Investing in bonds with inflation-beating yields

I’m Darius McDermott from FundCalibre, and today I’m delighted to be joined by Ben Edwards, who is the manager of the Elite Rated BlackRock Corporate Bond fund. Ben, good morning.

Good morning.

So, let’s dive straight into it. There’s no getting away from it: 2022 was a very tough year for corporate bonds, with inflation high and pushing interest rates up. Inflation is still quite high, [so] what’s your view on rates and is there more bad news for bonds to come?

[00:46] Yeah, I mean, there’s no getting away from the fact that it was a difficult year for bonds, it was a difficult year for everything. I think the worst thing that happened to investors was obviously the very high correlations in all of assets. I think we were -27% of the lows in the Sterling corporate bond market just after the mini-budget debacle – now defunct mini-budget debacle – in October time. But, you know, we recovered quite strongly from there [and] we finished the year about -19%. I think global equity is about -17 [per cent]. So yeah, it was a tough time all round. 

You’re right, the driver of that absolutely was inflation and the expectation that it may be high forever or at least for an extended period of time. I think the good news on that is that there’s some very real signs that we’ve peaked now in inflation in this country, but particularly I think importantly in the US, which really led us up in the first place. 

So, in terms of rate hikes, they’re still coming. The market’s currently discounting around two more 50 basis point hikes [two more rises of 0.5%] from the Bank of England. You know, we think that’s pretty reasonable actually. But after that, it becomes a lot more challenging to see further hikes in the UK. And as I said, I think the more important thing is that we now have a very well-flagged stepdown in hikes from the Fed[eral] Reserve: we’re now talking about 25 basis point hikes instead of 75s of 50s [basis points]. We’re only really looking at about two more of those, and then the Fed will be done in terms of its rate hiking cycle. And I think that that’s important. 

For investors, what’s important to understand is that just because hikes are coming, doesn’t mean bond yields are necessarily selling off longer-dated corporate bonds or government bonds that we tend to hold if it’s within the market expectations. What we are really trying to guard against or keep an eye on, is whether or not there are more hikes that are currently envisaged coming down the pike. And I don’t believe that there are. I think that, as I said, I think inflation has turned pretty decisively in the US, it looks like it’s peaked in Europe and the UK – although at high levels – and our expectations are that now they can fall quite rapidly. And I think the market’s reaction function, as it sees inflation start to cool and global tightening start to come off, is that we can see government bond yields falling quite rapidly – we’ve seen a bit of that in the last few days, actually – we think that’s good for government bonds. Ultimately, we think it’s good for credit spreads in the near term. And they actually can allow bonds to do quite well. I think we’ve already put on about 4% of total returns since the start of this year, just in the first few weeks. 

So actually, I’m quite constructive on where we are in terms of the income-generating capability of bonds. But more than that, [it’s] about its ability to generate total returns from here in a year that, now let’s face it, is not going to be a straight line and probably is going to come with some economic challenges, hopefully not quite so severe as last year.

Yeah. So, the one thing that last year’s volatility did give all active fund managers, was opportunity. And I know that you’ve made material additions to particularly banks in 2022. Can you talk us through the rationale for why you’ve been adding to those areas and, you know, whereabouts you’ve been adding into the financials?

[04:15] Sure. Yeah. I mean, look, it’s been a fairly well held view I think from fund managers, particularly credit fund managers, that since the GFC [Global Financial Crisis], banks have raised capital, they’re now much safer, and therefore, a material overweight in banking bonds has been a pretty easy place to be. 

It’s not really ever been our view, not because we disagreed with the safety of the banks, but just because we thought they were expensive. And so, if I went back a couple of years, you know, we probably had an underweight position in banks of something like 10% versus the sort of broader market, you know, that’s not insubstantial. We just didn’t see any value in these quite boring, safe things. Remembering too that European banks really haven’t been allowed to make any money in a time where rates have been zero or negative. And so, the equities have really struggled. And over that time credit spreads have remained tight relative to the market and tight overall. 

