Market Update 5th Sept 2023 – from Jilly Mann, Head of Investment

The question we hear more than any at the moment is: Why do Fixed Interest fund valuations move up and down, when they are meant to be fixed?

Hopefully this update will explain some of the quirks of the sector and how they currently apply to our portfolios.

Let’s start by taking a commonly owned Fixed Interest asset and break it down into its composite parts:

• The issuer of the asset is very important to portfolio selection when assessing how secure the asset may be. The UK Government is considered to be a highly secure issuer and so it has a credit rating of AA currently.

Gilt in blue is the type of asset being offered to the market. Gilts (also known as Gilt Edged Securities were so called because in pre-internet days they were issued as paper certificates edged in gold). Gilts are Government backed assets and so are often sold at a premium when markets are worried about equity returns or global geopolitical crises.

• Lloyds Banking Group Plc wouldn’t issue Gilts as they aren’t a Government, but they would issue corporate bonds for sale instead.

4.25% in green is the coupon attached to the asset. The coupon is the level of Fixed Interest that will be paid annually in return for buying the asset.

2032 in pink is the maturity date for the asset. In essence, it’s possible to just buy this Gilt and accept the Fixed Interest each year until maturity. It is possible to sell this Gilt before the maturity date, but then you are subject to there being a buyer willing to pay the price which you want to sell at. No different to any other buy and sell transaction. What will ordain how much someone is willing to pay is the prevailing economic and market conditions, as well as a buyer’s specific need to generate a set level of income for a set period of time. These buy and sell conditions are often wrapped up in the word liquidity.

• The maturity date of an asset is also known as the duration of the asset. On an individual basis, this may not be particularly relevant, but when looking at Fixed Interest funds, it becomes quite important. The fund we buy has to echo our thoughts on where the value of Fixed Interest assets may be in the future, but equally, we may want a basket of funds with differing duration periods to suit different needs.
  • For example, if a portfolio needs to generate a specific income every month, then we would be looking for funds which have 12 different payment dates throughout the year with a spread of maturity dates to ensure that a healthy level of interest can be generated over time, rather than load up with high interest levels in the short term and forgetting the longer term.

Fixed Interest is to my eyes one of the most complex areas of investment management. The jargon is endless. A coupon can be called interest, or income, or yield, for example. In comparison, if you open a bank account with a fixed rate, it is simply a fixed amount of interest to be added at the end of the fixed term. It does what is says on the tin and at the end of the term, you know exactly what you are going to get without any fluctuations in the value of your deposit amount during the term.

We are heavily weighted towards Fixed Interest assets in our client portfolios at the moment, as we think they offer huge opportunities, much greater opportunities than a simple cash deposit from a bank. Whilst investors don’t need to understand the intricacies of the Fixed Interest market, it is necessary to understand some of the nuances in the asset class to further understand your end return.

Credit ratings

When we are constructing our portfolios, the credit rating of the underlying asset is key. We will have some credit rating diversification within the portfolios, but presently we are heavily weighted towards the higher quality end of the credit spectrum.

Such assets may be UK Gilts, US Treasuries or Australian Government Bonds. These assets aren’t popular or well rewarded when stock markets are flying, or when there is a general level of optimism surrounding the economy. However, when geopolitical risk takes hold, or economic data turns the other way, there is always a flight to these Government backed securities, which typically come with a AAA or AA rating, the highest levels available.

It is important to point out that not all Governments are AAA or AA rated, but if faced with the choice of a US Treasury issuance or an Argentinian Government Bond for example, I know which one I would consider the more secure.

This leads neatly onto Emerging Market Bonds, or Emerging Market Debt (EMD), which refers to bonds issued by governments or corporations in emerging markets. The rewards for owning EMD can be huge and we have owned plenty of EMD over the years. The coupon (interest) available on these assets can reach double digits, but with that comes the risk of the asset not paying out or being significantly affected by currency movements depending upon whether the asset is valued in local currency or US Dollars for example.

Emerging Markets can be more volatile than Developed Markets. As our readers may know, we are extremely defensive with our portfolio positioning at the moment, as we anticipate a major mark down in global equity markets, but EMD is an area that we are keeping a close eye on. The time to reinvest into EMD may well come before other asset classes and may well be driven in part by the strength or weakness of the US Dollar, as a recession looms large.

