High yield opportunities in today’s bond market

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Hello, I’m James Yardley, and today I’m joined by George Curtis, the manager on the TwentyFour Dynamic Bond fund. George, thank you very much for joining us today.

[00:12] Thanks for having me, James.

I mean, George, you guys are the bond specialists, bond experts. It’s been a very interesting time at the moment in markets. There’s a lot going on in terms of inflation and interest rates. At the start of the year, we were all expecting a lot of interest rate cuts to come through. That hasn’t really happened yet. I mean, we’ve had one cut now in Europe and a few cuts around the world. But where are we now? I mean, are interest rates set to come down? What is your view?

[00:51] Yeah, so I mean, if you rewind six or seven months go back to December of last year. We had, you know, what could be probably called a kind of a dovish pivot from the Fed. And ultimately Jerome Powell and his colleagues did this because they were acknowledging that the risks were more balanced. Right. You know, inflation progress was still going to be bumpy and potentially slower than what we saw in the second half of last year. So the six or seven cuts that the market was pricing in at the beginning of this year was too much. You know, the Fed themselves in their summary of economic projections last year said they were planning on cutting three times this year. So, you know, the data has been pretty robust.

Inflation, particularly in the US in the first few months of this year we’re much stronger than expected. But we are seeing clear signs of cooling. You know, we had a pretty good inflation print out of the US last month. And labour data economic activity data in particular in the last couple of months is starting to call. And I think the Fed and other central banks are very aware of the two sided risks of monetary policy, right?

When the Fed tells you that the risks are balanced, they acknowledge that inflation is not yet at target, but that you know, they don’t wanna because too much weakness, particularly in the labour market, right? Once the unemployment rate starts moving historically it can move quite quickly and can be quite difficult to stop. So, you know, we expect a first cut from the Fed in September around the same time, maybe slightly before that well from the Bank of England. But we expect the cutting cycle to be relatively gradual. Why? Well, you know, in the US we’re still seeing potential growth of we’re still seeing GDP growth of around 2%, which is roughly potential, maybe slightly above potential and growth in Europe and the UK is improving.

And you don’t think that the US election is gonna get in the way of that. I mean, some people are saying the Fed doesn’t wanna be seen as political, therefore they’re gonna not cut in September because it’s too close to the US election. You think they’ll just ignore all that and just go ahead and do what they think is right.

[3:20] So I think it leaves September open because it’s just before the election. You know, I think you’re right. People have said that, you know, maybe they won’t want to cut in November because they don’t want to seem political. I would say that the environment now is difficult is different to the environment we’ve had in previous political cycles because we’ve got forward guidance now in a way that we never had.

They only introduced dot plots, which is their estimation of where rates are going in the next couple of years post GFC, you know, you go back to Greenspan era you know, in the nineties people didn’t know what had happened at the FOMC until, you know, well after the fact, right? They didn’t tell you. So we’ve got forward guidance and they’ve been quite explicit with that forward guidance, and we know that they will be led by the data primarily, right? So if the data weakens, they will cut. You know, we think that data will probably allow them to start that cutting cycle in September, which is just before the political or the election in the US.

And where do you then see the most value at the moment? Obviously we’ve got an inverted yield curve at the moment, so that means obviously you’re getting a higher yield, then if you hold cash versus if you lock up your money for longer. Butis it worth locking up your money by saying buying 10 year government bonds, getting 4.3% or wherever we are at the moment? What is your view for investors at the moment? Should you be playing that game, thinking that rates are gonna come down and therefore take a slightly lower rate, but lock in now? Or do you just stay shorter duration and stay take less interest rate risk, I guess?

[5:08] So what we’re doing in a portfolio is we want to have some duration, right? Because we want that balance in the portfolio. If for whatever reason growth and other data started to weaken more meaningfully because government bonds kind of longer data government bonds would protect you in a downturn. But we want the biggest driver of our returns to come from credit, which is kind of where we are seeing, you know, strongest returns at the moment. And actually we’re seeing reasonably low volatility. So the way we are thinking about credit is that we wanna be focusing in areas that have low default risk. We want to focus in areas that insects that perform well in a higher, for longer environment, for example, but are also well protected in a recession.

And we want to focus on generating strong excess excess returns. So we have that balance, we have that balance between government bonds, we have that balance but we still have an overweight, a significant position to credit, which we think is where the largest driver of returns will come from this year for us, you know, developed market credit, credit in particular. And as I mentioned, focusing on those sectors that perform well, both in a higher for longer environment, but also are well protected in a recession. So we like financials, we like ABS.

And do you prefer higher quality investment grade or high yield at the moment? I mean, the spreads are not huge i in credit at the moment, are they? I mean, what are your thoughts on those valuations? You still think you’re just buying at these low spreads.

