(VIDEO) Emerging markets update – July 2020

Adrian Hull, Head of Fixed Income UK, is joined by Jeff Grills, Head of Emerging Markets, to discuss the EM themes that have been picked up in our portfolios, including a review of Q2 2020 and an outlook for the rest of the year.

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A giant step for the EU

I first wrote about the European Recovery Fund (ERF), as part of the ‘Next Generation EU’ Recovery Plan, in early June (Next Generation EU – Testing the Water). This was agreed at the recent EU summit and is more or less in the same form as the original proposal, maintaining its ground-breaking large fiscal transfers between countries. This is transformational for the way the EU and the Eurozone is both perceived and funded, with the EU vastly increasing its presence in capital markets.

The EU will issue up to €750bn of debt over the next few years. So how big is that in comparison to other debt markets? Using the market value of the FTSE Russell World Government Bond Index (WGBI), the German Bund market is around €1.5tr – so, although the new debt will be a sizeable alternative, at approximately 50% of the size of the Bund market, it is unlikely to take over its benchmark status for the moment. It will, however, increase the amount of AAA-rated bonds available to investors, substantially eating into demand for other AAA markets.

At time of writing, we have no visibility on the maturity profile or size of immediate debt issuance. The ERF is expected to start making disbursements in 2021, but it is possible that the EU could start to pre-fund, taking advantage of current low levels of interest rates. Of course, all other sovereign nations in the EU are also increasing issuance to help fund government spending through the Coronavirus emergency, but the agreement of the ERF will mean that, for the most indebted and most effected countries, potential issuance is reduced on a relative basis. The fund also aims to boost economic growth in those countries, thus helping to contain debt-to-GDP ratios as well as debt in absolute terms. However, the nature of the crisis does mean that debt levels in absolute terms and relative to GDP will still be rising, despite the agreement.

Surprisingly, given this increase in debt, yield levels are expected to remain low for the foreseeable future. The European Central Bank (ECB) is not expected to change the level of interest rates for years to come, and remains committed to all asset purchase programmes. This new EU debt is eligible for purchase by the Euro system and is likely to feature in purchases under both the Public Sector Purchase Programme (PSPP) and Pandemic Emergency Purchase Programme (PEPP).  It shouldn’t be forgotten that one of the aims of the ECB is to reduce fragmentation of markets in the Eurozone. Therefore, we would not expect ECB purchases of the new issuance to be made at the expense of purchasing from the higher-yielding nations of the currency bloc. It is more likely that future purchases of core markets are reduced.

Finally, is this the first step towards common funding? That would appear to be the case as it is easier to agree to common funding if you have common revenue – and that is embedded in the agreement with proposals for an EU-wide corporate tax, digital tax and environment taxes.

The next step may be many years away, but for the EU this is a giant one.

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No dearth of opportunities any time soon

Last week, the Financial Times ran an article bemoaning a dearth of opportunities in the government bond markets. Quantitative easing (QE) and zero interest rate policy has sat heavily on the market and discouraged volatility, but has also quashed any expectations of change any time soon. It is strange that this response to the vast supply of government bonds we see today is the same as it was to having no supply of government bonds over twenty years ago.

Back then, in 1999 and 2000, the UK’s public finances were in rude health. Debt was being repaid as a booming economy, 3G auction receipts and balanced public spending swelled coffers. The concern was of a trajectory showing the government would have no debt in twenty years’ time – what were we to do without any government debt? What a difference a financial and public health crisis can make to public finances.

The current concern over a dearth of opportunities stems from the fact that in the UK, all the incremental supply to support the Covid-19 response has been funded by the Bank of England, thanks to QE. This is similar to other major countries’ policy response. But as we learnt twenty years ago, the trajectory of today’s expectations rarely comes to pass and projecting today’s extreme of expectations may prove foolhardy. There are plenty of opportunities ahead: the prospect of negative rates, future higher inflation, geopolitical turmoil or trade wars; or simply the upcoming US elections and the UK’s exit from Europe. Whilst many of these may lead to uncomfortable outcomes, they will not lead to a dearth of opportunity.

None of this is to say that material volatility in government bond markets is imminent, but rather expectations of no volatility are exaggerated. Expectations will differ for those who look at Japanese government bonds (JGBs) or Italian government bonds (BTPs). For the UK, upcoming net supply is set to be priced by the market rather than solely the Bank of England – and Andrew Bailey has suggested the future unwind of current policies starts with selling back government bonds to the market rather than raising interest rates. Given the Bank of England has £700bn-odd of Gilts available, there will be opportunities ahead.

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Boohoo indeed!

The recent case of the UK-based fashion house Boohoo has shone another spotlight onto the importance of responsible investing AND the resulting fallout if companies are found deficient on the ESG front. Boohoo’s share price is now down 43% from its recent highs, as three major retailers announced plans to drop the brand over as yet unproven allegations of low pay and unsafe conditions at a UK supplier. This once again highlights the perennial difficulty of ESG investing and the gathering of relevant information to make the appropriately informed decisions. In this case, Boohoo has no corporate bonds outstanding, but issuers in the bond markets have taken swift actions to dissociate themselves, such as Next plc which has temporary suspended Boohoo products from its website.

The vast majority of asset managers (including AEGON AM) will use third party providers as a sense check to aid their own in-house ESG analysis. A quick perusal today of two of the main ESG rating providers shows that in the case of Boohoo, one rates the company highly whilst another ascribes a medium risk assessment.

This poses a challenge to effective ESG investing especially the “Social” element. Experts and the company’s customer base have not sniffed out these issues and analysts sitting in Edinburgh, London or New York are also likely to struggle. Increasing disclosure by companies may just be paying lip service to the issues. What is clear is that one can’t rely solely on third party assessment and this reminds us of the advantages of being an active and often sceptical independent investor.

As themes of ESG and responsible investment become ever more popular, scrutiny from all angles will increase and this is where the glimmer of hope lies; the rating agencies are paying ever more attention to ESG issues and we anticipate that ESG gradually becomes part of the annual audit process in many jurisdictions. However, the more sceptical have commented that as both accountants and rating agencies are paid by the institutions they are assessing, the final assessments might not be as independent and impartial as required.

In a corporate world with global supply chains resulting in a proliferation of subcontracting and foreign jurisdictions, there will always be Boohoo scandals to be uncovered, and not just in the retail sector. However, the market response to these issues and the public demand for ever more scrutiny means that corporations worldwide should be paying more attention to these issues in order to continue raising ESG standards across the board.

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(VIDEO) Fixed income outlook 2nd half 2020

Adrian Hull, Head of Fixed Income UK, is joined by Sandra Holdsworth (Rates), Iain Buckle (IG), and Tom Hanson (HY) to discuss the outlook for the fixed income markets in the second half of 2020.

Click here to download a copy of the slides used in the video.

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Always something to worry about

There is plenty to worry about in the world right now, whether that be the global pandemic, the uncertain economic impacts of this recession, the normalisation of interest rates, or what nobody seems to talk about anymore….Brexit!

But if we are completely honest with ourselves, we always have a tendency to worry about something. Bank of America publishes a credit investor survey every month and it always surprises us that the market can come up with such a broad range of things to worry about (as can be seen in the chart below). Now, that is not to say we should disregard these concerns; indeed we should be aware of them within our investment decisions. But we should always be mindful to give them the proper risk weights within our thought and investment processes.

Back in February, we asked the question – “Why do we panic?” The answer is uncertainty. Uncertainty will always be there – after all we are trying to predict the future and anyone that tells you they know what is going to happen is either a liar or a lunatic. We base our decisions on probability and risk-adjusted outcomes. The famous investor, Howard Marks, talks about the market being a pendulum that swings from greed to fear. It’s not always easy to tell where you are.

Expensive markets get more expensive and cheap markets get cheaper, but following a proven, robust investment process and taking a long-term approach (without getting too caught up in the day-to-day noise of headlines) is always a sensible strategy.

Source: Bank of America

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Next Generation EU – Testing the Water

The European Union President, Ursula von der Leyen, presented the first draft of the EU recovery plan “Next Generation EU” last week. This initiative, should it come to pass in its current form (or close to its current form), will go down in history as the moment that the collective states of the EU dipped their toes into fiscal union waters. Of course many are cynical that this will happen – the water might just be too cold.

This comes after the worst health crisis for 100 years, the worst economic crisis since the Great Depression and at a time when the President of the European Central Bank, Christine Lagarde, has been telling her political masters that the Central Bank will do what it can, but is running out of monetary ammunition. None of this has passed Angela Merkel by. The Chancellor of Germany, and arguably the most influential leader amongst the EU nations and importantly the leader of the richest country in the Union, is in her last full year of power.

