Strategic Fixed Income view: disruption simply exaggerating existing structural trends
John Pattullo Co-Head of Strategic Fixed Income | Portfolio Manager
John Pattullo, Co-Head of Strategic Fixed Income, provides a brief update on the team’s current thoughts on the markets and the opportunities they see going forward, while explaining the reasons for their optimism.
We were always of the view that the world was short of growth and inflation and that bond yields would head lower. The surprise disruption of the oil price and the virus will simply exaggerate existing structural trends, creating a world of survivors (those with access to financing, though at a cost) and losers (likely smaller cap, more levered businesses).
There has been an impressive wartime response from policymakers. In particular; we believe the US Federal Reserve’s support for the investment grade bond markets is materially positive.
We remain optimistic on good quality, large‑cap, reasons to exist, global titans. While investment grade bond spreads have probably peaked, they remain reasonably priced on a risk‑adjusted basis and we have managed to lock in some sensible income streams for our investors in the past few weeks.
Hello, it’s Tuesday the 7th of April. It's John Pattullo here, Co-Head of Strategic Fixed Income. I want to give you a brief update of our desk thoughts and of what we are seeing going forward.
Oil price shock and coronavirus revealing material opportunities
We were always of the view that the world was short of growth and inflation, following Richard Koo’s and Larry Summers’ secular stagnation thesis. We obviously didn't anticipate the oil price [shock] or the coronavirus but we always felt that real bond yields and nominal bond yields were going to head lower for whatever reason. The timing and the pace has obviously surprised us. But this also throws up material opportunities; corporate bond spreads, as I said in my last video, have materially widened and in many ways this is a last grab for reliable, sensible income streams for clients going forwards. We are really quite excited about some of the valuations that we see going forward, as Jenna said in her video of last week.
Richard Koo always said you needed a wartime response to something like this. And I think this is a wartime response and it's completely justified given the complete disruption to world economies, activity and cash flows. So, on the back of that we've been fairly impressed with the [policymakers’] response; the QE programmes, the cut in interest rates, the fiscal policy, the refinements in the financial system and the banking system. And I think they're all justified, and actually if you like, the Fed in our opinion is really backstopping the investment grade bond market, which in our sense, is materially positive.
But the disruption of the virus and the oil price will just exaggerate existing structural trends and the rate of disruption will be even faster. So, our bias to large‑cap, non‑cyclical growth companies, businesses which can grow their dividends, rather than value businesses, which have just the high dividend yields, I think continues at pace and there will be survivors, people who can get financing and can continue. Unfortunately, there will be losers and some of the losers I think will be smaller cap, more levered businesses, businesses which don't have the luxury of accessing the capital markets or maybe even have access to a bridge loan or a bank overdraft - as simple as that. So that sort of dystopian world of disruption; bias to large‑cap, non‑cyclical businesses at the expense of value businesses I think continues and that certainly played out in the equity markets and it's very much a theme that we will continue in the portfolios.
Now, governments will support some industries. The Germans are supporting their travel agent, TUI. The French have said they'll support their airline, Air France‑KLM, and the UK government has made positive noises about our bus companies and some of our train companies, and so on. So, there will be winners and survivors and there will be losers. A good example — and there's no recommendation whatsoever for compliance reasons here — but Carnival Cruises, for example, which issued bonds last year at would you believe one percent for ten year money in unsecured [debt], are now currently operating barely any ships; they're burning cash at a billion dollars a month and they did DIP, debtor‑in‑possession, which essentially is bridge loan finance, at nigh on 12 percent, senior secured money over three years, combined with some converts [convertible bonds] and some equity finance.
That is a fascinating case, showing that capital markets are open for large businesses who can get finance, at a cost. And that's always predicated on the world opening back up, activity starting and people going back on cruises; but from 1 percent to 12 percent is just an idea of the cost of finance for some businesses.
A semblance of stability has returned to markets
So broadly speaking we saw in the last few weeks a stabilisation of markets after the brutal week we had a number of weeks ago, bond inflows are now, having been quite materially out[flows], are now just trickling in again, equities are probably stabilising. There's an exhaustion of sellers, I think [it] has washed out and we actually see some pretty good value operating and coming in into these levels.
Jenna [Barnard] and Nick [Ware] did a really good piece on highlighting the difference in bond coupons — the obligations of companies to pay their bond coupons — compared to the discretionary obligations of companies to pay dividends. Remember bonds are senior to equity and you are obliged to pay the coupons; a dividend of course is discretionary.
And unfortunately some of the European regulators have stopped banking dividends and have even suggested stopping some insurance dividends, in some insurance companies, across Europe, which hasn't been totally taken up. But that really doesn't help banking valuations. The dividend yield is one of the few things you can actually value banks on. And that is an example where the regulator, in my opinion, isn't really helping.
Portfolio strategy and activity
So, all in all, we think there's a massive bias, and increased bias, to large‑cap, non-cyclical businesses, which have got reasons to exist. We've added in a lot of those names, we've added a lot of investment grade. We've got the [funds’] yields higher by adding these investment grades, by really locking in a really good reliable and sensible income stream for our investors.
And a final thought on disruption. You know, our portfolios, we always thought were much more modern looking. So, we like lending to mobile phone, tower businesses. We like lending to data centres. We like lending to cloud computing companies and we don't like big fixed cost businesses like offices for example, office buildings and so on. And some of the early evidence suggests that some of the disruption isn't going to go away. I think most of us proved we can work fairly well from home and that would jeopardise businesses like cinemas. And, do we need big offices?
So, our businesses and our focus and credit has always been to modern day businesses, which have got a reason to exist. They've got a good return on capital. And I think on the back of that we remain pretty excited about the opportunities, especially in investment grade, which I concede is quite consensus, but there is some evidence now that high yield is stabilising, and equity seem to be stabilising a little bit here.
A note of optimism
So, we remain pretty optimistic on quality, large‑cap, reason to exist, global titans, sensible income, investment grade. I think investment grade spreads have probably peaked here but still remain, on a risk‑adjusted basis, pretty cheap. There's still some dislocations going on between the winners and the losers but that's encouraging as well. So, all in all, I think there's opportunities here, there is risk as well, but as long as we're getting paid good risk‑adjusted returns I think there's good opportunities.
So, we're optimistic, we're adding risk selectively, quite aggressively at times in investment grade but more selectively in high yield names. But I think there's a great opportunity to be locking in yield for clients with a longer-term perspective. Thank you for listening.
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