we could avoid a recession. And the reasons for that, as I mentioned, are the inflation signs have been getting better across developed nations; meanwhile, growth has actually remained better than what people were expecting for this year. I think uncertainty is definitely still elevated and it’s still early to put all your eggs in one basket there. I mean, as I mentioned, the rate rising cycle that we’ve seen has pretty much been the most aggressive since the early 1980s. And if we just look at the lagged impact of putting a hike through to the real economy, as a rule of thumb, that’s eight to 12 months.

Well, in the last 12 months, the Federal Reserve alone have put through 200 basis points of hikes. And so, with the economy already showing signs of slowing down and perhaps that’s still coming through to impact the real economy, then I think it’s too early to say that we’ve avoided a recession. And so, yes, so far, growth has held in strong, but I think weakening has begun and definitely more impacts from central banks to come through, means that we’re not out of the woods yet.

JY: And a lot of businesses still have to refinance their debts, and potentially that will be at much higher rates which might put them into distress. Are you expecting to see a tick up in default rates here as we go forward?

DL: Yeah, I think that makes sense. I mean, default rates at the moment are about 2%. I think we’re seeing them possibly go to between 3.5%- 4% over the next kind of year to 18 months. And the reason for that is, as you say, as we come up to maturities and with the higher yield environment that seems logical. I mean, the reason we don’t see it spiking to 2008 levels is that corporates, like the consumer really, are still in a healthy place. Corporates, their interest coverage levels are very strong; corporate leverages is also very healthy at the moment. And as well this time around, you know, the healthy banking sector means that corporates have lots of different avenues when they’re talking about refinancing debt. So, we don’t expect defaults to spike. But because of the conditions that you mentioned, I think they can definitely kind of drift higher from here. And I think that that plays into what we’re doing, increasing credit quality where we do have high yield exposure, making sure that you’re in BB or very strong B names. 95% of defaults come from the CCC sector, and so for us, you know, there’s really no reason to be in there when you can be paid very healthily elsewhere. So, it’s about reducing that exposure [and] going up in quality. And when you are in a name that has to refinance in 2025 or in the nearer term, it’s about having high conviction that they have the means and abilities to do that through free cash flow, et cetera.

JY: And just to explain those rating bands for our listeners, so BB is the first level when you’re coming into high yield or junk bonds, and obviously it gets progressively worse from a B and then CCC being the worst before default. And you, of course, have been positioning the portfolio further up actually into the investment grade spectrum, which is BBB and above at the moment.

DL: Exactly, yes.

JY: And in the US as well, I mean, a lot has been made of these student loan repayments which were paused, but which are now restarting and people are going to be having to pay a lot more. Do you see that as having an impact on the consumer going forward in next year?

DL: Yeah, I mean, it’s definitely something that we are looking at. As I mentioned before, the consumer has been extremely healthy thus far year to date, and much healthier than I think markets were predicting. And one reason for that is that they were able to build up excess savings, post-Covid. So, the fiscal expenditure in the US meant that the government was basically putting cheques in people’s pockets and that got to about $2.3 trillion extra to what they would’ve normally been spending. And so that’s acted as a really good buffer as rates have gone higher and inflation has meant that goods and services have gone higher, that’s acted as a really good buffer to keep the consumer stronger.

However, it’s definitely dwindled. I mean, there’s lots of assumptions that need to be made in terms of how much of that savings is left. And we think, you know, probably about $500 billion from the peak of about $2.3 trillion. So, it’s definitely dwindled and there’s probably a large amount of the economy that doesn’t have any of those excess savings left.

So, when the Supreme Court came out and said, these loans do need to be paid, and they’ve resumed, that is only going to act to the further headwind. And so for us, it’s looking at consumer data points, so retail sales in the US and developed markets, credit card usages, loan repayments. So, most recently we saw some worrying auto loan numbers come out of the US where more people than expected were in arrears on their auto loans. So yes, the consumer’s been very strong, mainly driven by the excess savings; those have now been dwindled and these student loans are only going to act as further headwind in terms of the cash in the consumer’s pockets. So, we expect those kind of consumer data points definitely to weaken from here. And that’s one of the reasons why we don’t think that we’re out of the woods in terms of the recession coming up.