These three women have decided that now is the time when the EU should take the first steps towards fiscal union – the part that needs to evolve if the monetary union is going to be sustained. This is not complete union but a step in that direction, binding the nations of the European Union ever closer as they make joint financial liabilities in pursuit of funding economic recovery.

The plan involves raising €750bn from the public debt markets to fund a series of grants and loans to be spent across the EU on a number of initiatives. These come under the broad headings of Supporting Member States to Recover; Kick-starting the Economy and Helping Private Investment; and Learning Lessons from the Crisis – all under the umbrella aim of Investing in a Green, Digital and Resilient Europe. What has surprised many has been the mix and scale of grants (€500bn) and loans (€250bn) rather than the scope. Grants tend not to have to be repaid and come with less conditionality than loans, and it is the scale proposed that is highly controversial amongst EU members. Some countries would prefer more conditionality and more repayment (i.e. loans rather than grants). Already the so called “Frugal Four” (Austria, Netherlands, Sweden and Denmark) have expressed their dissatisfaction.

The immediate financing comes from the bond markets. But the EU debt will have to be repaid in the future. To do this the European Union will have to raise revenue, increasing what is known as “additional new own resources”. To do this the EU is proposing to increase the ceiling on member country contributions to closer to 2% of country level GDP. Also there is the proposal of EU wide taxes, the often talked about digital tax, carbon and emissions taxes and the suggestion of a corporate tax on companies that benefit from the EU single market. All of this is still to be debated and agreed upon of course, but this could be the genesis of an era of larger EU budgets with tax and spending powers. The size of the current plan is meaningful at around 5% of GDP at an EU level, as compared with the existing budget of around 1% GDP. It could be the first of a series, depending how electorally and politically popular it becomes.

The money will be distributed according to a number of programmes with some countries benefiting and some countries contributing. There is a direct fiscal transfer of €300bn from contributors to beneficiaries. This, if it is agreed upon will be a significant moment in the EU‘s history. It goes some way to remove the existential risk of the euro and thus the financing premium that some countries pay for debt. It starts to remove the country risk for investment as EU members are more closely financially intertwined. The chances of sovereign debt crises begin to recede, leading to a more stable economic environment across the EU and benefiting the region as a whole.

What is interesting, but purely hypothetical to think about, is whether this could have ever been possible if the UK had still been a member of the EU. The UK almost certainly would be a net contributor rather than a beneficiary from the programme. EU contributions would almost double and as a result it would have been highly likely that the UK would veto the plan. The three most powerful women in Europe will be delighted to have avoided this obstacle, allowing them to take the step no one thought possible. Ironically, many UK commentators forecasted the demise of the EU after the UK departure. I would suggest the opposite, the absence of the UK has made a stable EU economic environment more likely. The UK government and their Brexit negotiators should take note.

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The price of lockdown

The office for National Statistics (ONS) has released its inflation data for April. The Core Price Index has fallen from 1.5% in March to 0.8% in April, which is the lowest number since August 2016 and reflects the economic impact caused by the first month of the coronavirus lockdown.

Interestingly, the price information on 16% of the typical basket of goods that the ONS analyse could not be collected due to difficulties caused by lockdown restrictions, or it is simply not currently available. This includes, for example, what a plumber would charge or what a cinema ticket would cost – activities which are not allowed at present.

For these non-available items, the ONS has substituted-in the average inflation rate of the rest of the basket that can be observed. Given that energy costs and the oil price are significant drivers of inflation, the Ofgem reduction in its default tariff cap and the global slump in oil have resulted in a compounded downward effect on inflation.

Inflation should trough around August, with some analysts believing that we are heading towards a zero rate. But is this likely to bounce back later in the year? I think that the key influencing factor to watch, as mentioned previously, will undoubtedly be the oil price.

Yet, if we are at a stage where the ONS has full data on the inflation basket we will also have exited the lock-down as we know it now. Businesses will have clearer information to set their prices and it will be intriguing to see the resultant variations we get on inflation rates.

It is not outwith the realms of possibility that prices will continue to fall across the board. Yes, there will be stock to be shifted and clothing retailers in particular could be inclined to offer discounted sales. However, where there are supply issues in meeting the demand of consumers as they come out of lockdown, the consequence may be some upward pressure on the price to be paid. It is this nuance which may not be immediately picked up amongst the predictable clamour to prematurely proclaim the end of inflation.

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Hopeless inconsistencies

On Friday, after the market close, rating agency S&P left Italy’s rating unchanged at BBB with a negative outlook. So let me think, Italy was on a negative outlook, the world has locked down due to the coronavirus, Italy has committed to spending even more money that it doesn’t have, and the rating is unchanged and still on negative outlook? 

So what did the agency give as reasons for the unchanged rating?

They said that Italy is an open and diversified economy with low levels of private debt. Well yes, but that hasn’t changed in any way during this crisis, so how can this be a counterpoint to the increase in government debt to an estimated 153% of GDP? Well I’ll tell you how – because the ECB are going to buy it. The review hints on numerous occasions that the ECB is Italy’s “backstop” to be able to finance its debt pile at real interest rates of “around 0%”.

They go on to say that Italy has private debt levels lower than Germany at 110% vs 114%. Is that a good thing? Italians have a high propensity to save, so is this not a symptom of low investment, not a counter balance to the high levels of government debt? I wonder if they are going to give the Germans a ticking off for their elevated levels of private debt relative to Italy when they do their next review?

Where did they admit they could be wrong?

If the debt path fails to improve over the next three years then S&P noted that they could lower the rating. They assume an end-of-2020 debt to GDP of 153% and deficit of 6.3%, where on Friday the Italian government produced estimates of 155% and 10.4%, so they are already behind the curve on the day they have released the review. 

What about Greece?

S&P also reviewed Greece on Friday, downgrading the outlook to stable from positive due to the fallout from the coronavirus pandemic. Does it seem to anyone else that there is some inconsistency here? Or is it just the fact that Greece is already junk and Italy is sensitively close to the sub-investment grade rating? 

I will let you decide for yourself if there is a smell of Italian sardines here, but not to worry, the ECB is at the dining table. 

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Rating the credit watchers

The Covid 19 crisis has re-written the playbook for crises in the financial and economic world. Crises are usually a build-up of excess in one form or another; too much overseas borrowing (1997-98), inflated tech prices (2000-2001), too much leverage and debt (2007-2008). And with each crisis there has been the “How come the experts missed this” and what were the credit rating agencies thinking? Not this time. This crisis is a virus and impacts humanity with tragic consequences – and allows the ratings agencies to respond to events as they unfold.

So on Friday S&P did not change their BBB rating on Italy which was already on negative watch. Given the impact of the virus is likely to shrink the economy by 10% and take debt up to 155% of GDP it might be reasonable to say S&P were being charitable, possibly even political. But elsewhere the debt picture is equally gritty and the agencies are being less charitable, indeed, the number of negative rating actions across the corporate and structured world has increased materially since the beginning of March, with agencies giving little benefits and indeed credit to large swath of their rated universe.

The focus for markets to date has been on the quantum of ratings migration. With over $150bn of investment grade debt exiting the IG market to become high yield these “fallen angel” issuers have already topped the number in 2009.  Whilst Ford and Occidental Petroleum are the largest components there are expectations that this number will top $300bn by year end. With fallen angels exiting the Investment Grade market there could, mechanically, be an improvement in quality; in reality the nature of this crisis means there will be further debt issuance and more BBB issuance – so that is not to be. But the High Yield market is likely to increase by well over 25% as the fallen angels enter its universe.

So what should we expect from the rating agencies? Whatever construes a lenient approach should not be expected. Paradoxically, in an odd turn of events regulators such as the Bank of England are suggesting banks should be less prudent in provisioning to ensure they are not “clogging up” their capital; against this banks are likely to see 100% government guaranteeing of SME loans – none of this makes for a straight forward assessment for the agencies. And whilst banks and insurance companies hold a special place in the financial plumbing, the airline, hospitality and retail sectors do not.

Whilst support may be forthcoming for national champions such as Air France, the rating agencies tackled grounded fleets with downgrading the likes of IAG and Ryanair way back in late March. Issuers such as IHG (Intercontinental hotels) and Next have also been placed under review. Their ratings are in hand of government’s lock down trajectories and whatever is the new normal for industries figuring how social distancing works with customers they used to herd.  So far for this crisis the rating agencies are up with events but we are barely two months into the crisis and uncertainty still prevails.  Rating agencies decisions are not without material implications or cost for issuers – and themselves.

