Fixed Income  

Best in Class: The secret to star quality

Best in Class: The secret to star quality

It’s hard to make fixed income interesting. But I finally watched the The Big Short this week, and they managed it. If you ever need to explain mortgage-backed securities, credit default swaps or collateralised debt, just use Netflix.

While the film is entertaining, it also serves as a reminder of how important it is to really understand the products in which you are investing. The devil is in the detail – and so are the opportunities. This is the case in bonds today.

Government bond yields around the developed world are either already in negative territory or getting close, and some investors are acting irrationally. Why would anyone purchase an investment for £110 that will pay no income and will return just £100 in capital to you after 10 years? But people are doing just this.

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Corporate bonds, however, are looking more interesting. A great hidden gem is Gam Star Credit Opportunities, run by Anthony Smouha and Gregoire Mivelaz. One of their main aims is high income, but the managers achieve this not by investing heavily in sub-investment grade, but by identifying opportunities in issues lower down the company’s capital structure. For example, by choosing junior and subordinated debt over senior debt, very little of what they own yields less than 6 per cent at the initial purchase point.

This might make it sound like more of a satellite investment, but it’s actually a ‘safety-first’ fund with very low turnover. Their process looks for loans from companies that they can hold for 10 years. Their mantra is ‘yield, value and capital preservation’ and their basic philosophy is that the chance of investment-grade companies defaulting on their loans is much lower than high-yield companies, especially over the longer term.

A big theme in the fund at the moment is European banks. The equity performance of European banks has been pretty terrible this year – the sector is down about 17 per cent over the past 12 months compared with a positive 11 per cent return for the wider market. In the fund managers’ view, this is because the equity market is pricing in the hit profitability will take as a result of legacy litigation, regulation and restructuring costs, as well as the low interest rate. There is also increased political risk due to Brexit.

However, the Contingent Convertible index, which has been notably resilient in contrast, tells a different story: that the quantity and quality of regulatory capital has increased and capitalisation is strong. While equity analysts examine banks’ profitability, more important for bonds is the solvency.

Mr Smouha and Mr Mivelaz see no sign of a potential financial crisis and, even if there were one, they think the banking system could cope. As an indication, post-Brexit, we saw no signs of contagion within the UK/EU banking sector. The spread between three-month and overnight borrowing costs for banks – a good indicator of financial stress – didn’t even move.

The pair are giving Italian banks a wide berth, though they believe the situation to be under control, and are avoiding Greek and Portuguese credit, where they see potential volatility. Still, they do have a 40 per cent exposure to banks.