JY: So, I mean, if we think about how you’ve traditionally positioned the portfolio, where do we sit today? Is this some of the most defensive you’ve ever been in the life of the fund? Because historically, I think this fund hasn’t been afraid to take credit risk. Is that fair?

DL: Yeah, so I think at the moment, we think that government bonds are extremely good value here for the reasons that I gave at the start in terms of them performing well on a growth slowdown, but also well if we see inflation get anywhere near to the 2% target. So, I think we’ve got 25% in US treasuries at the moment in between 10 years and 30 year duration, which the longer duration you have, the more protection that gives you as yields go lower, the more price movement you get, and so therefore the more protection.

JY: Well, you are locking into the yields there for longer.

DL: Exactly.

JY: So it’s a more risky position because there’s more potential capital upside and downside, I guess. But if things come as you expect and inflation does fall, and bond yields fall, potentially, there’s a lot of money to be made there.

DL: Exactly. Exactly. It’s a real high conviction that these yields are very, very good medium-term yields to be locking into. I mean, if we look at where the 10 year was trading a few weeks ago, at almost 5%, I mean, that’s not far off where the US high yield index was trading only three years ago. So we think, you know, at the moment, these kind of yields are giving you very good medium-term entry points and should protect you and should perform well on any growth rollover or in terms of also if inflation gets close to target or back to the 2% target.

In terms of our credit portion, the 75% of credit, that has been increasing credit quality, so the high yield that we were holding a couple of years ago, we’ve been rotating that out and into investment grade corporates.

However, we do have a couple of top picks as well, which are still offering a lot of yield and we think offer very good risk / reward-adjusted metrics at the moment. And those are European AT1s, so that is subordinated bank debt. And so here our rationale is we think that banks are in a very healthy position at the moment. They have been kind of revolutionised since 2008 and been made by the European regulator and the UK regulator to be much healthier. And so for us, we like banks at the moment, we like the national champion banks and we like them so much that we’re happy to take subordinated risk.

And that is where the AT1 bucket comes in. So, at the moment, you are being paid about 12% in some names of national champions, so Barclays, you’re getting paid 12% in Sterling to hold their AT1 risk, which we think Barclays in possibly historically the most strongest position it’s been in, rated BBB – even at an AT1 level, is a very strong proposition at the moment.

JY: No, no, that’s certainly a very high yield. And is that just in the European banks you’re taking that exposure?  Because there has obviously been a little bit of trouble with some of the US banks earlier this year.

DL: Yeah, so we prefer European banks. And one of the reasons actually was highlighted as you mentioned in March. Whereas the US banks are not all regulated and much, much lighter touch regulation over there, in Europe, every single bank is under regulation which means you get much, much tighter risk controls. And so we think that, on a risk/reward adjustment, we prefer to be in European banks. And, as I say, it’s because European – and when I say Europe, I include the UK in that as well – the regulator has done a very good job to make banks safer post-2008, and as a bond holder that definitely benefits you.

JY: And historically I think you as a team, you’ve always had quite an expertise in asset-backed securities, so exposure to mortgages and CLOs [Collateralised Loan Obligations] and some other things. Does that still form a major part of the portfolio? I mean, you mentioned the auto loan delinquencies picking up – has that had an impact on any of your positioning there and in those sorts of assets?