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Let the buyer beware

As Europe and the USA debate lifting their COVID-19 lockdowns, investor thoughts are increasingly turning to a post-lockdown / pre-vaccine world. Following unprecedented levels of support announced by the Fed, the ECB and the Bank of England, one could argue that recent corporate bond performance has yet to fully reflect divergent prospects across sectors.

There is much to consider. Exit strategies still need clarification. Will we have a staggered release of the population, with those under the age of 40 leading the charge back to work? Which industries will reopen first? (Spain restarted construction activity last week, but will the same pattern follow in each country?) Trump’s three phase reopening plan gives guidance at a federal level as to the order of reopening. Leaving aside the potential for individual state governors to demur, it’s interesting to see large restaurants and sports venues included within Phase 1, notably with the proviso that strict physical distancing protocols should be in place.

Some form of social distancing is certainly likely for the next few months and too few appear to be questioning the impact of this on consumer behavior and demand. Not only is mask wearing and observation of the two metre rule likely to dramatically reduce consumption in many industries (particularly leisure and retail), it will also increase costs due to lower capacity utilisation as well as increased spend on cleaning and distancing management. Has this adequately fed through to company estimates and asset prices? Or does this matter less when there are buyers of last resort with seemingly bottomless pockets? Last week we saw new car sales had plummeted to unprecedented lows, yet Ford, newly returned to high yield territory, was able to tap the US bond market with ease.

For some industries, it’s clear that the effects may be fairly long-lasting and certain sectors are clearly going to take the initial brunt of the crisis – namely the travel related industry. For other industries, credit assessment needs to be more nuanced. For example, the performance of gaming bonds is dividing fairly neatly into those companies with a significant online presence and those that rely on large public gatherings (casino and bingo hall operators). Furthermore there are many seemingly ‘safer’ credits that have large earnings exposure to social gatherings – Diageo has already predicted a large hit to earnings from its bar and restaurant business. And what about the utility-like public transport operators? Will the recent experience of home working and ongoing fears for personal safety result in ongoing lower use of public transport, well beyond the lifting of the curfew?

The staggered nature of this crisis across the globe gives a good insight into what might happen in the next stage and, worryingly, highlights the risk of second waves of infection. China may have re-opened, but it’s definitely not yet business as usual. There is likely to come a point when the discrepancy between economic reality and asset prices becomes unsustainable; the phrase ‘caveat emptor’ (let the buyer beware) has never been more appropriate.

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Details that blur the future in fixed income

At a headline glance it seems there is some calm returning to the financial markets. Equity markets are up 10% over the last month, sterling is back to around $1.25 and government bond markets are exhibiting some of their tightest ever-trading ranges in April. However, there remains gargantuan uncertainty ahead. Beyond the questions asked here of “Who pays?” there is also the growing changes in quality of data and markets.

Take inflation. It is not unreasonable to expect that the collapse of the economy will lead to deflation. We know toilet roll and hand gel cost more but to offset that package holidays will cost less. Yet what is the inflation (deflation) of a product that no one currently buys? And indeed, is the correct outcome to record a theoretical inflation number or a practical one? One of the premises of UK inflation is the manner in which products move out of, and into, our typical basket of goods.  For example, we now account for smart phones rather than vinyl. How this changes will have implications on everything from next year’s season ticket to RPI-linked bonds’ coupon payments.

And take central bank corporate bond purchases. Each central bank has responded in a way they believe is appropriate. Whilst the Fed has proved most expansive (announcing last week the purchase of BB-rated bonds) investment grade assets are very much front and centre of what central banks will buy. In the UK, this is the third time the Bank of England has purchased corporate assets since 2009. Given we have a well-trodden path of bank support it is not obvious why any corporate would want to be rated A. The ECB is set to purchase up to half of their “eligible” corporate bond universe by year-end. Credit market concerns in 2018 around the increase in BBBs to 50% now seem rather quaint, but 50% is now more likely a floor for BBBs (as a % of the overall indices) as the economic impact of Covid-19 send ratings lower.

The quality of markets is relevant to government bonds too. And not just in the most obvious ratings way; Fitch downgraded the UK to AA- at the end of March and markets will be on tenterhooks to see how Italy’s current BBB negative outlook rating is treated by S&P next Friday (24th at 10pm) – remember, the ECB prefers investment grade debt. The quality of markets is an elusive term but captures the sense of a free and fair market. The Bank of Japan has intervened to buy 10-year government bonds if they drift north of 20 bps since 2018. The Bank of England is stepping up its ownership of gilts to beyond one third of GDP.  The Fed has “infinite” capacity to purchase. Central bank policy – and details around that – are the key determinants of market value and the current aim is to crush volatility and see subdued rates for a long while to come.

These details and observations create different frameworks and value structures and do not detract from the immense monetary effort that has been corralled to deal with 15m unemployed in the US (as estimated by initial claims) nor the potential  collapse in the size of the UK economy by one-third in the second quarter but will create differing rational responses – some of which we can only start to imagine.

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Who pays?

There is a sigh of relief in markets as the long Easter weekend approaches. Sadly, too many are suffering or worse from the cursed virus and many millions of key workers will be providing support to ensure “the lights stay on” for the rest of us.  However, we know that many companies and industries will be able to access cash; furloughing staff (rather than redundancy) is happening however, it is on what terms that cash is available and ultimately who pays that matters.

Today, the government announced further borrowing through its “Ways and Means” account. This is Her Majesty’s Government’s overdraft. As uncertainty continues and the bills mount, the overdraft provides the ability for HMG to write the cheques. As the overdraft gets bigger, the Bank of England will refinance the overdraft via Gilts. At a time of crisis it is fortunate that the Bank of England can print money; it is currently set to have bought a further £200bn of Gilts and corporate bonds by July. But will it be enough? Given that the £435bn of debt that Bank of England accumulated in various rounds of QE since 2009 have never been repaid, what is the likely political will to pay this £200bn (or more)?

And so it is in Europe. There are general warm words to help one another, but details failed to be agreed by the European finance ministers during their 16 hour teleconference on Wednesday. The European Central Bank is actively spending up to €1tn but in a potential re-run of the Euro crisis, Spain and Italy – in the eye of the humanitarian crisis – are not hearing warm words from the so called “frugal” countries in northern Europe. The Netherlands, Germany and others are not inclined to share the financial burden by having joint responsibility for new debt. Joint responsibility for debt at an instant puts an end to Eurozone crisis but there remains little likelihood that there is the political will in Germany and elsewhere to pay.

But some are paying. Shareholders of some of Europe’s largest insurance companies are following the Banks and not paying dividends. But EIOPIA’s (European Insurance and Occupational Pensions Authority) writ runs less large than that of banking regulators. As we saw last week, a letter from the PRA can stop banks’ dividends and curtail bankers’ remuneration. More of a mixed bag this week from insurers that currently leaves Legal and General paying its dividend but Aviva not. Dutch insurers were advised not to pay dividends but there is a more mixed response in France.

And savers are paying. With effective cash balance rates now at zero, savers will need to look elsewhere for income. Dividends from corporates are now very uncertain with companies like Tesco also under the spotlight. And for all of the government’s largesse, Rishi Sunak talks of loans. Someone will need to repay at some stage; for all of the financial engineering we have seen over the past weeks it would be naïve to think that taxation is headed lower – COVID 19 in many ways is a great leveller.

As and when we return to normality it will not be as it was. There will be long and visceral debate – which has already started – about who pays. 

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…nobody thought that…

“Why did nobody see it coming?” was the question Her Majesty asked in 2008 of the financial crisis. From an investment perspective it is always good to review successes AND failures. The phrase “nobody thought that…” has been used in our virtual conversations many times recently and it helps encapsulate some of the dramatic events over the first quarter of 2020.

Nobody thought that way back in early February a virulent virus in the Wuhan region of China would collapse the global economy. Today’s estimates vary but global GDP is expected to contract in 2020 by around 3% from a previous expectation of positive growth of around 3%. For the year overall we should expect a 6% collapse in UK GDP too, from around 1% growth forecast at the start of the year. To put it into context, it is the worst collapse since the post-World War One contractions in 1920 and 1921, and worse than 1931. As the 6.6m weekly increase in US initial unemployment claims shows, this is truly horrific.

And nobody thought that interest rates would be cut to zero in the US within a fortnight. The scale of central bank intervention is truly staggering and, for the UK, at 10% of GDP mirrors the announcement from the Bank of England in March 2009. The Bank of England is currently buying £13.5bn of gilts a week. We have witnessed other quite incredible events; nobody thought that a geopolitical OPEC spat between Russia and Saudi Arabia would take the oil price to $20, lower than 2016, and materially lower than 1986 when adjusted for inflation.

