Fund Review: Managers generating income and upside from mispriced securities

He says: “The fund aims to generate a high level of income and, where appropriate, capital upside from mispriced securities. The mix between income and capital return will depend on where we are in the credit cycle, and on valuations. Later in the cycle, we focus on income, partly because there will be fewer capital upside opportunities and those that exist will be relatively high risk.” 

Mr Pakenham describes the pair’s process as “credit-intensive, probably 80 per cent bottom up, 20 per cent top down”.

“Credit risk is the biggest risk high-yield investors are taking so understanding those risks and pricing them appropriately is key,” he says. “These can be qualitative – such as market growth expectations, corporate positioning within that market, barriers to entry and quality of the management team – or more quantitative, such as stress testing of cashflows and balance sheets.

“We are always trying to understand how much headroom this company has to weather difficult times and what levers the management can pull in such a scenario. We do spend time thinking about what the bond will be worth in the event of a default. This is known as the recovery rate and is your ultimate downside metric through a restructuring.”

aThe top-down element of the process is far less prescriptive, according to the manager: “Essentially, we are trying to work out where we are in the credit cycle, which allows us to make a broader call about how much risk we want to take – be it credit risk or interest rate risk (duration). We also think about what sectors are likely to do well in the near to medium term.”

The only change to the process has been as a result of yields’ fall from 10 per cent when Mr Pakenham started at the company in 2011, to 4 per cent now, which means the managers focus more on income than capital.

Addressing changes in the portfolio, he notes: “We have a large off-benchmark position in sterling we’ve been running since 2013. This has been a great allocation, but we’ve been looking to bring it down a bit. It’s been tricky to reduce this position, though, because we continue to find opportunities in that market. Most recently, these would include Stonegate Pubs, which is a short-maturity bond, or Travelodge, which is performing well and yields 7.5 per cent.”

Ongoing charges of 0.89 per cent apply to the class X2 accumulation share class, part of the Sicav range, while the fund sits in the middle of the risk-reward scale at level four.

Mr Pakenham says: “After an exceptional 2015, we more or less matched the benchmark gross of fees last year. We generated a similar return to 2015, but the market has performed better.”

Over the past 12 months to December 1 2016, the fund has delivered a 26 per cent return in sterling terms, which is in line with the 26 per cent gain made by its benchmark, the BofA Merrill Lynch Euro High Yield Constrained index, FE Analytics shows. But in the five years to December 1 it slightly underperformed the index, with the fund returning 50.9 per cent, while the index rose 61.7 per cent.

Highlighting holdings that have performed well last year, he remarks that the sterling market has outperformed: “Our best-performing stock there has been Four Seasons secured bonds (+20 per cent). In the euro market, our best performer has been ArcelorMittal (+30 per cent) and Altice 22, +20 per cent. Our lack of exposure to Italian banks has also been a tailwind.”

Any disappointment in performance terms has been more a function of stocks the pair have not owned than the ones they have. Mr Pakenham cites Petrobras and Banco Espírito Santo as being the two best performers in the market this year: “Between them, they have contributed 70 basis points of performance to our benchmark,” he adds. 

Looking ahead to this year, he observes: “2017 feels like it could be an inflection year where we see monetary tightening and fiscal easing. This should be positive for spreads/credit and negative for government bonds.”