DL: Yeah, so I suppose that’s our second kind of favourite sector at the moment on top of European AT1s, is European CLOs, so as you mentioned, a type of asset-backed security. We still think that the kind of reward to risk there looks very attractive. They’ve benefited being a floating rate note, which means that as rates have risen, the yield that you’re getting paid there has also risen and made them look more attractive. And so for us, what we’ve done is similar in terms of the philosophy of the rest of the fund, is just gone up in quality there. So, really, in European CLOs we are buying BB and CCC – BBB, sorry – CLOs exclusively. On the BB tranche of a CLO, you are getting paid over 15% in yield. And at that BB kind of tranche, because of the structural protection that you’re receiving, you can really withstand levels of higher defaults for consecutive years. So, about a default rate of 8% for three or four years before you see any principle write down. And so that’s …

JY: Can you just explain to our listeners what a CLO is and and what exactly you’re getting there? Because obviously, you’re not getting that 15% yield without taking some risks, so what are the risks to that and what exactly is a CLO? And how much also is in the portfolio as the weight?

DL: Yeah, so a CLO is a package of loans that are grouped together and then sold off as bonds. And you have different tranches going from AAA at the top, to equity at the bottom. And so for us in the BB and BBB tranches, what that means is because you have people sitting below you, as I say, you get the structural protection in terms of against any defaults; you will not be the first to take any losses. Now there’s a couple of reasons why they trade so cheap as you allude to.

I think the first one is there’s a complexity premium. And that is because there are hundreds and thousands of loans in these CLOs and they each need to be underwritten. And so we have a team of 12 people who just look at European ABS [asset-backed securities] and CLOs. And so that kind of people intensity required means that there is a complexity premium; that’s why you’re getting paid more.

The second reason is I do think there’s a bit of a liquidity premium. So, a BB CLO will be less liquid than a BB European high yield corporate. And so that means that you do get paid a little bit extra for that. Now we recognise that second pillar, which is why at the moment we have about 15% of the portfolio made up from CLOs. That is probably the maximum that we would have due to the fact that we’re aware that, given the liquidity of the product, that that seems about appropriate for the fund.

And we’re at the maximum because we think at the moment they are extremely attractive vs a high yield corporate, and so kind of the risk/reward really stacks up there. We follow historically in what percentile a BB CLO looks cheap vs a BB high yield corporate, and at the moment it’s between the 80th and the 90th percentile. So, it’s the cheapest now that that has been pretty much for eight times out of 10 of the historical index. So, yeah, we like them at the moment, we think they pay very well, and they’ve been our best performer year to date. But we’re also cognisant of liquidity at the BB level. And so, you know, 15% is probably the maximum we would have appropriate for this fund.

JY: Brilliant. So, maybe just to conclude then, if we take a step back, I mean, bonds for years, they haven’t really yielded anything, but I mean, you are quite excited about where we sit today. I mean, can investors expect a good yield in the fund at the moment as well going forward, if they want to take income and things, for example?

DL: Yeah, definitely, definitely. I think as we kind of alluded to throughout, there’s definitely elements of uncertainty still in the markets at the moment, however, the one thing is at the moment you are being compensated for that in fixed income. And so, you know, I think government bonds are a very attractive proposition. Going up in quality definitely makes sense at the moment, and in those kind of lower quality areas, making sure that you are full full conviction.

And so for us we think that, having put that together, we are very happy with how the the fund looks at the moment. It’s yielding 10% which for a BBB+ rated fund we think looks very attractive. And you know, as you say, bonds haven’t been yielding this amount for a long time, and if you look historically at what is your main predictor of medium-term returns in fixed income, the main thing is your starting yield. And so, as we look at three, five-year predicted returns for this fund starting at 10%, having that as an annualised return, we think looks very, very attractive. And so yeah, we’re happy with how we’re set up, and I think fixed income looks like a very compelling place to be

at this time.

JY: Brilliant, well thank you very much for joining us today, Dillon.

DL: No, thank you very much for having me.

SW: TwentyFour Dynamic Bond has a very flexible approach in order to take advantage of changes in market conditions. The income produced is usually one of the highest in the sector, but will fluctuate as investments and market conditions change. To learn more about the TwentyFour Dynamic Bond fund, visit FundCalibre.com — and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.