08 Apr When diversification is wasted effort
The title of this newsletter is more than slightly ‘tongue-in-cheek’. Our starting point for any advice is one of diversification. After all, one of the oldest adages in the finance world is that the only investors who do not need to diversify, are those that are 100% right, all of the time!
The reason I mention this is that most of the weekly newsletters produced so far during this crisis have focused on the stock market, or equities. Whilst this is deliberate because CDC is generally overweight in equities, we should not overlook other key areas of our investment strategy, one of which is fixed interest.
I said in a previous note that sometimes the best investment decision is to do nothing, and that is especially true in times of uncertainty and volatility, such as we have seen. Whilst I am still of that view, and as the CDC Investment committee is meeting this Thursday, I wanted to share our thoughts on one significant opportunity we see emerging, which sits within the fixed interest space. First, a brief explanation.
The fixed interest area is a broad church but in simplistic terms, they are loans, either to governments or corporations. The issuer, say the government, borrows money from investors over a defined period of time, and in return makes interest payments until the capital is repaid at the pre-determined time. Wealth Managers like CDC tend to use fixed interest as ‘ballast’ to provide defensive qualities to a portfolio and because they are loans, they behave differently to stocks most of the time.
In very general terms we can split the fixed interest market into three broad categories- Gilts, Corporates and High Yield, though there are many nuances within this. Gilts (in the US they are called Treasuries and in Germany, Bunds) are loans to government and because governments, particularly those in developed economies, tend not to default on their loans, these are by and large, pretty rock-solid.
Corporate Bonds are a step up the risk ladder and are loans to corporations such as Tesco and Marks and Spencer. Quality firms also have a good track record on servicing their debt so these are also seen as safe, but because companies can hit financial difficulties or even go bust, investors demand a higher yield in the form of higher interest payments, to compensate them for the additional risk when compared to lending to government. This is called a risk premium.
High Yield bonds work in exactly the same way as corporate bonds, but here lending is to smaller or younger firms, and companies with weaker balance sheets. Again, investors need to be compensated for taking this additional risk.
Within our strategy we dislike government bonds because the yield on a 10 year gilt at the time of writing is a miserly 0.3%. Ten years ago the yield was over 4%. The picture in Europe is even more acute, with the 10 year Bund yielding -0.5% (which actually means investing £100 to get £99.50 in return). The reason the yield is so low is two-fold. First is the expectation that inflation and interest rates will be low for some time. Second is there has been a flight to perceived safe havens, which has increased the price and depressed the yield on gilts to all-time lows. The panic around COVID19 has merely made matters worse in our opinion and we just do not see any value at all in gilts. This is especially so when you consider the huge increase in government borrowing. Whilst the commitment to guarantee workers’ salaries and provide safety-nets to business during the coronavirus lock-down is admirable, it comes at enormous cost and that is borrowed money. Put more simply, the government will have to issue gilts on an unprecedented scale and that will impact prices in our view.
Where we see opportunity is in the High Yield area, which we already use in some of our portfolios. One of the ways we measure the attractiveness of High Yield bonds is the size of the risk premium compared to government debt.
From the chart above, you will see that since the financial crisis, the extra yield (risk premium) for investing in High Yield is usually between 400-800 basis points, or more simply 4-8%. At present the average yield in this area is comfortably over 10%, and the premium over government debt has spiralled up to over 9% (9.15% to be precise). This is too high in our opinion and historically when the risk premium has moved over the 8%, this has led to a sharp recovery in High Yield Bonds.
Of course, we need to remember that these are companies which are not as financially robust as the likes of Tesco, so some could well hit the skids if there is a severe downturn, as seems likely. We call this the default rate. In the chart above, during the financial crisis, you will see the yield premium spiked to almost 20% because investors were worried about organisations defaulting on their debts. At a 20% yield premium, the market was pricing in a 40% default rate. The actual default was nearer 15% and once realisation set in, the High Yield market returned investors a whopping 57% in 2009. We think history might be about to repeat itself.
The next chart compares the yield premium via the blue unbroken line (right hand scale), with the shaded blue area (left scale) representing defaults, which you can see currently sit around the 4-5% mark.
We do expect the default rate to edge up, and we think the energy sector will bear the brunt of this as it struggles to cope with oil at less than $30 per barrel. But overall, we feel the market is being unduly pessimistic and completely overlooking the fact that the financial stimulus packages are around twice that, not to mention more immediate than, witnessed during the global financial crisis.
Finally it is worth a reminder that High Yield bonds are essentially loans. This is significant because if the worst does happen, and a corporation encounters difficulty, bondholders rank higher than shareholders, meaning their interest payments take precedence over dividends, which does at least provide some degree of assurance.
Whilst at current levels we do not see value in moving out of equities to seize this opportunity, we are critically assessing our existing fixed interest exposure to make sure we have the appropriate emphasis within the corporate world. Of course, we can never be entirely sure that locking in to a 10% yield in this area represents the absolute pinnacle, but based on past experience, we think it represents the best value in the fixed interest space right now.
Dr Andrew Mann