The bond portfolio – tilted toward income

The focus on income of our mixed-asset funds means that bond exposure is predominantly tilted toward corporate bonds, typically high yield and higher yielding investment grade.

Credit Analysts - a well-resourced, highly experienced team

A core part of the investment approach is understanding the underlying credit risks within an issuer. The fund managers are assisted in gaining this understanding by a team of highly experienced and dedicated credit analysts. 

Typically, the analyst will actively contribute investment ideas to the portfolio. This involves them presenting their ideas to the fund manager and then through discussion a decision is made as to whether or not a particular bond is right for the fund.

As well as proposing new ideas, the analysts also monitor existing holdings within their sector so that they can be sure that the balance of risk and reward of a bond remains appropriate. If they think that a change in a position should be considered, they will discuss it with fund manager who will then decide on the appropriate course of action.

Along with meeting company management and taking on board the views of rating agencies, the credit analysts undertake their own in-depth detailed fundamental analysis of an issuer and issue.  Among the factors considered are any operational considerations, a company’s balance sheet, cash flow, the particular covenants and protections of a bond and the bond’s position in the issuer capital structure. The analysts will also take a view on the relative value between issuers. 

Environmental, Social and Governance (ESG)

Good credit analysis requires a holistic understanding of both the company and the bond being analysed. Ultimately, what we are trying to determine is whether or not the potential return we expect to receive from a holding a bond adequately compensates us for the risks of holding it. Environment social and governance factors have therefore been an important consideration within our credit analysis long before the term ESG entered common parlance.

In practice, this means that there may be times when we want to steer clear of a bond because of concerns we have over its governance or poor social or environmental operations that are negatively impacting the business.

Equally well, there may be times when negative sentiment toward a sector causes a bond to reprice. But, if we have confidence in the business and think the market has over-reacted, then this can provide an investment opportunity that we might seek to exploit.

Diversifying the sources of income

We will only invest our clients’ money when we think we are being adequately compensated for doing so. From experience, we know that bond markets can temporarily present significant imbalances of risk and reward, which can be exploited.

These imbalances exist across financial markets. Some of the building blocks of the fund’s long-term performance track record and contributors to income have been financial capital, peripheral governments, high yield, hybrids and equities.

Subordinated banks

As highlighted in figure 1, a key sector for the fund is subordinated banks.

These securities are designed to be loss absorbing under certain scenarios. The loss absorption mechanism varies across each issue from coupon suspension, equity conversion, temporary write down to full and permanent write-down (i.e. loss).

Because of these features AT1 bonds are higher risk instruments and they are currently one of the higher yielding areas of the bond market. Through our rigorous credit analysis process, we aim to understand the idiosyncrasies of each security so that we can take a view on its appropriateness to our investment strategy.

Typically, we prefer large, systematically important issuers and issuers with significant retail businesses, which we think offer valuable diversification of revenue streams, reducing volatility. We prefer AT1s that convert to equity rather than those that lead to write-down. In our view, this means there is a better alignment of interest between banks and regulators.

We prefer instruments where the conversion trigger is closer to the regulatory capital minimum as this reduces the risk of conversion. We would also rather quarterly coupons to annual coupons as this offers the potential for coupon payments to recommence sooner if suspended.

Corporate high yield

Outside of the financial sector, the fund’s higher yielding bond exposure is focused on corporate high yield. Some of these are high quality holdings that have predictable earnings profiles and strong cash flows such as utilities, cable groups and consumer staples businesses. 

In addition to these core high yield issuers, the fund will also invest in more speculative positions. Often, the performance of these bonds tends to be independent of moves in the wider high yield bond market, with returns instead determined by company specific factors.

An example of such a speculative position might be a company that has restructured and that we now think has the potential to become more cash generative as a result of the changes. These bonds can often offer much higher yields than the rest of the market – sometimes double digits – reflecting the challenges the company has faced.

Distinguishing between the genuine turnaround stories and those bonds that are simply bad credits is the key to this approach. The fund managers are helped in this challenge by a great team of credit analysts. Their job is to scrutinise the company’s financial position to understand what is making the company tick and whether or not its current valuation accurately reflects its ability to meet its financial commitments.

Hybrid bonds

Some of the fund’s corporate high yield exposure, particularly holdings in telecom and utility companies is through hybrid bonds. The subordination risk, call risk and the risk of coupon deferral of these bonds mean that they offer a higher level of income in often high quality issuers.

This additional yield coupled with the call feature of these bonds means that a typical hybrid security has a lower duration (interest rate sensitivity) than the senior bond.

As investors we need to be aware of the reasons why the income is higher than for a conventional bond and assure ourselves that the additional income provides sufficient compensation for the increased risks. Because of the additional risks hybrid bonds generally have a higher sensitivity to broader market movements than the senior bonds.

That said; if we have done the due diligence and are happy with the company and the additional terms then hybrid bonds can provide an attractive income boost to funds.