229. Now there IS an alternative to equities

TRANSCRIPT: EPISODE 229
Published 8 December 2022 (pre-recorded 1 December 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRO]

Darius McDermott (DM):
I am Darius McDermott from FundCalibre and this is the ‘Investing on the go’ podcast. Today we are delighted to be joined by Richard Woolnough, who is a veteran and legendary fixed income manager. [He] actually runs three Elite Rated products, which is the M&G Corporate Bond, M&G Strategic Corporate Bond, and the M&G  Optimal Income fund. Richard, good morning and thank you so much for making time for us today.

[INTERVIEW]

So, look, who knew bonds could be this interesting? And here we are. It’s been a busy few months in the world of bonds. What have you been doing in the portfolio that time? Have you made lots of changes because of that dramatic spike in yields?

Richard Woolnough (RW):
It is quite interesting when 10-year gilt yields and 30-year gilt yields are appearing on the national news – obviously, intertwined with the political issues and the budget and their effect on the economy. And it makes sense for them to be there, as there’s been a dramatic move in interest rates. That has been in response to [the] dramatic increase in inflation that we’ve had.

DM: Yeah.

RW: And, as a value investor, when the market has become distorted or they become more lively, then it results in us thinking, is it appropriate to take some kind of action? And so, it’s been quite an active year from us. Basically, on the back of those big moves in interest rates – interest rates have increased substantially – which means that you are getting paid more for lending than you were before; the opposite of the typical man on the street who, obviously has a mortgage now has to pay more to borrow. Well, the flip side of that is that if you’re a lender, you get paid more, it becomes more interesting to lend and becomes less interesting to borrow.

DM: Yeah. So, we get lots of acronyms in our industry and one of the ones I think you’ve been quoted as saying is, we’ve gone from TINA to TIAA. What the hell do we mean by that <laugh>?

RW: Well, there is no, there was no alternative if you wanted to have an income and the bank account was zero and gilt yields was zero …

DM: So TINA is, There Is No Alternative…

RW: There Is No Alternative. So, that was the argument to say, well, equities are good value because the alternative is so bad value, it’s a relatively good thing to have. And that’s what you have to do as an asset allocator. You have to work out what – whether an individual or fund manager – is it more attractive to own, let’s say, cash, equity, property? And then obviously you work through it; which kind of equity? Which kind of property? Which kind of bonds do you want to own? And that’s always a relative game. It’s not an absolute game because there is always an alternative. You have a smorgasboard of things to look at. And the …

DM: The new acronym…

RW: <laugh> a new acronym … but the opportunity set in bonds was very low, because yields were very low, it’s very hard to get negative yields, therefore upside was limited in the asset class. But obviously you can get yields returning to where they were before – which happened – which means you have downside.

Now obviously, it’s a bit more balanced now. Interest rates can go down as well as up, whereas in the past it was very hard for them to fall. And you get paid while you wait. Before you weren’;t getting paid anything while you were waiting to see what happened next. You now receive income in bonds and corporate bonds and high yield bonds that …

DM: So TIAA being There Is An (actual) Alternative.

RW: There Is An (actual) Alternative

DM: And bonds being that answer across the …

RW: Bonds among them. You might still prefer other asset classes, but you now have to take a more balanced view and say, well, actually that argument for why we don’t own bonds, no other asset classes is less strong. There is an alternative to how you look at managing your money and what kind of asset allocation you have. Historically, bonds are looking more attractive than they were obviously at a time of
zero rates.

DM: Yeah. And I couldn’t agree with you more, you know, holding in a government bond yielding a half [a per cent] isn’t really a recompense, whereas now I’m getting three and a half – four [per cent], and when your skillset with credit comes in, you can actually get five, six, and seven [per cent] to hold an asset which should pull to par and mature at a hundred given its maturity date.

RW: Yeah, so, the bonds have a set maturity date. Sometimes that’s very near and they’re less volatile instruments, sometimes that can be a very long time away. And therefore, you know, as interest rates move, they move a lot more.

Just think of it as a bit like a mortgage. If you’re locked into your mortgage for three months at a set rate and rates move or go right or wrong, it doesn’t really affect you. But if you’ve got locked to the mortgage for five years at a low rate or too high a rate, then obviously that economic decision actually translates into a very profitable or a very unprofitable decision.

The same happens to the bond markets and, though the bond market has a lot more term in it, so it’s not a question of … let’s say the mortgage market is two years on average, some five, the occasional 10, we can actually go out to 30 years and when we want to have that long-term income stream, we will take those risks on board and when we want to avoid it, we’ll avoid it and not take those risks within the mandates that we have.