So it is no surprise to see that in the last 10 days US investment grade spreads have touched levels not seen in over 30 years. No one could have predicted a 100 point price fall in the longest index- linked gilt in 10 days (from 300 to under 200). Similarly, in a rapid and unprecedented turn, moral and real regulatory pressure was placed on banks with a suspension of dividends for many major banks across the globe. This provided anxious subordinated bond holders (e.g. AT1 bonds) further worry, albeit these coupons seem safe for now. As with any investments, a turn of events driven by politics rather than contract can have unintended investment consequences and strengthen the chorus of “nobody thought that could happen”.

As we write our reports for the first quarter we will recognize good decisions; long duration, reduced credit exposures along with bad decisions, including exposure to oil companies and retailers. Such has been the ferocity of moves and prices that positioning for 1 March could be spectacularly wrong by mid-month. Many rational judgements have been destroyed as March played through and events happened that nobody thought could happen.

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Funding to stay afloat

Carnival Cruise Line is in the market looking for $4bn of funding to shore up their balance sheet. With the current restrictions in place regarding sailing, the business is in desperate need of liquidity to stay afloat. The company initially came to market with a multi-tranche deal, selling notes in both US dollars and euros, making this the first euro high yield new issue since the market downturn at the beginning of March. The euro leg of the deal was dropped before books were set to close and the dollar bond sale was bumped up from $3 billion to $4 billion. This move highlights the continued weakness in European high yield and the hesitance from companies to issue debt in this market.

Just one month ago Carnival was rated A- but has since been downgraded to BBB- as the coronavirus restricts the business from operating. Subsequent to this new deal the business will have enough liquidity to survive until November. However, this funding comes at a cost. Despite the investment grade rating, investors are expecting an attractive compensation on the notes, of over 11%. The new bonds which are only three years in length are secured on the majority of the company’s fleet as well as other assets, with a combined book value of $28bn. Optically this suggests that that debt is extremely well covered should the business run of out of liquidity. With only 0.6x turns of leverage through these notes, should the business not navigate out of these choppy waters, we believe bond holders would be well covered on any emergence from Chapter 11.

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How long can Italy cling on to its investment grade rating?

With the coronavirus having spread throughout Italy, and with the country’s already worrying debt profile, how will the ratings agencies view the sovereign that is hovering perilously close to junk status? 

GDP growth in Italy has been broadly on a falling trajectory since the start of 2018, with growth falling into negative territory at the end of 2019. The manufacturing and services sectors followed the overall Eurozone picture of decline throughout the past two years, with signs of stabilisation more recently. Italy however, is obviously different to the average Eurozone market regarding the debt position, which is currently north of 135% of GDP. This level, while high on a relative basis, is more acute in Italy than other indebted nations like Greece or Portugal, given the level of yield spread that the government must pay to refinance, along with the large nominal amount of debt. Having said that, the debt profile is elongated enough such that the requirement to refinance is drawn out over a long period.

Much of the volatility in Italy in the past few years has been broadly a function of politics. It has been an evolving theme of populist, nationalist and socialist agendas involving a mixture of regional and national political parties. Generally, the widening of spreads is related to the success of the Lega and Five Star parties, which have sought to battle the EU for more expansionary fiscal policy than is acceptable under the stability and growth pact. More recently however, the tension has been reduced, as the vote of no confidence called by the Salvini-led Lega backfired and left them out of a new ruling coalition. As such, budget tensions are reduced for now and the danger for the Lega is that the conversation has now moved on.

So with the coronavirus worsening the fiscal position, how likely is it that we will see a downgrade to junk?

The issue with the Eurozone fiscal response is that Italy can’t afford it, despite the ECB pouring over €1 trillion worth of QE into Eurozone bond markets this year. The current government is more fiscally sensible than in the past and it is also aware that the market will punish it if it tries to push through irresponsible spending plans, however the macro data will be significantly hit by the virus. The government has also announced significant fiscal and liquidity measures in line with other Eurozone governments. The pandemic fiscal package will be waived under the stability and growth pact rules, but that doesn’t mean that Italy can afford it with debt to GDP of 135%. To be clear, debt sustainability is not the issue, with the term structure they have – it’s more of a market confidence issue. 

On the plus side, the ECB’s Pandemic Emergency Purchase Programme (PEPP) package is significant, and affords the ECB the ability to support member countries as its sees fit, without worrying about breaching individual-country exposure limits. Furthermore, the ECB has been explicit within the PEPP programme (and through its external commentary) that they will not allow an isolated blow-out in Italy to potentially infect the wider Eurozone.

The ECB stimulus has been announced and is significant, but should now be broadly in the price. In the short term, the rating review by S&P on 24 April is a flash point (S&P already have a BBB rating / negative outlook, and Moody’s review follows on 8 May). Over the medium term, the overwhelming driver will be the horrific growth and debt trajectory. It seems increasingly likely that the ratings agencies will decide to downgrade the sovereign.

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A month to make your head spin

As you will have read, we have had one of the most dramatic (in speed and magnitude) three weeks of sell-offs in global markets, as Covid-19 fear spread globally and literally drove the world economy to a standstill. As people panicked, markets did too, hitting the sell button on absolutely anything that looked like it could possibly be liquidated. The carnage was so brutal and indiscriminate in bond markets, that often what is the most liquid part of the market – bonds with 1-2 years to maturity, not only sold off to wider spreads than its longer dated equivalent, but were also simply impossible to sell, in any size or package.

USD mid-March Credit Spreads (bps)

  1-3 yr 3-5 yr 5-7 yr 7-10 yr All
BBB 460 426 407 405 425
BB 940 803 725 656 743
C 1507 1180 978 859 1072
CCC 2692 1959 1576 1135 1828

Source: BofAML, data as at 19 March 2020

Systemic stress became so elevated at one point that even rock solid, risk free instruments such as US Treasuries, sold off (doubled in spread) in less than two days. Liquidity simply evaporated and there was no safe asset to hold, none. Credit markets were just too stretched by large fund outflows, making many market participants forced sellers. Perversely, this also resulted in bonds that were more liquid underperforming, as investors sold what they could leading to the inversion of the credit curves shown above.

It seems that initially the policymakers’ response was neither very swift nor coordinated, which escalated the market panic at the beginning of the month; but given the speed of market falls and spread of Covid 19 this is not really a surprise. It took several attempts from Global Central Banks and G7 try to put a lid on the carnage.  In the end, however, we have seen a very broad based mix of policy response, which we think puts a floor under credit spreads here. Direct fiscal stimulus is underway in almost every part of the developed (as well as Emerging) world now. Even in Germany. This will have a much-needed real world tangible impact on people and businesses.

To that end, we believe fixed income markets have emphatic systemic support to valuations.  We see investment grade corporate bonds in particular as an area when investors can improve the quality of their portfolios AND pick up a significant amount of extra compensation for it along the way.

To us, investment grade asset prices simply do not reflect true fundamental value or macroeconomic reality at the moment. In the ongoing hard and sharp economic impact that is spreading across the world due to the Covid-19 situation, investment grade markets have valuations that mirror the peak of the 2008-9 GFC and post the TMT bubble burst. Assuming Covid 19 can be contained we believe valuations are as cheap as anytime over the last decade and possibly future decades. There is no doubt that many businesses may not survive, as the impact that we are seeing today will fundamentally change people’s habits going forward. This is the beginning of a new secular shift that will permanently change industries such as healthcare, cash payments, travel or hospitality, to name a few. Being alive to these seismic shifts should prove a very fertile ground for active managers and outperformance.  

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Picking our way through the rubble

There was an explosion in financial markets at the start of March; major economies literally shut up shop due to Covid 19 fears.  The emergency services arrived swiftly (albeit day by day it didn’t feel like it). The Fed and the Bank of England cut rates twice, the ECB announced bond purchases; generally there has been a spirit of “whatever it takes”. Fiscal support, everywhere, has been announced too. Investors are now picking their way through the rubble and seeing what is left, what can be salvaged and what has changed forever.

Bond investment covers all types of fixed income markets but readers will now know that that fear of dislocation in government bond markets has subsided. Central banks are hoovering up bonds and the US and UK yield curves are behaving accordingly. Nuanced gestures in Europe mean that the ECB is able to buy more Italian bonds than should prove necessary. Central bankers wearing their emergency services high viz jackets have done their job – and they have sorted the plumbing too. The mad rush to buy $ has subsided as the $ trade weighted index has reversed half of its crisis jump. Like all disaster sites, however, some areas remain higher risk.

