322. How to maximise returns with high yield investing

11 July 2024 (pre-recorded 5 July 2024)

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.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Today’s interview looks at the high-yield bond market and the advantages of an investment trust in this area of the market.

Chris Salih (CS): I’m Chris Salih, and today we’re joined by Rhys Davies, manager of the newly Rated Invesco Bond Income Plus Investment Trust. Rhys, first of all, thank you very much for joining us today.

Rhys Davies (RD): Thank you. Thanks for having me.

[INTERVIEW]

CS: As I said, this is a newly Elite Rated investment trust. So for the listeners, I wanted to start with the origins of the trust. It was obviously formed from the merger of two other trusts back in 2021. Could you maybe just give the listeners in a nutshell, the aim of the portfolio and what it sort of aims to do for shareholders?

RD: Yes, of course. So Invesco Bond Income Plus, we call it BIPS because BIPS is the stock market ticker. So it is an investment trust. Its focus is on income and earning that income primarily from the bond market. So having a focus on high income means that we’re naturally investing more in the high yield part of the bond market, not exclusively, but that is the part of the market than investors are accessing when they buy BIPS.

As you mentioned, BIPS was formed in 2021, but with a very long legacy sitting behind that with the two investment trusts that were merged to create BIPS. So it was a combination of Invesco Enhanced Income and City Merchants High Yield Trust, which were two investment trusts that we managed for many years on the desk here in Henley. And the boards of both of those thought that it was a good idea rather than having the same manager managing two separate vehicles with slightly different mandates, but ultimately trying to do the same thing – a good level of income for shareholders – it made sense for them to merge. So it wasn’t an Invesco led decision. It can’t be because these aren’t our, they weren’t our vehicles, per so to speak. They are listed companies with their own board of directors, but it made a lot of sense, I think, for shareholders. So what we now have is actually one of the largest – or the largest in the AIC sector – after having merged those two back in 2021.

And what we want to offer shareholders is a high and consistent level of dividends, paid quarterly, that are well flagged in terms of what investors, what shareholders can expect to receive. So we have a target of 11.5p per annum per share, and shareholders know exactly what to expect in terms of income going forward.

CS: I just wanted to set a bit more of a backdrop, obviously there’s perhaps nowhere near as many sort of fixed income and particularly high yield offerings in the investment trust space than perhaps those compared to say, equities.

And then on the other side of things, you have a huge resource within Invesco in the sort of open-ended direct funds that you can invest, you have a whole suite of funds there. Maybe just tell us what the advantages are of having a closed ended offering compared to an open-ended fund in this space. Maybe just highlight a couple of advantages for a vehicle like this.

RD: Yes, as an investment trust being, as you described, closed ended, it means that when an investor in the trust, investor in the fund, wishes to sell their holdings, instead of taking money out of the fund, they’re going to sell those shares on the stock market. So straight away being closed ended versus being open-ended like some of the other funds – all of the other funds we manage on the desk – does create a nice advantage in terms of, as a manager, knowing what it is that I’ve got to manage. So not having to worry ultimately about potential outflows should we be in a weak market perhaps. So it gives me a lot more confidence when I’m investing within a closed ended vehicle than you can have in an open-ended vehicle.

There are advantages and disadvantages to both types of vehicle. But that’s probably the most important one.

It then feeds into other things such as being able to invest in less liquid, perhaps smaller issuers. Where there is less liquidity in the market, an open-ended fund would need to have a certain level of liquidity in everything that it’s holding so that it can sell those positions to fund outflows if needed. For BIPS being a close ended vehicle, we can think about participating in some of those less liquid names. The majority of what we own is very liquid. It is marked to market on a daily basis. The NAV is very accurate in terms of pricing. But it’s nice to have the opportunity, the option, to be able to invest in some of these smaller less liquid issues.

CS: You make it sound like some of the guys on the open-ended desk sort of biting their tongues and their lips when they see something and they just don’t quite see the risk/reward in open-ended and this sort of vehicle gives you the opportunity perhaps to delve into some of those names because of that closed ended nature.