DM: Great. So, just one question which points directly at Optimal Income. The Optimal Income [fund] is a strategic bond fund, but one of the differentiators that you put in place at outset, was the ability to have up to 10% in equities. Given what you’ve said about bonds now being a genuine alternative, what have you done with your equity weighting, say the last couple of years, and how do you view that in the year ahead, 2023?

RW: We are looking at the Optimal Income stream and the guidelines allow us to go up to 20% equities.

DM: Is it 20? Right. Okay.

RW: But it’s a non-index bet for us. Or non-index view. What we think is that every asset’s value is a function of its income stream. The optimal income stream is about getting the highest number. It’s about trying to get the best risk reward given the alternatives that we can invest in – investment grade, government bonds, high yield and cash. Sometimes the most attractive income stream isn’t in the bond, it’s in the equity…

DM: To the dividend…

RW: It’s the dividend or the earnings. [DM: Right.] Whether that dividend is realised now or it’s a future dividend that will pay out. And so, if the equity part of the capital structure is very good value versus the bond part of the capital structure, we’d want to own that, because that’s a way of really expressing your view about owning an asset that’s very long-dated, because we really like it. Well, that’s an equity because it hasn’t got a maturity date. And also, obviously, you’re at the lower end of the capital structure ie. the risky part of the capital structure, the bottom part of the company’s capital, which means you’re obviously a lot more volatile; when things go wrong, it’s a lot more painful; when things go right, it’s a lot more rewarding.

And the other thing about equity is that people are very comfortable with the idea of high yield bond funds and high yield being in a portfolio like this, but you tend to find that equity is highly more correlated to high yield than high yield is correlated to government bonds. Because high yield has got many equity risk characteristics, it’s at the bottom part of the capital structure.

You know, things go wrong – they have high default rates, things go right – you get paid
well, while you wait, you get more income. So, I think that’s one of the reasons that that we use these bonds, use equities in the fund.

At the moment, it’s very low. The highest it was, was in 2012-13 when the equity market was very good value versus the bond market. Now historically, the equity market, it’s not as good value versus bond market and therefore it’s a very low holding we have, it has less companies exhibiting this capital structure arbitrage.

DM: So, last time we spoke in February, you talked about a 12-to-18-month lag from interest rate policy into the real economy. Where do you think we are, and does that still seem an appropriate timeframe for these rising of interest rates to slow down the real economy?

RW: Yeah, I think historically it has been observable, whether it be in the UK, US, Europe, elsewhere in the world. And the inflation we have now is the function of the very loose monetary policy that we had 12-18 months ago…

DM: Yeah.

RW: … in response to what’s going on with public health and covid. And what we have now is Bank of England started putting rates up in the autumn to December of last year – 2021 – and it’ll take a while for it to feed through, which is why  unemployment is still near record lows. That’s why inflation is still high.

Things work the lag; the labour market is sticky, the housing market is sticky – it takes a while for things to happen. The [central] banks have tightened policy aggressively and continue to do so we think. They’re also doing something in that they’re doing quantitative tightening. And what that basically means is they’re destroying money; they’ve reduced the amount of money in the economy. Why does that matter? Just think of it as the more supply of something, the cheaper it is, the less supply, the more valuable it is. And obviously if they print lots of money…

DM: … Which they have done in two batches, one post-GFC [Global Financial Crisis] over a multiple year, and then again in covid, in very short order, a big, big chunk of printing.

RW: Yeah. And I think there is, they did it both times. The first time you didn’t get inflation, you might ask why. I think that was, they were just filling the hole from the previous excess consumption, the banking system. So, they printed the money to bail out the banking system in the GFC; this time they were printed the money to bail out us. And then we get the money and we’re going to spend it. So no, that supply has been enormous. And that has caused, tends to cause inflation. Look around the world, the countries that printed the most money, tend to have the highest inflation. The countries that printed the least money tend to have the least inflation. And they’re all now doing that. They start to destroy, not just in the UK but obviously worldwide in Europe, US, they’re all changing them. They all had a very synchronised monetary policy of very low rates and printing money, and they’re now all tightening and it should, you know, result in a slowing of the economy and a slowing of inflation.

And if you were to be very … traditional monetarist, you’d argue actually that the destroying of the money does more to destroy inflation than it does to destroy the economy. That’s what a pure monetarist would argue [is] that it’s the amount of money that matters to create the inflation and its side effects on the economy aren’t strong. And I think that’s something that’s very out vogue, out of fashion. But it’s pretty obvious we can get high inflation. How did we get this high inflation? Well, we printed lots of money Well, how are we going to get back inflation back to normal? We remove that money from the system.