[6:55] So you have to be, I think, quite selective in terms of how you allocate a credit. You know, let’s not forget, let’s go back to, you know, September of 2021. The CCC rated index gave you all in yields of 6%. Right? Now you take your typical BBB rated bond and the credit space, you’re getting anywhere between kind of 4-4.5% financials, you can get maybe slightly more than that. So you don’t have to take a huge amount of credit risk to generate strong returns. So our kind high yield exposure is the lowest it’s been through the cycle. But there are areas where you can get both still attractive spreads and, you know, strong protection from defaults as I mentioned financials and ABS in particular.

Yeah. And you are bond specialists. You do go into these more niche areas. So can you explain for our viewers what ABS is and why you’re excited about it?

[7:58] Yeah, so I mean, these are just, these are securities that are backed by a particular asset that are securitised on a particular asset [ABS = asset backed securities]. So of course you have kind of mortgage backed securities, residential, residential commercial backed securities. Our A BS exposure is primarily CLOs.

CLOs: all they are is securitisation on a diversified portfolio of high yield loans. So you take a hundred to 150 loans through you know, European the high yield market. You securitise that, and you know, we are taking exposure to that securitisation. Why? Well, you get a very attractive yield that there is a complexity premium there. But there is also strong structural protection, right? You know, in order to take, say principle loss, right? To see a default in a BB CLO, you’d need to see a cumulative default rate in the underlying portfolio of loans of almost 30%. So you’d need to see multiple 2008 layman type years in a row. And this is at the same time that you are getting 600, 650 basis points of spread for a floating rate bond, right? Soa bond that does well in it, this environment where rates are potentially moving lower, but at a relatively slow pace.

So our CLO bucket in sterling is roughly 11% and that’s after very strong performance over the last 18 months. It’s been I think the best performing sector in well, global fixed income really for a number of reasons that make sense? You know, we’ve been talking about CLOs for a long time now.

Very good. And then the other area, I think you’ve got quite a lot of exposures in the AT1’s. Do you wanna explain what those are as well to our viewers a and why you like them?

[9:59] Yeah. So AT1’s, they are subordinated bank risk. So you have a bank and a bank has a large capital structure with, you know, dozens if not, you know, hundreds of bonds you know, going from kind of senior and secure to tier two and then and all the way down to the most subordinated level, which is the AT1 bond.

So look, we just view it as kind of unsecured subordinated bank risk, but it’s a high quality sector, right? Because the bank banking sector in Europe is high quality. You look at the AT1 index, for example, it’s giving you average yields of BB plus. So just below investment grade, that’s at the subordinated level. 95% of our AT1 buckets is investment grade at the senior uncured level.

So these entities are almost exclusively investment grade issuing subordinated bonds at an average rating of BB+. And we are seeing still yields of, you know, 8.5%, so high single digit yields for a sector that is performing really better than it has at any point in the last 15 years, right? That this rate environment is a good thing for financials. You know, steeper yield curves, they, you know, borrow short and long allows them to generate better profitability. So we are seeing now return on equity in the banking space of 11-12% versus the kind of 4% or 5% we saw during the QE era. So we’ve seen much better equity returns. We’ve seen much stronger credit upgrades to credit downgrades. In fact, Western European financials was, I think, the strongest upgrade to downgrade sector of global fixed income last year, and still highly attractive yields.

Very good. So what’s your overall outlook then for the fund and for fixed income over the next year and looking forward into the future?

[12:00] Yeah. So I mean, look, second half of the year, we expect both the Bank of England and the Fed to start their cutting cycle. We expect cutting cycles to be fairly gradual for reasons I’ve already explained, and that, you know, growth and unemployment still remain in a pretty good place. We expect growth to weaken maybe slightly in the US from very high levels. We would expect growth to continue to strengthen in Europe and the UK from very low levels. All of this is a pretty good environment for credit, right? Credit fundamentals, corporate fundamentals remain very strong, particularly up the upper, the quality curve. So we want to remain invested in kind of higher quality credit. We wanna remain liquid. So we’ve got this large government bond bucket, which is giving us, you know, better yields than really anytime in the last 10 to 15 years.

We’d still expect some kind of month to month volatility driven by you know, data potentially, because we know the central banks are very data dependent particularly some in potentially some kind of geopolitical role. But we use that really as an opportunity to add credit. I think the most important thing for fixed income, you look at three year, you look at five year total returns going out forward returns they are highly correlated to your starting yields, right? Looking at five year returns there’s a 90% correlation to starting yields. So I think the most important thing for fixed income investors is now when you’re seeing yields of 7% or 8% on the fund. You know, this I think is a good environment for fixed income where you can generate high single digit returns mid to high single digit returns and do it with, you know, a lot less volatility than, than than the equity market.

Fantastic. Well, thank you very much for joining us today, George. That’s been very interesting.

Thank you, James.