Much of the fiscal support has been aimed at workers rather than corporates; that comes as no surprise as the economic impact hit the US employment market with 3.3million making initial unemployment claims. Earlier in the week it was the partisan politics in the Senate that delayed the US fiscal plan and equity and credit markets disliked the impasse; equity markets have marched materially higher since but the breakdown of who gets what is only starting to be assessed but credit markets are already sensing obvious winners and losers.

It will come as no surprise that companies in the airline, hotel and pub sectors are at the sharp end and their debt has yet to establish active trading valuations in many cases. However, in the winning corner are the largest credits and banks; the Intel, HSBC, MacDonald’s who have lead credit markets to the largest ever weekly supply of $ bonds with more than $100bn of new debt issued. Top quality investment grade credits have priced at a discount and capture generous spreads that reward for more than reasonable expectations of ratings downgrades and defaults.

The assessment of value, however, is ultimately an assessment of the timeline of this crisis. Spain’s death toll pushes higher, the human tragedy in Italy is real and the UK is seeing its leaders infected. We are all saddened by the human cost. Looking forward, the impact on the US economy still remains very uncertain. Our expectation is that all major economies will suffer dramatic GDP falls in Q2 but if the economic effects of the crisis start to be measured in quarters not months the relief in credit markets partially seen this week will become ever more palpable. 

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The most incredible week

The most incredible week. More liquidity, fiscal support and forbearance than in any week, ever. Globally, responses have ranged from cheques in the post to government salary subsidies; central banks have shaken off reluctance to reveal largesse. Beneath the economic tumult there is the chill of humanitarian tragedy.

To steal from the more profound, this week marks the end of the beginning. We have an assessment of the crisis ahead of us. In the UK the government suggests anywhere between one and three months interruption of normal life. We are starting to sketch an outcome that will leave many businesses struggling and most with no clarity on outcomes for 2020.  Exhaustion not elation is the driver of pricing on Friday.

There is no need for a blow by blow account of the policy responses although £330bn stimulus and £200bn QE in the UK looks – at c.10 % of GDP -as empathic as anywhere. The ECB’s €750bn is as important in the detail – buying Greek bonds and reducing some current bond buying limitations – as in the size. National governments in Europe are supportive with Macron promising €300bn at the start of the week. All these measures- and more – in totality prove almost sufficient to deal with the economic pain of this crisis.

It is, however, the US and its currency that has been pivotal to the week. Whilst the €1.2trillion relief plan is working its way through the house the Fed slashed to zero and found a further $700bn for QE and a whole host of other measures. But it is access to $s -underneath all the above – that has been so crucial to investors this week. Countries, companies, traders and managers have needed $ to spend, service debt and margin call. The $ has had an unprecedented rally, outperforming its trade weight basket by 6%. Only by Friday have we seen a reversal of the $ appreciation. For $, read liquidity. And weak performance in EM, credit markets and volatility in government bond markets have been a response to the demand for $. We anticipate this to settle somewhat; some stability should return to the underlying structure of bond markets – but the crisis has further to unfold.

Central banks have made the provision of $ front and centre of their policy response through global provision of $ swap lines. Liquidity is provided but we are still feeling our way through the commercial impact of this crisis in risk assets. Despite the savage risk markets response – in equity and credit markets – there has been some new issuance in corporate bonds. Those that have been able to issue bonds have been utilities, telecoms companies and Pepsi – all perceived as universally robust for the current crisis. Companies in the travel, hospitality and gaming sectors ( to name just some), however, will need both access to government support but also some clarity through the passing of time and the crisis abating to regain some composure and confidence previously seen from investors.

It is safer to go back into the water today than Friday last. Government bonds have active buyers, $s are available. But we should anticipate for credit markets that many will want to stay on the beach until there is a clear sense of the beginning of the end of the crisis. And that is measured at a human level; a material decrease in the spread of Coronavirus and most importantly a collapse in deaths and a vaccine. Our thoughts are with all those affected and especially Italy.

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The week that changed everything (again).

10 year Gilts, it seems incredible to say, ended the week more or less unchanged at 37bps. In the meantime the FTSE 100 lost over a 1000 points or around 17%. It might not seem like the most stunning event of the week but the inability of rates markets (risk free)  to rally – or act as a hedge to equity holdings ( risk markets) may have the most profound implications for investments. This is not to belittle the exceptional UK rate cut on Wednesday, the impact of the most expansive budge in a generation nor indeed the human toll of the Coronavirus and its knock on implications.

The slowing down of the Global economy is now a fact. The impacts will now be measured in units of severity rather than uncertainty. The EU now see GDP contracting by 1%. The UK’s forecast of positive 1.1% growth for 2020 very much looks like last week’s news. Evidently, there are sectors that will take the full brunt of major economies going into “curfew”. Travel and hospitality sectors are the most obvious but the knock on effect on banks is already being felt in valuations in credit markets. Both the ECB and the Bank of England are seeking to provide reassurance to the plumbing of the banking system and provide support to those effected, small and medium sized entities through loans and loan support. SME and larger companies can benefit from the cash flooding the system. Everywhere, prudential safety buffers have been removed to allow more cash to flow to the real economy. This is good news but there will always be concerns about the detail.

Credit markets –sandwiched between equity and rates markets had a compellingly fearful week. A simple measure of credit risk would be a frequently traded index of weaker credits (Crossover). This ended the week 1.5% higher in yield. Many high yield credit bonds fared worse than this with the oil sector particularly hard hit. With a slump of 1/3 in the value of oil occurring at Monday’s open many bonds fell dramatically in price between 10 and 30 points. Much like the relationship with Gilts and the FTSE the relationship between cash bonds and Indices became very confusing making tried and tested risk management techniques obsolete.

Much has been done by authorities to soften the blow of the virus. Expect more. We debate timelines but what was once set to effect Q1 will impact certainly H1 and clearly the whole of 2020.  Markets like to describe future outcomes in letters: V (swift bounce back), U (it will recover after a while) or L (we’re down here for a long while). At the end of this week, even with Friday’s bounce back in equities a U would be the best of it and credit markets believe “down here for a long while” is a real possibility. We have had no week quite like this since 2008. There is so much new information to digest. Much has been thrown up in the air and it will not all land back in the same place.

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BOND awards 2020 – and the winner is……

To celebrate 40 years of the BRIT’s, Kames Capital make four special awards to commemorate the occasion.

The Samantha Fox / Mick Fleetwood gong for least successful combination – the duo co-presented the awards in 1989 in what has widely been acclaimed as one of the oddest combinations in the awards’ history – would go to Royal Bank of Scotland and ABN Amro. RBS paid £45bln to buy ABN Amro in 2007, a move that was largely credited as one of the first steps in RBS’s ultimate nationalisation, with the value of the acquisition effectively written down to zero within 18 months of the deal being completed. Thirteen years later and the RBS brand has been quietly retired, much like the aforementioned presenters.

In 1998, Jarvis Cocker took exception to the content of a Michael Jackson performance at the awards ceremony and promptly stormed the stage, halting the show and perhaps signalling the beginning of the end of a 30 year career. The Jarvis Cocker Whistleblower award goes to Sherron Watkins, Vice President of Corporate Development at Enron. In August 2001, she sent an email to CEO Kenneth Lay, outlining what she called an “elaborate accounting hoax”, which included inflating income and hiding epic losses. Despite the company’s concerted attempts to humiliate and punish her, four months later Enron filed for bankruptcy, becoming the biggest corporate bankruptcy in history.

The self-confident tone of Noel Gallagher’s acceptance speech for Oasis’s award in 1996 – when the band accepted the best video award from Michael Hutchence with the quip “Why is a has-been presenting to the gonna-be’s?” – is widely viewed as a “changing-of-the-guard” moment, which Hutchence struggled to recover from. Although Tesla regularly features as one of the most shorted stocks in hedge funds’ portfolios, the company’s current market cap of $146 bln makes it bigger than Ford, General Motors and Daimler combined. These figures – combined with Elon Musk’s relentlessly bullish marketing and self-promotion – ensures Tesla receives the Noel Gallagher Self-confidence award.

Finally, the Robbie Williams award for Biggest Winner – Williams holds the record after collecting a grand total of 15 Brit awards – goes to the Gilt market, which has a total return of 200% over the past twenty years, and 13% since Williams won his last award in 2017. Much like Robbie’s prospects for future glory, it would be difficult to foresee such triumph for government bonds over the next few years, although its capacity for reinvention should not be underestimated.