So, on the fundamental side, banks are allowed to make money, again, higher rates – and ultimately, I think we’ll have steeper curves [where investors are paid higher yields for bonds with longer maturity dates] – are good for banks, they’re good for bank margins, they’re good for bank profitability. And notwithstanding the fact that we think that probably loan losses are going to pick up from very low levels in the small business, in the residential mortgage market. We have to remember that banks are not in the business of not taking any losses; they’re in the business of taking losses but making enough money to cover them. And so, we’re in a situation where I think the market has now pushed spreads on bank bonds, senior tier two, and deeply subordinated bank debt, where we typically don’t have large positions, to actually very wide levels relative to the rest of the market on this fear that loan losses are going to pick up. We think they probably will, but we think the market is wrong in understanding that they’re going to make enough money on the other side of that to more than cover those losses. So, when I think about that position that used to be minus 10% over the last two years, we’ve now moved, that’s materially higher. And it’s probably our largest active overweight position. 

The sorts of things that we bought … November was a great opportunity in primary markets to buy Sterling bank paper, particularly in the tier two. So, that is just one step more subordinated than senior debt, but still more senior than equity in the capital structure. And top tier banks like HSBC, Barclays [etc.] some of the Scandinavian banks issuing tier two debt in November with coupons of around seven and a half to eight and a half percent; that’s the sort of income generating that we have not seen from the bond market in over a decade. We really are in an absolutely new starting position, and I see these things as fundamental in terms of our ability to generate cash flow in the portfolios over the next few years actually. We just don’t have these sorts of securities yielding these very large amounts. So, you know, tier two debt was, was very attractive. 

At the same time, there was some senior debt that’s been issued from November, and again at the start of this year, with coupons in the sort of six to six and a half percent range. So, you know, for senior debt of top tier European and UK banks in a six and a half percent type range makes no sense to me relative to the rest of the investment opportunity set. So, we’ve been adding a lot there. 

And as I said, I think fundamentally these things are sound and I think that they’ve a very strong ability to earn income and more probably over the next year to three.

Thanks for that, Ben. So look, acknowledging that obviously you build a broad exposure to credit across different sectors and different issues, I thought it might be nice if we could talk about a few individual names if we may, and get your explanation. I’m probably going to pronounce this very poorly, but I noticed one of your top holdings is Électricité de France [Électricité de France S.A.]. This interests me for a couple of reasons. Firstly, because it’s partly state-owned, and I believe it’s become fully nationalised soon, how does this impact on you as a bond holder? And secondly, France, like the UK has introduced energy price gaps. Does that have any impact on the company and subsequently the bond holders?

[08:32] Yeah, so EDF is a challenging story to be honest with you. I mean, it’s a holding that I quite like and I have full faith in. But it was a difficult hold through 2022 because it became a perfect storm for the company. As you say, regulatory action by the French government was the largest part of that. They started the year with a holding of about 84% of the equity of EDF. They finished the year with a hundred percent of it, as you said. 

But really their regulatory actions, one, in terms of prices, but also, and importantly in terms of this concept called ARENH [Accès régulé à l’électricité nucléaire historique]  – which is a contracted amount of power that EDF is forced to sell to its competitors, to maintain competition in the French energy market – at a time when EDF was experiencing some problems with their nuclear power fleet; effectively their output from those nuclear power plants came down at just the time that they needed more power, meant that power prices skyrocketed across Europe, left EDF in a deep, dark hole, and actually those actions from the French government basically wiped out over a year’s worth of profit for that company. 

In my view, it’s one of the reasons why EDF had to take a hundred percent control of that company. You know, it’s a very, very important part of the French electricity market – effectively, it is the French electricity market – so, at the same time that operationally you had a very challenging time and for instance, we saw credit rating downgrades of EDF in February, it was ever more entwined with the French government and its status as a ‘too big and too important to fail’ institution was cemented in my view. 

So, it’s a weird one where actually operationally the picture looks worse; from a credit rating point of view, it looks worse, but from actual chances of default, nothing has changed. What did change through the year was the price. And so, you know, so we have corporate hybrid exposure – again, this is just one level down from senior debt. We’d quite like to take subordinated exposure to, you know, very highly stable cash flows. It wasn’t the case with EDF last year, of course. But typically, utilities and telecoms are where we like to have that exposure. And those bonds got up to about 13% yield at the absolute lows of the market, and the lows in pricing of those bonds. They’ve recovered quite strongly since then. We’re actually looking to add some EDF to the portfolio this morning. And one of the interesting things about the operational story is now all of those headwinds are going into reverse ie. the additional volume that was mandated by the French government is no longer required; spot prices in energy in Europe have obviously come down very meaningfully; and that nuclear power fleet is starting to come back online and they’re starting to generate the sort of output that they need. And so actually, we see that all going into reverse. All those headwinds become tailwinds and we expect actually, some quite strong profitability from the company. I would expect that their earnings are going to look something very similar, if not quite a lot higher than they were in 2021 – so, prior to this most recent and difficult year. So actually, it’s a name we quite like, but you’re right, it’s been a storied name and a difficult hold through 2022, but at 9%, we still think they add value.

