Five ways bond investors can protect against inflation
“Bond investors are the vampires of the investment world. They love decay, recession — anything that...
Alex Pelteshki became co-manager of the then Kames Strategic Bond fund in the summer of 2017, when Phil Milburn and David Roberts left the business to join Liontrust. There were further changes the following year, when Stephen Snowdon – along with three other fund managers – left to join Artemis. It was at this point that Colin Finlayson joined Alex as co-manager on the fund.
We caught up with Alex on 4th November 2021.
This was a face-to-face catch up with Alex to have an in-depth discussion about the fund and its composition, review performance and to get his thoughts on several macroeconomic considerations. It was extremely positive.
The team has grown considerably in recent years. What was previously a small team in Edinburgh, where fund managers were also analysts, is now a fully integrated fixed income platform of 143 investment professionals across Europe and the US, with separate fund managers and analyst roles. Colin is based in Edinburgh and Alex in London.
The managers can invest across the full fixed income universe. Core investments are in government bonds, investment grade and high yield bonds (with exposure to the latter capped at a maximum of 40%). Opportunistic investments will be those in emerging market bonds and asset-backed securities (also capped at 40% of the fund). Interest rate futures and credit derivatives will also be used.
The six sources of Alpha the fund has always sought remain unchanged. Top-down macro views will help shape duration and curve positioning. Credit strategy and relative value are used to frame the asset and ratings allocation. Bottom-up research will then lead security selection and sector allocation.
The process starts with a monthly global meeting where all major markets are scored. Both Alex and Colin are active in the week-long discussions and use the views as a broad basis for their positioning.
The managers will then look at asset allocation and credit risk positioning with the support of the global macro strategy team, before looking at duration and curve positioning with the help of the global sovereign, rates and currency team. The Global research team will then be used for sector and security positioning.
Balance is extremely important for the managers, and they will use ideas that will also protect the portfolio if their broader views are incorrect. They work with the risk team to look at several scenarios and what could happen, as well as using the analysis to spot unintended risks they could be taking.
Under the new managers, the allocation to high yield bonds in particular, has become far more dynamic and flexible. This was evidenced in 2020, when the fund entered the year with virtually nothing in high yield before the managers added risk back into the portfolio in March after the sell-off. This added considerable alpha over the year.
The managers stress that the fund has a total return objective – there is an income share class, but income is not its primary objective.
Over the tenure as co-managers the fund has returned 30.3%** compared to 17.8%** for the IA Sterling Strategic Bond sector average, making it the third best fund out of 81.
In January the managers thought inflation would go higher, so were short treasuries rather than taking credit risk. They also sold corporate hybrids in Europe due to valuations.
During the whole of the first quarter, they also had very little duration, but moved this up during Q2 and Q3.
The managers have been close to zero in high yield for most of this year again, as they felt the sector had rallied quite a lot already.
One area that Alex highlighted to us was a strong allocation to Greek bonds. It’s been a position they have had for 18 months and is still in the portfolio today.
“This is a pure self-help story,” Alex said. “The Greek economy went through a very tough patch. There are four banks, each with the same market share and SMEs get their funding from those banks. Bad loans were some 50% a few years ago – double that of Spanish banks at the very worst point of the financial crisis.
“Thanks to a scheme set up by the IMF and the EU, bad loans are now just 12-13% and should fall to around 5% in the near future. This is a massive deleveraging story, so we’ve owned subordinated bonds and we still think there is some upside left. Greece is the biggest recipient of the pandemic funding scheme, which should give it the next kicker.”
The managers are also spending a lot of time trying to find opportunities “that not correlated to J Powell liquidity” and therefore should insulate the portfolio from any US central bank moves.
They don’t hold much in emerging market debt – around 2% in emerging market corporates that the analysts like. “When Carnival cruises is paying 11.5%, I think there are better selective ideas in high yield,” Alex said. “We remain cautious because parts of the world remain largely unvaccinated and most of these areas are in emerging markets,” Alex continued. “So, economies will still struggle. If there are also rate hikes in the US, the carry trade doesn’t work anymore. So, we’re not eager to buy right now.”
“There are two possible scenarios next year,” Alex said. The first is that we have higher inflation and central banks raise interest rates. We expect the US to raise rates marginally and investment grade will be in a tough spot – it’s likely to have outflows. High yield should do a bit better.
“The other scenario is that there is a slowdown in economic growth. This could lead to a sell-off in the market, but I think the sell-off will be capped as investors know central banks will step in. There will be more volatility and the moral hazard of more money being pumped into the system. That would be negative for government bonds, investment grade and high yield.
“In either scenario you need a fund that is not too correlated with other assets.”
*Source: FE fundinfo, total returns in sterling, 1 December 2018 to 12 November 2021
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