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Monstrous bond supply

Henry Frankenstein: “Look! It’s moving. It’s alive. It’s alive… It’s alive, it’s moving, it’s alive, it’s alive, it’s alive, it’s alive, IT’S ALIVE!”*

The bond market enjoyed a record breaking year in 2019 in terms of the quantum of bonds issued globally. And following a brief hiatus over the festive period, issuance in the first week of 2020 saw bond markets resurrected with a monstrous amount of supply.

Investment grade supply in euros was at its highest level since March 2016, with €31.3bn of deals pricing. The overwhelming bulk of this was squeezed into four days, with Monday considered a holiday in some parts of Europe. Including all issuers (i.e. including covered bonds, sovereigns, supranationals and Agency bonds, etc.) euro supply for the week was a whopping, and record breaking, €79bn. 

In US dollars, while not a record breaking week, it was not far off! Last week was the fourth busiest week ever by volume and by number of deals, as 41 companies pumped out $61.9bn of new bond supply.

Closer to home, the absolute numbers in the sterling market were smaller, but we saw several senior bond deals from UK and international banking names. This was enough to expand the senior financial market size by nearly 5%! 

Elevated periods of issuance are sometimes treated with a degree of trepidation by bond investors, who are prone to fret about the difficulty in digesting said supply. In this case, however, we saw healthy demand, well covered deals and broadly strong initial performance, suggesting cash remains for attractive issues.

As one would expect, there were opportunities among the weight of issuance, and we selectively participated in these across our fund range.

* Quote from the movie: ‘Frankenstein’ (1931)

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Who’s afraid of President Warren?

Whispers are growing louder about a potential collapse in US equity markets this time next year – the days following the 2020 presidential election. Why are capitalist alarm bells ringing? Senator Elizabeth Warren, rather than early favourite Joe Biden, could be confirmed as the Democrat presidential nominee. This would pitch a candidate set on an overhaul of tax, trade, healthcare and more against Trump who, in his first term, nailed his pro-corporate colours to the mast. It is wrong to say that Warren wants asset values to collapse – or to put her in the same basket as Bernie Sanders – but she does seek a significant overhaul of the current order.

Domestically, Warren proposes wealth taxes on highest earners, higher capital gains tax, and perhaps most pivotally, repealing Trump’s corporate- and market-friendly ‘Tax Cuts and Jobs Act’ of 2017. Simultaneously, Warren would introduce a ‘Real Corporate Profit Tax’ of 7% on every dollar above $100m in profit. It is not just higher tax burdens that corporates would face, but the largest firms – particularly the champions of Silicon Valley and Wall Street – would be faced with potential breakup under an administration intent on increasing anti-trust enforcement.

Beyond their own borders, protectionism has been a worry for markets and economists since Trump took office, but the bite could become more unforgiving under a Warren administration. The very public war of words would likely cool, but the retreat from post-war liberalism may well accelerate. Whereas Trump has confronted China alone, Warren would almost certainly work alongside the likes of the EU as a more unified front to achieve goals, but with stricter preconditions on the rule of law, democracy and human rights. All of which are likely to find more opposition in Beijing and in the capitals of other trading partners.

We are still a long way from the election. Warren faces many hurdles, not just surpassing Biden and Trump, but also gaining a majority in the Senate. However, uncertainty over the future tax and regulatory regime could well add to current trade angst. Another thing for CEOs to worry about when mulling over their investment and hiring plans.

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Talking high yield (video)

Kames Head of High Yield Thomas Hanson discusses the competing forces of sustained central bank support versus the deterioration of macro-economic data on the high yield market.

Talking Bonds (video)

What’s our fixed income strategy for the next month? With central bank cuts and softening macroeconomic data influencing bond markets recently, one of our Fixed Income Fund Managers, Colin Finlayson has given us his insight in to the main areas of focus for the Kames Fixed Income Strategy over the next month.

Metro Bank’s tug-of-war between shareholders, debtholders and regulators

Successful banks typically prefer to avoid negative press and speculation. On that basis, Metro Bank has not had a successful year.

The bank, like other UK ‘challenger banks’, continues to face significant headwinds from the very competitive landscape, the low interest rate environment, Brexit uncertainty and much higher regulatory costs, especially around the amount of capital and “bail-inable” debt that banks are required to hold since the financial crisis.

Unlike its peers, Metro Bank has also been in the news for its own failings, from risk and accounting controls to governance issues, and as recently as last week a botched attempt to come to the market to issue “bail-inable” MREL (Minimum Requirement for Own Funds & Eligible Liabilities) debt instruments.

The bank came back to the market yesterday, and this time successfully issued £350m of senior non-preferred instruments at 9.5%. The very high coupon, as well as its structure to allow US investors to participate and the longer tenor, helped attract around £550m of interest from the debt market, with the bonds trading up around the 101.5-102.0 level.

Whilst Metro Bank’s management team will be relieved to have met its upcoming regulatory requirements, questions will remain around the sustainability of its business model. The new debt transaction – and the £33.25m annual interest cost attached to it – will have a material negative impact on the bank’s profitability metrics, and likely their medium term strategic direction.

Whilst Metro Bank share price has now partially retraced the move related to its failed debt issuance, there should be no doubt that there has just been, yet again, a material transfer of value between stakeholders. Shareholders are picking up the tab to the benefit of debtholders and, ultimately, regulators.

Kames holds bonds from Metro Bank in its fund range

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The myth of the equity cushion

A margin of safety is a wonderful thing for a company. It could be an unassailable market position, an industry-leading level of competitiveness or similar. As investors, we love margins of safety. It gives us confidence that companies can overcome challenges and therefore confidence to buy or hold onto investments when times are tough. Sometimes, bondholders will blithely say that a large ‘equity cushion’ is a margin of safety. An easy way to think of the equity cushion is how much the equity market loves the company in question. Of the total valuation of the company, how much is equity versus debt? The theory goes that if a company has a significant amount of equity value relative to its debt then bondholders are protected – the equity market will support the company. This is dangerous.

An obvious and topical example of this going wrong is WeWork. The company is notoriously lossmaking and much has already been written about its financial position and business model. But the bull case for bondholders has, in our view, an undue reliance on the massive equity valuation of the company, courtesy of SoftBank’s Vision Fund. While the bonds haven’t traded particularly well over their life, they recently looked like a slam dunk as an IPO loomed. When a company is private and the equity cushion can be quite uncertain, an IPO is the Holy Grail; it provides confirmation of the market valuation and typically comes with a debt reduction kicker. But WeWork’s valuation wasn’t what was hoped – investors balked at the price relative to the real fundamentals of the business. The IPO gave them an initial valuation of almost $50bn, but was soon drastically cut to $10bn. This was still not enough to entice investors, and the IPO was withdrawn – and CEO Adam Neumann was forced out. The equity cushion was vaporised, and so has the supposed bondholder margin of safety.

Source: Bloomberg

It isn’t just ‘new economy’ companies like WeWork that can suffer from the vicissitudes of equity markets. Petrobras is the state-owned Brazilian energy company. They supposedly had two ‘equity cushions’, one from a chunky market capitalisation (in 2013 this was $124bn of equity vs $95bn of debt) and one from the protection of state ownership. But in the energy crisis Petrobras’ market capitalisation was destroyed, so much so that in 2015 it was only $22bn versus $124bn of debt. Equity cushions work for as long as the equity market keeps believing in the story, and as long as the market and sector isn’t in meltdown.

The key message here is that we don’t rely on the benevolence of equity owners as a fundamental part of our investment thesis. We lend to companies that we like, based on our bottom-up analysis, and can clearly persist past their next debt maturity whether equity markets are in meltdown or not. A company that thinks it can rely on the equity market to fund it in extremis may find itself in danger if the equity market loses faith in the story.

Equity cushions exist… until they don’t.

Kames Capital does not hold WeWork


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Thomas Cook fallout

The loss of Thomas Cook from the high street should see TUI the marginal winner, the sole remaining tourism company with any significant retail store base. In the UK, Thomas Cook had an 8% market share compared to TUI which has 19%; in Germany, Thomas Cook had a 10% market share versus TUI with 17%. Following the demise of Thomas Cook a significant portion of market share will go to TUI in both countries.

While the public may be worried about the collapse of Thomas Cook being repeated at TUI, they should be mindful that both companies have materially different balance sheets. For starters, the TUI credit rating is 10 notches higher at BB (versus D for Thomas Cook). TUI also has more than double the amount of equity in its capital structure when compared to debt. In comparison, Thomas Cook had zero equity with its debt trading below face value, resulting in an inability to perform any type of rights issue. TUI has larger scale with €19bn of revenues (versus £9bn), but crucially has access to liquidity.