Right. Sticking then maybe with energy, I see you have a holding in Iberdrola [Iberdrola SA] an international Spanish renewable energy company, so a different type of energy company. Maybe tell us a little bit about that, and do you see that renewables sector growing as more countries see energy independence and the move to carbon neutral?

[12:29] Yeah, Iberdrola is a much cleaner story and has some similarities to EDF in terms of its structure and its position in the portfolio. So, you know, again, we have corporate hybrids in Iberdrola; again, we added to a new issue from Iberdrola yesterday in the portfolio, so, increasing that position. Those bonds yield less, they yield about 5% in Euros. We hedge those back into Sterling for about six and a half percent. But the fundamental story on Iberdrola is much cleaner and much better. 

So, this is a company, as you mentioned, that are at the forefront of the kind of mega trend towards decarbonisation – that is clearly going to continue. It’s a company that is, you say Spanish utility, but actually it’s fairly well diversified between the UK, the US, Spain and the rest of the world, most of that being South America, so very, very roughly, in those four quarters – so, very well diversified. 

It’s nearly 80% now in renewables and in regulated distribution of electricity, so very, very stable. And a utility company that’s growing earnings at 10% a year. So, 10% a year in organic earnings growth for a boring utility company that is moving into renewables and is very heavily regulated. I think that’s a great name from a creditor’s point of view – one where the management team are very credible. You know, they’ve for a long time been very clear about their desire to move into green energy, but at a time when actually the return on that investment is a little bit lower for a number of reasons, the company is, or the management have pivoted towards the networks business. So, they’re green, they want to be greener, but they don’t want to be green at any cost – they’re not zealots – and they see the benefit but they’re still mindful of taking capital decisions that are based on financials. So, actually I see that as a very, very strong story and one that should continue and probably will feature in the portfolio for a long time.

Thanks. So maybe you could just wrap up then by highlighting any other interesting opportunities, whether it be any sectors or potentially different parts of the capital structure that are really exciting you, given that we are in a new environment for bonds where a decent income is achievable now on lots of parts of the asset class.

[14:58] Yeah, I mean, you know, to be honest, I think that is the opportunity … the opportunity is the asset class … I’ve been running the BlackRock Corporate Bond fund since 2011, this is the genuinely the first time I’ve been able to stand side by side with my equity colleagues and tell them that they have to buy bonds because the yields on equities are too low; it’s generally worked the other way around! 

So, you know, the important thing for me is that the opportunity to earn genuinely strong total returns, but also that flip in diversification that worked so badly for investors last year, where everything was at one and everything was negative. We think that’s very much a 2022 story here. So, you know, were you to see risk-off markets with equities down and credit spreads wider, we think that would come hand in hand with government bond yields being materially lower. So, it’s a good standalone story, it’s also a better portfolio story. The conversations I’ve had with clients for the most part have been ones where underweights to fixed income – oftentimes long standing underweights to fixed income – have been closed. And the conversations I’ve been having over the last six weeks have been very much about how to fund an overweight in the asset class for the first time again, in a very long time. 

If I think about how we came into the year, just to put some numbers around that the BlackRock Corporate Bond fund was yielding something like 6.8% versus a market broadly that yields about 5.8%, so about 1% higher than the market. When I compare that to a) what’s been available in history, but importantly what’s available now, it’s pretty compelling. I think about a yield that is probably 3% higher than the dividend yield on the FTSE [index]. I think about a yield that is probably about the same, about just a little bit less than 3% higher than inflation expectations – remembering where we started this conversation, was still about inflation being the boogeyman – we’re talking about, a yield that, after taking away forward inflation expectations in this country, you’re still looking at a return of around 3%. That’s a change in entry point for fixed income. And it’s happened very swiftly, and I think that it’s an opportunity in of itself.

Ben, thank you very much. That’s a really interesting dive, not only into the BlackRock Corporate Bond fund, but actually into the asset class. And if you would like to get more information on the BlackRock Corporate Bond fund, please do visit FundCalibre.com.