RD: Yeah, that’s exactly it. So recently BIPS was able to purchase bonds rate of a small UK building society called Saffron. It’s a relatively small building society with a very small bond. And actually because of the small size of that bond and the lack of interest from open-ended vehicles, and you know, our analysts did a lot of work on this and it’s a nice investment, but just not suitable for the open-ended vehicles that I manage. And so buying that for BIPS meant that we also got a much better coupon because of its small size and its relative illiquidity. So that is paying 12.5% per annum, and that’s very nice to be able to put into an income portfolio like this.

CS: Okay. Just to turn to look at, we touched on high yield and I feel like the listeners will have a grasp of sort of the investment grade corporate bond space, but that’s only sort of some of the areas you touch on. I wanted to maybe just explain a couple of other areas in a bit more detail. The likes of, you also cover subordinated financials and you also look at corporate hybrids, that the listeners may not know as much about. Could you maybe take one of each of those in turn and just explain what you’re looking for in those spaces?

RD: Yeah. So I mentioned at the start that the focus is on high yield bonds and that’s what shareholders should think about being at the core of what BIPS is invested in. But, you’ve touched on a couple of other very important areas of the market that we look into. And they have slightly unusual and potentially a bit scary sounding names or complex sounding names, but they’re not as risky or as complex as they sound.

So, subordinated bonds, it’s an area of the market we really like for the portfolio because of the level of income that we can earn for from these types of bonds. So subordinated just refers to where these bonds sit in terms of the capital structure of a company. So they tend to be the layer that sits just above equity. So they’re still debt, they still rank above equity.

You may have heard of bank CoCos, which are also called additional tier one (AT1) bonds, those are an example of subordinated bonds. So Lloyd’s Bank, which is an investment grade rated bank and a huge national champion bank in the UK et cetera. They actually have an investment grade rated CoCo or additional tier one bond. So that’s a subordinated bond and it pays a coupon of 8.5% per annum. So investment grade rated, it’s deemed to be a very low likelihood of default but pays a nice coupon because it is at the lower end – or the lowest ranking piece of debt in the structure. BNP, a very good quality French bank, they pay 9.25% in dollars on their bonds.

So we can get some nice income from good quality companies by buying their subordinated debt. And it’s also worth noting, I think that CoCos or additional tier one bonds are not directly accessible to retail investors. So that was a decision taken by the regulator a few years ago, we can debate whether or not that’s sensible, but certainly within this vehicle, this is a route to accessing those types of bonds.

I mean, a little more in terms of that label, should we be concerned about something that is called subordinated that sits at the bottom of the debt stack? It does mean they often have less protection if things do go wrong. And so that is where we need to be careful as investors with subordinated bonds. So for us, when we do invest in them, it’s about diversification and it’s about credit quality. So it’s making sure the portfolio is comprised of a good mixture of different companies.

If we’re gonna have subordinated bonds, then from lots of different companies, that’s very important. And if I take the banks, for example the funds CoCo exposures spread across about 25 different banks. And also then we are favouring those better credit quality profiles.

So actually most of the subordinated bonds, subordinated insurance bonds within the trust, are typically investment grade rated. And then corporate hybrids essentially they’re very similar instruments. They are the most subordinated piece of debt often from an investment grade rated company. So names like Volkswagen, Vodafone, BT, we own corporate hybrids from those companies. And overall for us, subordinated debt, it’s another place we can find high yields alongside those traditional higher corporate bonds. The range is normally around 20-30% portfolio.

And then the other area I would just mentioned is moving to the kind of the other end of the the risk spectrum, actually investment grade rated bonds have – investment grade corporates – have become a yield product again which they hadn’t been for a few years. So that’s an important part of the portfolio as well.

CS: Okay. Let just quickly, I mean, the universe itself is very large, but maybe you’ve always sort of stated that you have a preference for companies that sort of have those good cash flows and good fundamentals, but by that same token, you wouldn’t ignore anything if you felt that the price was right. And you know, you’re happy to target the companies with challenges if you can see the light at the end of the tunnel and how they get to that light, for lack of a better way of explaining it. Could you maybe give us a bit more detail on that, please?

RD: Yeah, so I mean, I would start by saying what we’re looking for are companies, as you say, with good cashflows, good fundamentals. So cash is the most important aspect for us to be looking at as a credit investor. You know, ultimately we want a company to be able to pay us their coupons. It’s the interest that they have agreed to pay each year, and to then be in a position to repay us at the end of their the maturity of the bond.