What ultimately caused Thomas Cook’s decline was not Brexit, not margin pressure, and not a hot British summer – it was ultimately banks pulling their funding lines as the proposed rescue plan left them still worrying about the company’s liquidity position. With TUI having almost €1.6bn of cash on hand, it is an entirely different story to Thomas Cook.

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The ECB sheds more light on the September Meeting

On Monday, the ECB’s Chief Economist Philip Lane gave a speech. Given the timing, so soon after the September policy meeting, it was no doubt crafted as an opportunity for the ECB to clarify its message in light of the market reaction. It is the Governing Council’s chance to either validate or correct the market’s response to the new policy measures.

In the conclusion, he said “Forward guidance on the key ECB policy rates is a very powerful instrument and remains our principal tool, together with the level of our key policy rates, for adjusting the monetary policy stance.” This speech was attempting to clarify the ECB’s position even further, to stop markets from swinging their expectations wildly ahead of each policy meeting.

There were two sections to the speech: the economic environment; and the ECB’s monetary policy response to it in the September meeting. The first was nothing new – trade disruption is weakening the global economy, the manufacturing sector is slowing but services and the labour market have not yet been hit.

The second section, on the ECB’s response, had a number of significant points:

  • Inflation target: “a clarification of our reaction function: our determination to act when inflation falls short of our medium-term inflation aim is just as strong as our determination to act when inflation exceeds that aim.

This appears to be a response to those who suggest that the ECB would allow inflation to “run hot” to compensate for the lengthy period of sub-target inflation we currently inhabit.

  • Negative rates: “Negative rates have supported the portfolio rebalancing channel of the asset purchase programme (APP) by encouraging banks to lend to the broad economy instead of holding onto liquidity.”

This is a re-emphasis that the ECB views negative interest rates as an effective tool, and that they have a positive impact on bank lending – perhaps in response to those that ask whether negative interest rates are actually hindering, not helping.

  • Further rate cuts: “We judge that, if needed, we can further lower the deposit facility rate and, with it, the overnight money market rate. As a result, there is no reason for the distribution of future short-term rate expectations to be skewed upwards.”

This is fairly self-explanatory, but confirms to the market that they won’t be seeing any upward surprises in the near future, and the effective lower bound is not here yet.

  • QE: “we are confident that the envisaged purchase volumes will be consistent with the current parameters of the APP for an extended period of time.”

We have on this very blog questioned whether the €20bn Asset Purchase Program figure is a realistic upper bound, and the ECB is responding (though perhaps not specifically to us) that they don’t expect QE to exceed this level. The ECB thinks they have time and headroom, but that will run out within six to nine months.

  • Forward Guidance: “The phrase “robustly converge” means that the Governing Council wants to be sure that the process of convergence is sufficiently mature and realistic before starting to lift policy rates. The qualification that convergence needs to be “consistently reflected in underlying inflation dynamics” means that the trajectory of realised inflation should underpin our inflation outlook.”

This is, in my opinion, the key point. He says that before policy rates can rise, and before QE can again be wound down, not only do inflation expectations have to rise, but realised inflation needs to follow those expectations. This stresses that the ECB needs to see actual, sustained inflation growth before rates will rise again – reducing fears of over-tightening killing any nascent recovery.

So if you’re looking for the potential pain trade from here, taking this speech into account, it would be where the trade tariffs cause more harm to the industrial sector and the weakness spills into services and the labour market. Underlying inflation stays depressed, and the ECB cuts rates further and lifts the ISIN limits on government purchases.

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How will the Swiss react to the ECB

The Swiss National Bank meeting this week will be more closely watched by markets than usual. Typically there is little drama stemming from the safe-haven alpine nation. But with inflation threatening to fall through zero, an appreciating currency and the ECB having just cut interest rates, the SNB faces a challenge to keep the economy on track.

The question this week is, how can the SNB use the policy options it has in its toolbox to try and slow the currency appreciation, which is weighing on exports and growth? In my view it’s likely that they will change their characterisation of the currency from “highly valued” to “overvalued”, which will help put a brake on the FX market, at least for a while.

Then there is the question of a rate cut. On the one hand, inflation is falling, growth is weak and the currency is rising. On the other, the inflationary forces at work are external, imported from the ECBs recent rate cut. The SNB could choose to cut rates further into negative territory, from the current -0.75% level. A token 10bp rate cut would keep up with the ECB, but would have little effect on the real economy – it’s just not as effective a tool to manage the currency as direct FX market intervention. However, a larger-than-expected rate cut of 25bps would send a strong signal that the SNB will resist the external pressure. This is not the market’s base case, and would be a surprise.

With the spread between the ECB deposit rate and the SNB target rate now wider than before the ECB meeting, if the SNB does not cut, they will need to communicate why and questions will be asked about their reaction function should we see further rate cuts from the ECB.

We can look at the interest rate expectations derived from the yield curve to see what the market is currently pricing. As you can see below, the market expects rates to be 9bps lower by October and trough at 18bps lower from today’s level of -0.75% in February next year.

Source: Bloomberg

You could argue that the fact that the ECB only cut rates by 10bps, and not more as some expected, takes some pressure off the SNB to cut. But holding steady is going to disappoint the market and likely cause further appreciation in the Franc, further stifling the Swiss economy.

Post-meeting update, 19/09/19:

At the policy meeting on the 18th September, the Swiss National Bank left rates unchanged, and reiterated that they are “willing to intervene in the foreign exchange market as necessary”. Following the ECB rate cut last week, the interest rate differential is now wider than it was and the FX and bond markets took the announcement as a disappointment. The market was expecting a cut of around 10bps, so the decision to hold saw front end yields rise and the currency strengthen. The statement stuck with the language that the currency is “highly valued”, which given the limited amount of appreciation since the last meeting, is fair enough. But the whole picture here is important, not just the currency. With inflation hovering above zero and the SNB’s projections signalling only limited pick-up to 0.2% next year, I think that this policy stance needs to shift in the future. This fits with the view that the ECB needs to cut rates further into negative territory, something I have made a case for in the past, and a natural follow on from the tiered rate policy they have just introduced. So for now we have to await the next meeting on the 12th December to see if the SNB will capitulate and cut rates further. A lot can happen between now and then.

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ESMA weighs in on bond liquidity

H2O, GAM, Woodford. Three fund managers that all faced crisis due to liquidity. Or rather, a lack of it. It’s not surprising, therefore, that the trade press has been filled with panicked comment on bond market liquidity.

Last Wednesday, the European Single Market Authority (ESMA) added fuel to the fire, releasing a report on their liquidity stress-testing. It was actually relatively benign, saying “The results show that overall, most funds are able to cope with such extreme but plausible shocks, as they have enough liquid assets to meet investors’ redemption requests”. It was not entirely rosy, however, noting “pockets of vulnerabilities” in certain asset classes where some funds would see liquidity dry up in the event of a fire sale, and would struggle to sell assets in a hurry. Naturally the press seized upon this and continued to work itself into a tizzy.

Illiquid assets bring a yield premium with them, and in a world of low yields these have become increasingly attractive. Many funds are snapping them up to boost returns. But it is vital to remember that the extra yield is in return for extra risk. Those who forget it may join H2O, GAM, and Woodford in realising that liquidity disappears at the very moment it is needed most.

At Kames, consideration of liquidity is absolutely key when evaluating a potential investment. We do not use illiquidity as a source of alpha. Instead, by maintaining a disciplined and rigorous investment process, we look to avoid those stocks that will become untradeable during a crisis. By keeping our funds agile, our clients get to sleep a little easier.

For more of our thoughts on bond liquidity, look here

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[VIDEO] A Red Herring: Our view on the ECB announcement

Mario Draghi’s penultimate policy meeting yesterday brought a rate cut, the return of QE, and some assistance to Europe’s beleaguered banking sector. But will it have the intended effect of stimulating the Eurozone? Watch now to see our take on the ECB policy changes.


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Fixed income outlook 2nd half 2019 (video)

So far 2019 has been unpredictable. We’re yet to see Brexit come to a conclusion, new EU and ECB leaders have been announced and are poised to take on their roles, and Trump (and his Tweeting) remain an enigma. With all this in mind, Adrian Hull, Iain Buckle and Sandra Holdsworth give us their thoughts on what lies ahead for markets in the second half of 2019.

When liquidity dries-up

Suddenly the fund industry is talking about liquidity – or lack of.

Most investors will have read about Woodford Investment Management’s well-publicised challenges around managing redemptions, which led to the suspension of dealing in one of the company’s funds. Then last Tuesday we read about Morningstar suspending the rating on a bond fund managed by H2O, citing concerns over the “liquidity of certain bonds”. H2O have since challenged these concerns, although investors and regulators are increasingly asking questions of their asset managers around liquidity risks.

