Pricing for Armageddon offers opportunities in bonds, despite oncoming recession

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Hello, I’m Chris Salih, investment research analyst at FundCalibre, and today I’m delighted to be joined by Chris Bowie, manager of the Elite Rated TwentyFour Corporate Bond fund. Chris, as always, thank you for joining us today.

Pleasure. Thank you.

Let’s get straight into it. Obviously, a lot of column inches about what’s been going on in government bonds and the opportunities there in in recent months, but perhaps a bit less so in the corporate bond space. Could you maybe give us an insight into what’s happening there at the moment?

[00:29] Well, in government bonds, really, the story has of course been inflation, and higher inflation has led to higher base rates around the world. In fact, the Bank of England was the first to hike rates, but the US Federal Reserve have done the same, and so have the ECB in Europe, and that has made government bond yields go much higher. In fact, now government bond yields are the highest they’ve been since the financial crisis. So, we’ve seen a very big move higher in government bond yields and corporate bond yields on the back of that. Corporate bonds are priced off of government bonds, so they take their lead from the government bond market. So, yields everywhere have risen a lot this year.

And in terms of the attraction – in terms of how long you’ve, sort of, been in the industry – would you say that now we’re in a sort of good space for corporate bonds, in terms of the opportunities in the market?

[01:14] Definitely. If we look at yields this century, we are now back to the sorts of yields that we used to have before quantitative easing started in 2008, and that means we’re talking about yields on the corporate bond fund of around 7%. These sorts of yields don’t happen that frequently. So, I think this is personally a very good buying opportunity, but we have seen a lot of volatility this year. So, capital values have not been immune from this rise in yields.

Is the opportunity across the board? Is it in certain parts of the market? Just give us a bit of an insight on that quickly.

(01:47) I personally think the opportunity is best in high quality investment grade credit, because we believe that a recession is coming everywhere next year: in Europe, in the UK, in the US. And the further you go into junior bonds or high yield bonds, the more your capital is at risk. So, I think to be able to withstand the risks of a recession, stay in blue chip, well-known names like Tesco, like BP, for example, and their high-quality bonds.

Should we just go a bit more into a bit more depth on that? I mean, you mentioned you’ve touched on the impact recession would have on corporate bonds there. Does it matter if it’s a prolonged recession, [or] if it’s a short recession? How would you play that in terms of the portfolio?

[02:27] It certainly does matter whether it’s prolonged and how deep it is. In fact, we have felt the Bank of England have underappreciated the risks. They’re now saying the recession could last two years. I think that’s possibly a little bit too bearish. I think certainly four quarters, or a full year of a recession is very possible.

And what tends to happen with weaker corporates, is that they can get into a position where they end up defaulting on their debt. They don’t pay their interest payments, or they don’t pay their principal repayment. That tends to be a big threat in high yield, but not so much in investment grade. It’s very rare in fact for investment grade bonds to default, unless there happens to be an accounting fraud. But I don’t think this cycle is likely to see a spike in accounting fraud, compared to any other previous cycle.

But there will be a slowdown, unemployment will be a feature; that will lead to weaker growth and all companies will suffer. But investment grade companies will do relatively better I think.

Do you think the opportunity could be even greater at one point in the next year or so?

[03:27] I actually think a lot of bad news is already priced in. For example, we are seeing things like BP with a 9% yield on their very short dated bonds, and, you know, BP’s just had great earnings. Okay, they’ve had issues this year; they’ve had to sell their Rosneft stake (PJSC Rosneft Oil Company) and they’re having a windfall tax applied, but they are still very, very profitable. And I think too much bad news is priced in.

We’re not just priced for a recession in some cases, I would say we’re priced for Armageddon. So, I think the bond market has gone too far, and that’s why there’s an opportunity right now.

Okay. Just quickly on [a] bit more depth in the portfolio, I mean, I notice you have a lot of financial company bonds in portfolio. Is that a particular opportunity, a subset within what you’ve just discussed there?

[04:12] It is. There’s two fundamental reasons we like financials. Firstly, their credit quality is the best they have ever been. We all remember the financial crisis of course in 2008. Since then, banks and insurers have fundamentally changed their business. They’re now much higher quality, and on top of that, they also have some of the best yields available.

For example, we’ve been buying Nationwide bonds recently at a 13% yield. That kind of yield in Nationwide, which has very strong capital ratios, it has tier one capital 24%, making it one of the strongest banks in Europe, if not the world, a 13% yield on their short-dated bonds happens very, very rarely. So, we think that’s a perfect example of the best bond to buy.

Okay. Do you want to give me another couple of examples of some opportunities in this pricing of an Armageddon scenario, a couple of things?

[05:02] Yes, absolutely. Coventry Building Society’s in a very similar space. It’s a 12% yield, but you’ve also got things like BP, which is not financial: it’s benefiting from the high oil price at the moment, still yielding 9%.

You’ve got things like Scottish and Southern [Scottish and Southern Energy – SSE plc], or Vodafone, yielding 8-9-10% for their short-dated bonds. These are investment grade bonds, high quality companies, and you’re getting double digit yields in some cases, even when you’re only loaning your money to these companies for two or three years. We’re not talking about locking it away for 30 years here. It’s a relatively short timeframe and very attractive yields.

And just lastly, I believe you can allocate some of the portfolio to high yield. Could you maybe just give us a quick insight on that? Is that an area that there’s also opportunities in or why would you need to go into that at the moment, given the opportunities in corporate bonds themselves?

[05:51] Yes, it’s more the latter really. We are very, very selective in high yield. We actually have a low exposure to high yield compared to our normal position. We have less than 5% in high yield. But the high yield we have is actually the junior bonds of investment grade banks, rather than, say for example, in a cyclical heavy industrial business where the parent credit quality is high yield.

We prefer strong banks where we can tolerate a little bit more risk in their junior bonds because they’re so well capitalised. But I think … well, we certainly are avoiding the high street, consumer-facing stocks, for example, or deep, cyclical stocks because of the looming threat of recessions.

Chris, as always, thank you very much for giving us your time today.

Thank you. Pleasure.

And if you’d like to learn more about the TwentyFour Corporate Bond fund, please visit FundCalibre.com.