High Yield is another asset which you will see sparsely in our strategies at the present time. The easier option for us right now would be to load up on high yield assets. Many are offering coupons of over 7%, which looks like a hugely valuable return across a year. The difficulty is that high yield assets behave similarly to equities. High yield assets are typically BBB rated or below by credit agencies. This rating is a lot lower than the Government backed assets we discussed above. Sometimes and perhaps unfairly, these lower rated assets are termed “junk bonds”. The ratings agency will ordain the credit rating of the asset based on the perceived strength of the issuer.

Royal Caribbean Cruises Plc for example offer an 8.25% coupon through to 2029 on a Fixed Interest asset, but their credit rating is BB-, as decided by the global credit rating agency, Standard & Poors. Their credit rating has bounced around frequently post Covid, sometimes higher and sometimes lower, as trading conditions have varied so widely through lockdowns which are entirely out of the company’s control. This bond is therefore deemed to be a high yield asset.

The difficulty some of these types of businesses will face in a recession, is whether they can maintain the same level of customer support if discretionary spending tightens. If core goods are consuming most of a household budget during periods of heightened inflation, less people will have surplus monies to spend on luxury items. This impacts the valuation of the bond on the open market. If there are economic concerns about a particular industry, then less people will be inclined to purchase assets within that industry and that can lead to liquidity woes.

Liquidity risk is the imbalance of buyers to sellers within a market. Not enough buyers willing to buy too much available stock leads to a stalemate in the market. Ultimately, this imbalance can lead to default risk. We have seen liquidity risk many times over the years, but the Global Financial Crisis of 2008/2009 and the ensuing Eurozone crisis of 2011 were particularly challenging examples. During the Global Financial Crisis, anticipated default rates soared and the assets most impacted were high yield corporate bonds, especially those in the financials sector. During the Eurozone crisis, the PIIGS (Portugal, Italy, Ireland, Greece and Spain) saw their Government bond yields soar out of control and they had to be bailed out by the other EU nations, predominantly Germany. Generally, default rate expectations are overstated and often turn out to be less extreme once the situation plays out, but nonetheless, highly rated Government and Corporate Bond assets are more insulated than high yield, lower rated assets.

The graph above charts Global Emerging Market Bonds (blended currency) in dark red, UK Gilts in turquoise, Sterling High Yield Bonds in purple, FTSE 100 in orange and the S&P 500 in Green from the 1^st October 2007 (start of the Global Financial Crisis) to the 30^th September 2010. We expect markets to follow a similar pattern this time once the acceptance of a recession takes hold. In October 2008 the chart above shows that Gilts rallied, then as we moved to the end of the year, EMD outpaced Gilts. Once we had benefitted from the bounce in Gilts, we rotated into EMD, amongst other assets. However, High Yield bonds followed equity markets down, falling over 25% until it started to rally over 18 months after Gilts and EMD assets. Once the high yield market turned, it rose well ahead of equities, but had we owned High Yield at the start of the Global Financial Crisis due to the attractive yields on offer, we would have lost investors a significant sum.

Not all Fixed Interest is made the same which is why understanding the asset class is so important but returns of 63% for EMD and over 26% for UK Gilts over three years are not insignificant, whilst equity markets remained down over 4% for that same period.

A flight to quality often happens during market uncertainty and those assets which are unlikely to default and which are more likely to continue to pay the coupon through to maturity, will maintain and even rise in value despite broader concerns about liquidity in Fixed Interest markets.

If we look at where we are positioned today, our portfolios are heavily weighted towards higher grade Fixed Interest assets. Not because we expect conditions to become as difficult as the Global Financial Crisis or the Eurozone crisis, but because we think investors are so desperate to believe that this time is different and that the alarm bells ringing from the economic data and Central Bank interest rate rises are nothing to worry about, that there will be more of a shock to markets when in our view, the inevitable downturn in equity markets takes effect.

The snapshot below of the Janus Henderson Strategic Bond fund, one of our key Fixed Interest holdings, demonstrates this quality bias clearly:

Why do Fixed Interest assets rise and fall?

The answer lies in splitting the asset down into two parts. Recalling the example at the start of this update, the UK Gilt paid 4.25% as a coupon. 4.25% is the fixed part, the yield as it is sometimes known. That coupon is guaranteed to be paid regardless of what happens to the valuation, or tradability, of the asset on the broader market.

However, the value of the asset will fluctuate depending upon how many people want to buy the asset, where economic sentiment lies and most importantly, Central Bank interest rate decision-making.

