Analysing gilts – a hostage to politics of all persuasions

Postulating that the gilt market currently trades with a degree of a Brexit risk premium hardly qualifies as searing insight.

The most recent aggressive shift downwards in gilt yields – implying almost zero chance of the Bank of England raising rates in the next 18 months – has largely been a function of the negative political reaction to the “Withdrawal Agreement” that the Prime Minister brought to Parliament last week. The political horse-trading that has begun will continue to envelop the debate over the coming weeks, prior to any “meaningful” vote taking place in Parliament (presumably in the middle of December if the most recent media coverage is to be believed).

As the political debate around the nature of the UK’s exit intensifies, attention will inevitably refocus on the economic prospects that any disorderly Brexit would bring. That economic activity would be severely damaged under a “No-deal” scenario is another statement that hardly qualifies as controversial. Less clear however is the likely gilt market reaction to such an outcome. In “normal” economic circumstances, such an economic shock would precipitate a fall in gilt yields and a dovish Bank of England response.

However, the probability of both domestic and especially international lenders to the UK requiring a higher risk premium in such a scenario is something that should not be dismissed. Given the current febrile political backdrop, a possible new (Labour) government that rips up the fiscal rule-book – and conventional economic wisdom around sustainable debt levels – is unlikely to preside over a compliant gilt market.

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Volkswagen drives price

Most things in the bond market have an analogy with cars. So when a car manufacturer’s sticker prices are slashed, don’t expect second hand car values to look too perky. Same for bonds; as we saw this week with Volkswagen’s jumbo $8bn deal. Thus, one of the most obvious risks for credit markets is the capacity for new bond deals to aggressively re-price the secondary market.

Issuers seem determined to raise finance. For VW they offered a discount of around 0.5% to where existing bonds trade. Issuance at borrowing levels that are almost irrespective of the current secondary market pricing does little for the existing bonds’ valuations.

This price insensitivity is a feature of the trickier market conditions that have prevailed over recent weeks. The impact of re-pricing not only impacts bonds from the same issuer (i.e. VW) or sector (car manufacturers), but increasingly also bonds of the same rating in different sectors (ratings of Single A or BBB). This development has been most clearly observed in non-financial credit. Or to get back to cars – don’t expect your BMW 3 series’ value to remain stable if Audi’s A3 is suddenly five grand cheaper!

As ever, identifying what is currently happening is the easy part; the more pertinent question is what to do in such an environment? The re-pricing of credit in the face of such cheap new bond supply we suspect is a trend that is likely to continue, which today encourages a more cautious stance. However, there will be occasional anomalies and opportunities that present themselves. Just because the discount is aggressive doesn’t necessarily mean it’s wise to ignore what’s on offer. After all, if you’re in the market for a car, you need a car and price will be a key component.  And an active bond portfolio needs well-priced bonds. Er… Vorsprung durch Technik.

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Can’t see the Micro woods for the Macro trees?

The market’s focus over the year to date has been dominated by concerns over the potential actions of central banks, and perceptions over the underlying strength of the global economy. Will the European Central Bank taper before September? Does the new regime at the Federal Reserve signal a change in approach to policy? How much will Brexit influence the Bank of England’s Monetary Policy Committee? And just how strong is underlying wage growth in Europe?

Whilst all of these factors are very worthy of consideration – and regularly demand analysis and debate in our own strategy meetings – the influence of bottom-up stock selection, including the term structure of credit curves, is equally as important for high conviction managers.

It becomes even more important in prolonged periods of low macro volatility, which are actually more frequent than a cursory glance of the financial press would have you believe. Actively managing portfolios from a bottom-up perspective and sweating the assets is of most importance in times like these.

If we are able to lend to a corporate for the same potential return for 10 years as we would get over 30 years (an increasingly common feature of global credit markets after the recent period of performance and credit curve flattening) why would we not effect such a switch in our portfolios?

We are continually reassessing our sector recommendations too. Does our telecoms analyst continue to see value in his sector? Or would the portfolio’s risk budget be better expended in a sector with a more stable M&A backdrop and that is less prone to event risk?

Managing fixed income portfolios is often assumed to be all about asset allocation and interest rate risk – at Kames we see the bigger picture.

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G stands for Governance not Green

The explosion in demand for green bonds in recent years has left them looking expensive versus other fixed income securities, with better options available to investors outside this niche part of the market.

Over $100bn of green bonds have been issued so far this year, with the euro-denominated market leading the way after accounting for 43% of all issuance. Investors have been attracted in their droves to green bonds, with market conditions exceptionally favourable for the securities over the past 18 months.