But really we are looking for improving credit profiles. So we want companies, we want to invest in companies who are actively improving their credit profile over the life of the bond. That just makes it a lot easier for us to get comfort that they will be able to refinance when it comes to the maturity of the bond. So that’s what we are looking for.

Sometimes things do go wrong for companies that have issued bonds. Their bonds will trade down in price, trade up in yield, to reflect the issues that they’re facing. And that can create opportunities for us as well. So we may look to be buying those in the secondary market. You know, it could be that it’s just a company and I’m thinking of a name like Aston Martin, for example. It’s at the riskier end of the credit spectrum. Not making much free cashflow. You know, they make great cars, but what we care about is their ability to convert that into cashflow. So they’ve got a lot of money to spend on CapEx. They won’t be making much free cashflow for the next couple of years. And as a result, their bonds have to pay a relatively high yield. It’s into the double digits to be able to lure investors in. So it’s a very nice income for us to be able to earn. But we’ve got to be confident that there is an improving story there.

Then if we move a little further into kind of stressed, we call it stressed and potentially distressed bonds. So these may be companies where things just haven’t worked out for them since they’ve been a bond issuer. Their bonds are trading maybe 30 or 40 points below par. So at a price of anywhere from 60 or 70 or lower. Just to be clear, all bonds are issued at a price of par, which is 100, and are redeemed at a price of par. So they’re trading significantly below par.

And we may start to look at them as a potential not just for a recovery back to par, but maybe we’ll do something with them and take them for a restructuring. So that is something we can also do. It’s something that we’ve got good experience of within the team.

A very, very topical name at the moment is Thames Water. Some of their bonds are trading at stressed levels. There is a lot of work for that company to do, but ultimately we think bond holders, the role of bond holders as creditors is very important for Thames Water going forward. The company, whoever owns it going forward, will need funding from the debt markets. It will need funding from bond markets. And so we would like to be a part of that solution and we can be looking to buy those bonds with a view to potentially go through some kind of a negotiation with the company, with its new owners, if that is what happens and come out the other side with the company in a better position and hopefully us having made some money for our bond holders. So that would be an example where we’re looking at not just the income that we can earn, but also maybe capital upside.

CS: Okay. I wanted to talk about the sort of challenges of managing a product like this in inflationary times – challenges and opportunities – to run a product like this in inflationary times. I mean, I did a bit of digging around and, you know, the high yield bond market was only from a yield to maturity of sort of 3.4% at the end of 2021. So you had many bonds with coupons that were uncompetitive versus interest rates. I mean, you fast forwarded it to 12 months and the yield to maturity in the European high yield market was sort of around the 8% mark. And the average price of bonds in the index had sort of declined from around 101 to less than 86. I mean, that sounds a lot of information.

Maybe the best way to sort of put it is how do you break that down? Is that in a nutshell a lot of pain on one hand, but a lot of opportunities on the other?

RD: Yep. In a nutshell, definitely. I mean, 2022 was definitely the year to avoid bonds. But bonds and equities are different. So the return profile is very different. The beauty of a bond is, if a company doesn’t default in its obligation or a government doesn’t default in their obligation, then they will recover back to a price of par 100 at the maturity date.

So the problem as you rightly pointed out was that at the end of 2021, yields on offer were very, very low levels. And that then also coincided in 2022 with inflation being a lot higher than most people had expected, and inflation you can think of as the nemesis of the bond market. So we had not just inflation, but also it coincided with yields starting the year at very low levels. So a lot of pain was felt by bond holders during 2022 as we moved from low yields to high yields. Bonds just mathematically repriced. So as yields go up, the price goes down. So there was a lot of pain, as you say, felt by bond holders. It was severe and it shouldn’t be played down, but the beauty of a bond is that they will recover back to a price of par.

So the nice thing last year, the start of 2023 was we were looking ahead and saying, well, there’s a lot of income out there because yields are a lot higher than they have been for many years. But also there was the potential for capital appreciation as bonds moved back towards that par price. And it meant that we could put together a very well diversified portfolio of bonds that were paying a far more attractive level of income than we had been able to do, say, in late 2020, or definitely do 2021.

And I would say that now that we have gone through that and we have moved to a high yield environment, what we do have is, unlike at the end of 2021, the start of 2022, unlike that at that point today we have higher bond yields, and that could compensate investors much better for negative surprises in a way that was just not possible before. And that could be around inflation, or it could be around weakening economic outlook.

