Insights into Corporate Bond investing: trends, risks and opportunities

Staci West 21/02/2024 in Fixed income

Shalin Shah, co-manager of the Royal London Corporate Bond fund, discusses the key drivers affecting government bond markets and the likely trajectory of yields over the next two to three years. Shalin shares insights into factors such as inflation, central bank actions, and interest rate forecasts. The conversation also looks at the composition of the fund, with a significant portion invested in financials and insurance.

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I’m Staci West from FundCalibre, and today I am joined by Shalin Shah, the manager of Royal London Corporate Bond fund. Shalin, thanks for joining me today.

[00:11] Hi Staci. Thank you for the opportunity to speak to you.

So let’s start with your view on government bond markets. What do you see as the key drivers in where are yields likely to go over the next two to three years?

[00:28] Sure. Thank you Staci. So, government bond yields have historically been very volatile over the last couple of years. Just to give you a bit of the history, we started 2022 at a 10-year UK government bond yield of around 1%. As we sit here today, those government bond yields have gone as high as around 4%. So a lot more income as an investor for lending for 10 years. And that’s been driven mainly by high inflation over the period and central bank action to take rates up. So, the base rate has gone to higher than 5% at the present time. The key driver going forward will be a combination of factors.

The first being inflation and its trajectory downwards. The market is predicting that inflation will come down and it has been coming down recently. So it’s then around whether that inflation print goes to the central bank’s target of 2%. That is slightly challenging in terms of getting it to 3% seems easier than all the way to 2, but that will be a key driver of reduction.

And the second factor will be central banks easing conditions as we come out of the high inflation period, which will mean that rates will come down. So as interest rates come down – and our forecast tend to be around the quarter percent per quarter reduction in interest rates – but of course that may accelerate if we start to see a more in-depth recession, that is not our base case. Our central case would be that UK base rates will drop to around three and a half percent by the end of 2026.

And of course, government bond deals, which are at 4% will drop from where they are at the present time. But in the, in the journey to that, there’s a lot of volatility around net gilt issuance at around 200 billion a year, we may see 10-year yields go up before they go down again. And it will also be driven by those central bank inflation numbers as they come through, as well as central bank narratives around what they plan to do on interest rates.

And roughly half of this fund is in financials and insurance. So perhaps you can first just give us an overview of why the sectors are relatively large position, along with then their appeal and maybe how they’ve benefited the portfolio in recent years.

[02:59] Sure. So, within the Royal London Corporate Bond, which is coming up to its 25 year anniversary in a few days, the fund has always had an overweight position in these sectors. It has increased in the recent periods, and that’s been driven by elevated additional spreads – so the extra yield available for investors in those areas. Now, when you think about banks as an asset class, banks actually benefit from a higher interest rate environment because they’re able to pass on that higher interest rate to consumers. And so, as long as the economy is running at a reasonable state, the banks are in a good position and in addition, they’re in a very different position to where they were during the financial crisis of 2008 and 2009, they’re much better capitalised. So we go in eyes open knowing that in the strongest banks we can pick up a lot more spread and also in the strongest insurers. So if you think about a typical insurer, they have to hold capital for one in 200 year events. They hold around twice that across the board in very strong insurance entities. And we can lend to them with relatively high confidence that their bonds, which are typically BBB or or higher, we can lend to those companies at very elevated spreads and the risk of downgrades. So the risk of going from BBB to sub-investment grade, which is a risk we want to avoid, is much lower in these types of entities than, for example, in other sectors which are more geared to the consumer cyclical environment where, you know, the consumer is more stretched where there is less regulation – so the banks and insurers are much better regulators. We think there’s greater risk of that downgrade and that impact on portfolios in other areas away from financials as we go into a slightly weaker macroeconomic picture.

And about 40% of the fund is in secured debt. So again, if you can just explain briefly what secured debt means for the listeners, but then also why you believe this is an attractive area of the market.

[05:14] Sure. So within that framework, that secure debt reflects lending to companies where we’ve got a claim on assets, which is great because if a company starts to get into trouble, those legal covenants, so the legal language within the bonds, are very protective. A bit like if you were to borrow from a bank against a house – a mortgage – you would have to speak to the bank if you can no longer pay that mortgage and the bank will then have a claim on that house. In the same way we will have claim on assets.

And that helps us because again, I mentioned earlier in terms of downgrades, if a company starts to deteriorate and potentially get downgraded, they can’t actually go to the banks for a lifeline and then subordinate our position, which is what typically happens in an unsecured bond where a company in its journey to default, the bank will get ahead of you and provide liquidity to the company. In exchange they will take security over their best assets. So, we own secured debt at around 40% in the fund, which is around three times the size of a typical market-weighted secure debt because we’re able to access this type of debt with the covenants and the protection from claims on assets, but without sacrificing yield. That’s where the real inefficiency comes from. We can get the higher yield despite the fact that we’ve got that protection.

And to give you some examples, we can lend to Tesco but secured on their supermarkets at a higher yield than Tesco unsecured debt. We lend to BBC, but if you’re watching the 10:00 PM news, we’ve got a bond secured on their Broadcasting House at a higher yield than unsecured debt from other media companies like Sky or Comcast. So to us, I think there’s a real inefficiency there because investors are undervaluing and under-researching these areas.

Interesting. And another well interesting part is I was looking through your fact sheet and I saw that 5% was in unrated bonds, which I had to stop and look up. So maybe you can just explain to our audience what they are and then how are they used in this portfolio?

[07:36] Sure. So, the vast majority of debt in the market is investment grade rated. And that is what we are actually investing in. The unrated portion has actually been dropping over time. It actually used to be higher than 5%. And the reason it exists is when we started investing – before credit indices even existed many years ago – we only lent to companies again on a secured basis, but there were a lot more companies then that would borrow without a credit rating. It was relatively expensive to get a credit rating and credit indices didn’t exist. Now that experience led to us investing in certain companies at elevated spreads with security.

And one example might be British Land where we own debenture bonds, which don’t have a rating, but for every hundred pounds we lent to British Land, they’ve got to maintain at least 150 pounds of property collateral or cash backing our bonds, which is a key protection for us because as property values potentially decline, we benefit from that massive unencumbered pool of assets – so the huge amount of property that they’re not secured against sucking in to protect our bonds. And British Land is an example of a company that does have a rated debt, but it’s all unsecured. So when British Land comes to borrow tomorrow, it will come on a rated basis and we would look at that in its own right.

But there are lots of these, or a few of these unrated bonds that are not always easy to get hold of, but provide you some real benefit in terms of bondholder protections that we look to access and provide that additional yield in a low-risk way.

Well, that’s been very interesting and thank you for coming to talk to me today.

[09:26] No problem. Thank you, Staci, I appreciate your time.

And if you would like to find out more information about the Royal London Corporate Bond fund, please visit

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