As a result, issuers have generally been able to dictate the terms of new debt and thus rush to create green bond structures. The sector has become overvalued as a result.

We do not want to ruin the party, but we choose to avoid buying green bonds due to current pricing. Where an issuer’s long-term ability to pay is not backed up by the right business model or balance sheet, adding a green moniker to that issuer will not make us invest.

Investors must consider green bonds within the wider context of ESG, and ensure they drill down into the underlying drivers for each bond, rather than focus simply on the notion that they have some level of green credentials. In particular, investors need to be aware that the underlying risk from green bonds is not ring-fenced from other debt the company may have issued.

Our belief is that green bonds should be treated much like any other anomalies; we will seek to exploit them. Where we can lend to an issuer for the same length of time, with the same security, and support a green project – that is great. But we are not in the business of lending money to the disadvantage of our portfolios and clients where the cash raised by those issuers is fungible with the rest of their cash pile and our security is ranked along with all their other debt in the issuer’s general corporate purposes.

Green investing should be actively encouraged, but not at prices or in companies that could otherwise not pass investment scrutiny. A strong business model and good governance are key to our process and ESG success. That ‘G’ stands for Governance, not Green.

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A green opportunity, but at what cost?

Green bonds have grown in prominence over the last couple of years, with a company’s ESG (Environmental, Social and Governance) credentials assuming ever-greater importance for investors. The terminology used to describe green, or ethical, bonds – and the definition of investing ethically – can often be interchanged to such a degree that the end investor is left with an incorrect understanding of the difference, and perhaps a lack of appreciation of the risks.

Dedicated green or ethical bonds are sometimes issued by established blue-chip corporates (e.g. Lloyds and SSE have issued green bonds in recent times); the proceeds of such issuance is essentially ring-fenced by the issuer to fund socially responsible or environmentally-friendly projects. Liquidity in instruments issued by such well-established entities is typically as deep as would be the case with the rest of such an issuer’s capital structure.

Unfortunately the same liquidity is rarely as prevalent in green bonds issued by unlisted entities, regardless of how “green” the opportunity may be. The substandard issue size of such bonds (very often less than £100m outstanding), combined with the lack of disclosure limits the scope that such bonds can be bought or sold in the secondary market. It is this trade-off between maintaining liquidity in an investor’s portfolio, whilst maintaining their overarching desire to fund responsible and environmentally-friendly businesses that perhaps deserves greater attention than it is given.

One avenue that facilitates an efficient combination of the dual requirements of investing ethically without compromising liquidity is to invest in an ethical fund. At Kames we have managed ethical portfolios since 1989, with an independently administered “dark green” screen in place to ensure that the portfolio’s investments are consistent with the expectations of our client base. The end investor has regular disclosure on the nature of the fund’s exposures, whilst they can also sleep well in the knowledge that their investments have daily liquidity.

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Prime time to checkout Amazon?

Amazon is a company that polarises opinion in the investment world. It has been variously described as the biggest not-for-profit organisation in the world to one that epitomises the new technology world we live in, a company that is at the vanguard of the equity-market-favoured “FAANG” quartet (comprising Facebook, Amazon, Apple, Netflix and Google).

Whilst there can be no disputing the incredible equity market performance it has exhibited this year (the equity is up more than 30% in 2017), it is fair to say that the credit rating agencies also have sharply differing views too – in their case on creditworthiness. It is not uncommon for Moody’s and Standard and Poor’s to perhaps differ by a notch or two in their assessment of an individual credit, but it is rare for them to diverge by four notches as they do in the case of Amazon. Moodys rate Amazon at Baa1, with Standard and Poors assigning one of its highest ratings for a corporation at AA- .

As part of its ongoing strategy to be a one-stop shop for all consumers, Amazon recently announced its intention to acquire Whole Foods Markets Inc, a takeover that would give the e-commerce giant more than 460 physical stores. This week saw the company issue a multi-tranche (7 dollar issues) deal to raise $16bln and help finance this acquisition. We viewed the 10 year tranche, initially to be priced at 110bps over the underlying US Treasury, as good value relative to the secondary market curve. However, spill over from equity market enthusiasm ensured the deal finally priced at spread of 90 over for Treasuries. A stretch too far for us; the deal left investors with little value and Amazon with a very competitive cost of funds.

The Amazon example is very representative of our investment style; we try not to be too dogmatic in our assessment of individual credits; we look to buy good investments, which is not always the same thing as buying a good company. We will leave “not for profit” investing to the experts – like Amazon.

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