100 Club: Smith gears up for rise in interest rates
Paul Smith has moved to target more sectors and create a longer tail of holdings in his fund in anticipation of interest-rate rises.
The manager of the Premier Corporate Bond Monthly Income fund said he was preparing his portfolio for different conditions in the bond markets, which could be prompted by an rise in interest rates by one or more of the developed world’s central banks.
The yields on corporate bonds have broadly fallen in recent years, which is beneficial to investors as the price of a bond moves inversely to the yield.
However, with growing expectations about interest rates being raised from their historic lows – particularly by the US Federal Reserve (pictured) – corporate bond yields could begin to increase if interest rates go up.
“Our current strategy is to position the fund with greater sector diversification and probably a longer tail of holdings, but still be active and aggressive in credit and duration versus peers, some of which reflect the broader market,” Mr Smith said.
“The portfolio’s low correlation to the sector highlights this strategic approach.
“Our expectations of a flattening in the yield curve were realised in 2014 and we now expect higher yields across the curve as the market begins to factor in rate rises in spite of anticipated short-term deflation.”
The manager said he was being particularly wary of companies that were increasing the amount of debt they had purely because rates were low.
Mr Smith said he remained “cautious” about the degree of increased leverage being used for shareholder returns, although he accepted some debt raising for the right merger and acquisition activity would be “positive in the medium term”.
“Bondholders should be alert to refinancing risk, as opportunistic issuers that rush to the market to finance operations cheaply may find primary markets closed in a normalised rate environment,” he said.
He added default rates were “likely to remain low in the immediate term”, in spite of further releveraging taking place “as issuers lock in cheap borrowings and corporate liquidity remains at historically high levels”.
“However, some sectors, such as energy, are likely to experience elevated default rates arising from industry-specific risks, such as commodity price volatility,” he said.
Mr Smith said recent returns had been driven by investments in Punch Taverns and Enterprise Inns, as well as exposure to European real estate.
“Overweight exposures to the consumer sectors and an underweight position in utilities continue to add to credit performance,” he said.
“Maintaining a shorter duration than peers restrained performance as sovereigns rallied during the latter half of the year.”
He also said the fund’s £60m size meant it was “nimble” and could be “more strategic” in its stock picking than “the majority of the strategic bond sector constituents given their size and limited market liquidity”.