DM: So, 2022 has been a difficult year for bond holders. It’s also been a difficult year for equity holders, particularly those in long duration growth assets have had a really tough year. At the centre of this is inflation driving rates. Let’s talk about then your view on inflation for the next year, year and a half, given that I’m allowing you 18 months because of the lag of maybe the last interest rate coming, what’s your view on inflation? And if you could then finish it, what that means for bonds and potentially other asset classes over those 12-18 months?

RW: I think central banks have signaled they want to get inflation back to target.
That’s 2% or thereabouts [12:15] 2% thereabouts. Maybe they were a bit more aggressive pre this event, but they get inflation back towards 2%. They’re late starting, you know, they were late starting because they were facing a difficult problem. We didn’t know what the public health issues were going to be in 2022, and therefore they run a, you know an aggressive margin policy in 2021, probably assuming the worst. And fortunately, you know, society has reopened.

So, what they want to do is they want to get inflation back to target. And in the UK is quite interesting. And one thing that has changed from February – if you’d asked me then I would’ve said that the government would be not pro austerity. You know, Boris would continue to want to spend, they would continue to want to go down that route. And that’s almost, when you think about it, the situation we got in the UK with the brief mini budget.

But now that political will has changed, whether it be the European government, the UK government, the European central banks, they’re all looking getting inflation back into control, it’s a priority.

And that gives the central bank permission to do as it is. And I think it will get it down. It used to have the natural things, you have a lag now the oil price and dollar is now back to where it was pre the Russian-Ukrainian situation. And you know, we will see the market come back just for a year-on-year effect as the oil price comes down.

But secondly, I’m a firm believer that if they do stick to their guns and start destroying the money they printed, by definition it has to increase its value. And it’s very hard to sort of conceptualise. But the value of money going up, is the same as inflation going down. Inflation going up is the same as the value of money going down. So, it’s a very sort of hard thing.

I think the simplest way to think about it, it’s very sort of weird way to think about it; Quite often you look at… you think of the strangest thing you can do. So, imagine if they said, okay, every 10 pound note’s got a zero on it, well, inflation would be enormous; they’ve printed a lot more money. If they said every 10 pound note, it’s got a zero taken off, it’s now a one pound coin; they’ve destroyed lots of money. So, it’s one of these things and you know, they don’t do it, …

DM: But they’re not doing it in one go, they’re doing it slowly…

RW: … They don’t do that. No, certain countries have to do that. You know, when you’re in the Zimbabwe, they do all sorts of things to the coinage, [to] the value and all that kind of thing. But in the past, not anymore.

But I think, you know, that’s one of the key things that sat there. And as you rightly said, inflation coming down is actually not just good; if you think about an income stream, it’s not just good for bonds, it’s good for a number of asset classes, especially if it means that we don’t buy as much as we need to, because inflation does come down.

And then obviously this question we look at: which asset classes are appropriately priced for these movements? Which ones would provide the best risk reward? And that’s an area where people have to make their asset allocation what they want to look at in this more like … the economy’s slowing down, but not going into a heavy recession, as inflation is solved by monetary phenomena as opposed to an economic phenomena of a recession, then what kind of assets do you want to look at, if you believe that is a potential outcome?

DM: And then maybe one final extra question. We are lucky enough to work in financial services, savings, asset management and [the] city – do you think broadly everybody’s a bit too bearish? Again, everybody I meet, you know, recession’s going to be terrible. Is that now the consensus and possibly wrong? Or do you think they’re right to be bearish for a 12-month period?

RW: The question is, it doesn’t matter whether your right to be bearish or not, it’s a question of what the value in the security you are willing to buy and sell is. So, you can be really bearish, but it’s a great time to buy because the price …

DM: You’re buying it for 80p in the pound or 60p in the pound!

RW: … Is great! And you can be really bearish, and the market is very expensive; you don’t want to get involved. Same with bullish; you can be really bullish, but what you’re doing, buying it up here? So it really is a valuation view that you have to look through, to look at where your view differs from how the income streams and those bonds are priced. And that’s what we – and the team I work with – spend our time thinking through, and working through, to see where those risk rewards are on balance more favourable. And that’s what we spend our time doing.

But it’s as a bond investor, we tend to be naturally quite bearish people. We tend to avoid credits against difficulty. We tend to be biased that way. But I think whenever you see a general consensus, then you should look at the opportunities that that can create. And I think you know, as you say, there’s a general consensus that things are going to be really bad. The only way we get rid of inflation is to have an almighty recession. Well, if that doesn’t happen …

DM: Things are cheap

RW: Things, things are different, and you want to work out where you want to be invested on that spectrum.

DM: Richard, thank you very much for your time this morning. Now, if you’d like any more information on the M&G Corporate Bond, the M&G Strategic Corporate Bond, or the M&G Optimal Income, please do visit FundCalibre.com. And if you’ve enjoyed this podcast, please don’t forget to like and subscribe.

Thank you.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.