When Central Banks raise interest rates this negatively impacts the price of Fixed Interest assets on the broader market. The reason being that if you can earn 4.25% in a bank account guaranteed, why at face value would you invest in a Gilt paying exactly the same amount, but with the potential for the capital value of the Gilt to rise and fall. The relationship is usually; interest rates rise, Fixed Interest valuations fall and as a necessary consequence, Fixed Interest yields rise to match what you can earn on cash.

A fixed term bank account won’t rise and fall. In short, investors need to be rewarded for owning any asset that may fluctuate in value and this is harder to achieve whilst Central Banks raise interest rates, hence Gilt values fall on the open market when interest rates are rising.

If we look at what has happened with high yield assets versus Gilts. High yield assets have still been showing some positive returns, in a similar way to some equity markets of late, but the majority of this return arises from the yield of the asset. The underlying value of the asset has fluctuated and mirrored both the upturn and downturn in equity markets.

The Schroder High Yield Opportunities fund (see chart below) isn’t in our client portfolios at present given that it invests in High Yield bonds. It is the highest yielding fund in the IMA Sterling High Yield sector at present, offering a yield of 8.66%. Over the past 12 months, the capital value has actually deteriorated by 3.02% (green line), but once you add back in the yield (interest), the overall return is 4.12% (red line). If earning an income was the predominant concern, then the interest yield on offer would be highly attractive. If you are seeking a relatively stable valuation for your assets, then a negative return is less appealing. This is a deliberately extreme example, but it highlights the disconnect between the fixed element of the asset and the capital element which is subject to market fluctuation.

For any eagle-eyed readers wondering why the difference between the total return of this fund and the capital value return of the fund don’t equal 8.66%, that is due to the manager rotating the underlying portfolio during the last 12 months. As interest rates have risen, yields have risen and so the manager is constantly looking for new, higher yielding assets to bring in, whilst perhaps selling some of the lower yielding assets in turn. This too affects how the value of a Fixed Interest asset can behave rather than be fixed.

Gilts haven’t been rewarded by the market yet. As interest rates have risen and investors maintain this hope of this time being different, the value of Gilts has continued to be hurt. Despite the average yield for a 10-year Gilt being around 2% for the last decade as interest rates were virtually zero. A yield of 4.25% in that context should be attractive, but not with Central Banks continuing to raise rates further. However, when equity markets have taken a sharp downward turn on the back of negative economic news, or more pertinently, Central Banks indicating the end of interest rate rises, Gilts have risen whilst equities have fallen.

Timing the point at which this sustained realisation in markets takes place has proven difficult as Central Banks haven’t really had a grip on inflation and similarly don’t appear to have a grip on when they will pause further interest rate rises and indeed start to cut. That pivot really can’t be far away as we start to see unemployment rates rise, the property market stumble and significant downwards revisions to key economic data points, which aren’t being widely reported. Revisions always take less airspace than the initial economic data announcements and so can be slipped through the economic press more easily. Nothing like hiding bad news.

The reason to own Fixed Interest assets over bank deposits right now is for the inherent value of both the coupon, duration and uptick in market valuation when it happens. It will be short and sharp and one needs to be invested to benefit from it, because nobody knows exactly when it will happen.

As soon as Central Banks start to cut interest rates, interest rates will plummet quickly in our view. This will feed through into High Street banks, who will in turn offer significantly less attractive fixed term deposit rates, which will especially impact anyone with a maturing account over the next 12 months.

The UK Gilt we examined at the start of this piece offers a yield of 4.25% per annum until 2032. It is highly unlikely that any other asset will provide such a consistently high return for the next 9 years from a secure issuer, allied to a likely rise in the value of the underlying Gilt price. This double whammy matters, because if, as we expect, we see greater opportunities in other areas of the Fixed Interest market, we should be readily able to sell this Gilt for a high price to investors who need a portfolio of AA rated assets with known maturity dates, paying a virtually risk free coupon for 9 years.

Right now is about owning the best assets to future proof the portfolio and to ensure that we are best placed to benefit from the inevitable improvement in Gilt valuations, as well as being insulated from broader concerns that may arise in lower risk credit.

To give you an idea of the potential upside from UK Gilt investments, if interest rates remain at the current level, we expect the return over the next 12 months to be 4.5%, if interest rates fall by 2%, the gain should be around 20% and if they fall by 4% then the return could be as high as 30%.

We want to be owning the assets that other investors need and want to buy, thus allowing us to play the Fixed Interest cycle through the recession and recovery period just as we have done before.