So it was tough, but then it immediately created an opportunity for us. And a lot of that opportunity is still there. What we really like, or what I really like actually as a high yield investor, is being able to buy bonds that pay much higher levels of coupon, so that’s the interest rate they pay per annum than we were seeing in 2020 and 2021. And in many cases companies that are issuing bonds today are doing so at at least two times the level of coupon that they would’ve been able to issue and pay when they were issuing issuing back pre-2022. And that makes, you know, life a lot more interesting and exciting when you’re looking for income from the bond market.

CS: You’ve sort of answered half of my next question, so I’ll try and skip to the second half. I mean, does this sort of change, you mentioned earlier that investment grade side is now an option again, I mean, that creates a really nice sort of <inaudible> for you to invest with. I mean, does that give you a greater freedom, perhaps to look up more riskier, higher yield bonds?

Should you want to, I mean, we talked about biting your lip earlier because you weren’t quite sure. Well, how does that change the structure of the sort of you know, the underlying positions you want to invest in? Does it give you a lot more freedom, a bit more freedom? And do you fish in slightly deeper seas? But just give us a bit of an insight into that as well, please.

RD: I think what it has done is it’s meant that we’ve been able to earn a decent level of yield without having to take too much credit risk. So on the one hand, it’s great to see more yield in markets and to be able to put that into portfolios. And as you kind of referred back to that point about investment grade bonds which hadn’t really been an income product for many years, that suddenly became an income product, a yield product again. And so around a third of the portfolio today is actually in investment grade rated bonds. Simply because over the past couple of years, we’ve been able to find yield in that part of the market without having to take too much credit risk. So it allows us to create a kind of a better quality portfolio, but still doing what we need it to do in terms of income and yield.

So my background is as a high yield credit analyst. So I will always be looking at the high yield part of the market and the riskier parts of the high yield part of the market, if that’s where I can find risk reward that looks compelling. So a vehicle like this, the BIPS trust has no issue investing in the risky part of the high bond market. So that would be bonds at a rated maybe weak B or even CCC provided we think that the risk reward is appropriate. And actually that has been more challenging than you might think. So despite record levels on stock markets, and we keep hitting new highs say in the US on equity markets, actually we do have concerns about what is going on in the weakest parts of the high bond market. And it goes back to a a point that I made earlier about the levels of coupon that companies have to now issue at. So if the average was say 3.5-4%, pre-2022, that may be 7% or 8% now for a similar rated company.

And so much like governments, individuals, companies, small companies, households, we’ve all got very used to borrowing at very cheap levels. And now if we’re in a higher rate environment or certainly higher than we have got used to, we do have to think about the implications of that will have on some companies. And in the weaker parts of the high bond market where there is a lot more debt to service, we do have some concerns around the ability of companies to be servicing that debt at much higher levels of interest burden.

So that’s something for us to watch out for that part of the market.

CS: You’ve come on nicely to my next question again there, which is regards to leverage, which is obviously a key part of the investment trust structure. Maybe just explain how you used it in the past couple of years, and whether that’s changing at the moment.

RD: Yes, so it also ties in I think to one of the earlier questions around the benefits of an investment trust. And it’s probably the most important feature of an investment trust that we try, that we do make use of, and that is using borrowing.

So we think that some borrowing when it’s used carefully can be a very useful tool. As anyone who’s had a mortgage will know, borrowing in a rising market is very beneficial. So it has to be used carefully because borrowing in a fallen market can also hurt. The nice thing about borrowing on a bond portfolio is essentially it allows us to buy more of the bonds that we like. So those bonds will not only move around in price, but also there we are buying more of the income that they generate.

And so over the long run, what we have seen through our experience of managing the two predecessor trusts with varying levels of gearing is that having gearing is overall beneficial to the portfolios over the long run. And we do have over two decades of experience of managing borrowing through the cycles.

So for this fund it’s just below 15% at the moment. So that’s 15% of the net asset value is then borrowed again. There is a hard limit which is set at 30% of the gross asset value. So slightly confusingly looking at two different ways of calculating it there. I always talk about it in terms of the net asset value. So it’s roughly around, the hard limit is around 40%. So we’re at just below 15% today. So we can take it higher if we feel that the market is looking particularly exciting in terms of opportunities.

Right now we’re not feeling that. And so we’re also thinking about the potential risks that are outlined with refinancing in high yield and also just one eye on the potential for an economic downturn going forward. It’s still, you know, this is the kind of most spoken about or most forecast recession that hasn’t actually happened yet, say in the US. But we think it is sensible to at least factor that potential risk into the portfolio. And so gearing at around 15% today, we feel is an appropriate level.

It kind of does what we need it to do, which is allows us to invest in more of the bonds that we like, without having to take too much credit risk in the portfolio. And to more than cover the income target that we have, the dividend target that we have.

CS: You’ve given a nice sort of piece on your outlook there. And also you mentioned your exposure to the investment grade side of things. Maybe just give us a quick line on to sort of positioning of the portfolio at the moment. Is it quite spread out in terms of sectors, are their particular sectors you’re focusing on? I just want a little sort of scan of that please to give I investors a bit of more insight.

RD: Yeah, so diversification is really important I think for a portfolio like this. The risk reward for a bond is different to an equity. And so it’s important to actually have quite a lot of diversification in terms of the companies that we’re lending to. So we have around 150 different issuers, different companies, that we lend to within the portfolio. So bonds that we own from 150 different companies.

Sector wise, it’s a wide spread. So the most concentrated sector would be the banks which is around 20% of the portfolio. And that is because we like those subordinated, the subordinated financials, the bank CoCos or additional tier one bonds. That’s a little different in terms of a sector and exposure to say the rest of the market where we like areas like utilities, telcos, food [and] gaming.

But really it is a bottom up built portfolio as in our analysts, we have a team of very experienced analysts. Their job is to talk to companies, hopefully meet with companies in person maybe go and visit those companies, understand their financials, really focusing on the cashflow, the balance sheet and be thinking about the company, its outlook, the industry that it’s in and forming views on the credit worthiness of a company. And then we think about where their bonds are trading or whether we think that’s a good risk reward. So then building a portfolio that is built up from the bottom but tends to then find itself with exposure to some of those slightly more stable, maybe less cyclical areas like gaming, for example, more stable like telcos, for example, but spread across a wide range of different sectors, I would say.

CS: And just to finish, last but not least, I mean, a lot of people will look at this for that dividend yield. Could you maybe just explain in a little more sort of insights in terms of what you are looking to achieve and how useful that investment trust structure is in achieving that yield?

RD: Yes. So I’ve been managing the two predecessor trusts for over a decade and they had two very different sets of boards, but both boards were kind of consistent in their messaging and their belief that having a consistent level of dividend and a target that shareholders know what to expect is very important. And so it was good when they merged that is what we’ve maintained.

So the target is currently 11.5p per annum. And that gives a dividend yield today of around 6.7% on today’s share price. That 11.5p is more than covered. So at the last set of results, that dividend was running comfortably above 12p per annum. So we choose not to pay all of the income out. Some of it will just sit in the portfolio in the NAV. So it is still there in the fund. So that’s where we are in terms of the dividend that gets paid out.

The yield on the portfolio today is just below 8%. And so that comprises both the income that the portfolio is making, but also the potential for that capital upside. So you mentioned earlier during 2022, bond prices fell. Not all of that has been recouped yet. So that is still there in the portfolio. We put those two elements, the income and the capital upside together into one yield, which we call the gross redemption yield or the yield to maturity. And that’s around 8% portfolio.

But then because we have that gearing in place it’s around 13.5% as of today, that helps amplify the yield further when we think of it on an NAV basis. So with that gearing in place, you can start to think of it as maybe around a 9% yield on the net asset value.

CS: On that note, Rhys, thank you very much for joining us today.

RD: Thank you, Chris. Thank you. It’s been a pleasure.

SW: Invesco Bond Income Plus Trust, or BIPS, aims to provide capital growth and a high income by investing predominantly in high-yielding fixed income securities. As discussed in this interview, the portfolio is well diversified across countries and industries and has maintained a consistently high level of dividends for many years. Backed by the huge fixed income resource at Invesco, this closed-ended vehicle is a strong consideration for investors wanting access to the high yield market. To learn more about the Invesco Bond Income Plus Trust please visit fundcalibre.com