In my own area – the corporate bond market – liquidity is something we spend a lot of time thinking about. In January I spoke on this topic at a leading bond market conference and published a paper titled Beating the liquidity freeze in bond markets.

To summarise my argument, since the Global Financial Crisis of 2007-2008 we have seen reduced bond market liquidity. There are two main reasons for this:

  1. The greater regulatory scrutiny of banks’ balance sheets following the crisis has had an inverse (and material) impact on the appetite of those institutions to hold bond inventory (and thus provide liquidity for the market); and
  2. Consolidation within the asset management industry has led to a greater concentration of holders (of individual bonds), which has increased the risk of liquidity bottlenecks in times of stress.

I argued in my January paper that central bank QE programmes have to some degree mitigated these risks, and indeed acted to support liquidity. However, the extent to which QE will alleviate the corporate bond liquidity conundrum on any longer-term view is, by definition, limited.

One of the (unintended) consequences of a price-insensitive buyer of corporate bonds (the central banks) has been to compress credit spreads, lower volatility and increasingly push the client base into the arms of a passive industry offering the allure of lower fees. The proliferation of passive bond funds – all seeking to construct essentially identical portfolios that mirror an index of limited size – will ultimately only exacerbate the liquidity problems in the corporate bond market.

So if we accept this is an issue and that it’s here to stay, how should we protect the consumer?

We argue that active management is the answer – with liquidity a key consideration within the investment process.

Quantitative tools can form a valuable part of any liquidity assessment. However, the reality is that liquidity is a fickle beast that does not readily conform to scientific analysis. Mathematical models cannot entirely substitute for experience and market knowledge. A careful assessment of an individual bond (and by extension its impact on an overall portfolio) should form part of every investment decision.

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Save the whale

When President Trump recently met with Prince Charles, the “Prince of Whales”, one quote taken from the subsequent interview of Trump struck me:

“He wants to make sure future generations have climate that is good climate, as opposed to a disaster, and I agree.”

This is not only a noble aim, but I think one which would garner near-universal agreement. However, BP’s recently-presented annual statistical review was a stark message that we may be diverging from our aim of a “good climate” for future generations. BP’s chief economist, Spencer Dale, stated that “the world is on an unsustainable path”, revealing that “the increase in carbon emissions [in 2018] is roughly equivalent to the emissions associated with increasing the number of passenger cars globally by a third”.

Let’s take a moment to think of an equivalent scenario. Imagine, in 2018, it was well known and well understood that the number of passenger cars on our roads had increased by one third, would we really feel that the world was on anything other than the brink of disaster regarding climate change?

Averting disaster will be difficult from here, though we are moving in the right direction. For example, this week the UK set a stretching and legally-binding target to have net zero emissions by 2050, with Theresa May saying there is a “moral duty to leave this world in a better condition than we inherited”.

In the financial markets, there are an increasing number of opportunities to invest in green bond issues. Over the past two weeks the utilities sector has seen three green bond issuers, two of which are new to the financing structure. We continue to evaluate these on their own investment merits of course (and are wary of “greenwashing”), but it is pleasing to see borrowings being dedicated to environmentally-friendly projects, particularly in the utilities sector where the arguments for this issuance type are so strong.

Some reasons to be optimistic, then, but as with our investing decisions we prefer cautious optimism as we endeavor to achieve President Trump’s (and indeed most people’s) objective of a “good climate”.

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Price caps: Burnt fingers?

Here in Scotland it was recently the season for Burns’ supper celebrations. In case you haven’t had the pleasure, the haggis, neeps, and tatties are usually accompanied by whisky (preferably lashings thereof) and readings of the native bard’s poems.

I cannot hear the poem “To A Mouse”, and in particular the lines “the best laid schemes o’ mice an’ men, gang aft agley”, without being reminded of a notable highlight in PG Wodehouse’s “Jeeves in the Offing”.

The inevitable failure of a typically hare-brained scheme leaves its unfortunate protagonist, Bertram Wooster (or “Bertie” to his friends, among them “Kipper”!), commiserating with Kipper, as he rues,

“I don’t know if you know the meaning of the word agley, Kipper, but that, to put it in a nutshell, is the way things have ganged.”

Among the Conservative party’s “best laid schemes”, we saw the party abandon their free market mantra by voting in favour of a price cap on home energy bills.

Notwithstanding the price cap, the Conservatives remain staunch proponents of free markets when compared to Labour’s stance on utility nationalisation. Presumably, in the Tory party view, the real issue of concern to consumers was one of affordability, not of ownership.

Under the cap, the maximum monetary value that UK consumers are charged on the default Standard Variable Tariff is set (and periodically reviewed) by market regulator Ofgem. The price cap has now been in place for just over a month, and it is widely expected that this Thursday Ofgem will move to increase the cap by around £100.

A wave of smaller operators going bust, combined with job losses at Innogy’s UK subsidiary Npower, suggest all is not rosy in the capped-price world of UK energy supply. A rise in the cap is likely to be a difficult sell to the electorate, but it may be viewed by Ofgem as the most prudent approach. Against rising wholesale costs for suppliers, it is hard to argue that smaller operators going bust reflects an effectively functioning marketplace.

The rise in the cap level will doubtless counteract much of the positive spin from the introduction of the cap at the start of the year. Here as elsewhere, reality bites.

When it comes to the energy price cap, agley appears to be the way things have ganged.

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Don’t blame the Algos

According to a recent report in the Wall Street Journal, “Roughly 85% of all trading is on autopilot—controlled by machines, models, or passive investing formulas, creating an unprecedented trading herd that moves in unison and is blazingly fast.”  Think “Synths” from telly series Humans leading trading decisions rather than, well, the human fund managers at Kames Capital.

The article goes on to blame the recent market weakness on computerised trading algorithms (algos). Just as a reminder, Google summarises an algorithm as “a process or set of rules to be followed in calculations or other problem-solving operations, especially by a computer”. What we find interesting is that while the algos are blamed when it comes to bear markets, they are never blamed when it comes to bull markets. Shouldn’t they be responsible for both?

That eminently non-programmable human, Donald Trump, has come out and blamed the recent market weakness on a “glitch”. We remain a little more sanguine, and view market pricing as trying to tell us something. The Federal Reserve puts a dozen people in a room to deliver a rate decision, but the market rallied to the text of its statement and not to the bearish and mechanical process of a rate rise.

Whilst it is undoubtedly true that the vast majority of trading is now done by computers, this tells you nothing about human choices behind them. Algos execute trades based on a multitude of factors, with flow clearly being a key component.

If you want to blame recent market weakness on outflows that’s fine, but don’t blame the algos per se. There will always be some humans in the process.

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Blinking Brexit

There is a danger in writing about Brexit that the article is out of date before it hits the screen, but I‘ll have a go anyway. 

At the time of writing, the way forward for the UK and the EU still appears exceptionally unclear. The “backstop” is the main issue of contention, with the Irish Government, the EU, Northern Ireland’s DUP, and the notorious sub-group of the Conservative party, the ERG, all determined not to blink.

This reminds me of a famous (and highly recommended) episode of Dr Who from 2007 entitled ‘Blink’, where the good Doctor manages to restrain the powerful Weeping Angels for eternity. In the episode, the Weeping Angels (the baddies) are a powerful species of quantum-locked humanoids with the characteristic that if they are observed they turn to stone – hence their appearance of statues covering their faces. By covering their eyes they cannot see each other and thereby avoid literally petrifying each other. Of course, the Doctor manages to engineer a situation where they remain staring (and not blinking) at each other and thus everlasting petrification follows.

One can only hope that the current political leaders’ refusal to blink won’t leave us trapped in the same way…

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Beating the liquidity freeze in bond markets

Compared to a decade ago there is significantly less liquidity in global bond markets. Last week I presented on this topic at a specialist bond-market conference in London.

I enclose a paper which summarises my presentation. I explain the extent of the liquidity challenges and consider the implications for investor expectations, pricing, capacity management, and the prospects for active investment fixed income strategies.

Download paper

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ReWard your investment not your doctor

A key part of our investment philosophy revolves around whether the cash flows generated by the businesses that we invest in are sustainable. While many factors play into our analysis, ESG considerations are a key component in determining the sustainability of cash flows and indeed, a business.

We recently looked into a new issue to fund the KKR-led buyout of Envision Healthcare, a provider of staffing and other services to the US healthcare industry. For the most part, Envision provides doctors when hospitals choose to outsource their emergency departments. We typically place a great deal of emphasis on the ‘G’ in ESG analysis, Governance. But in this case, the social aspects gave us cause for concern.

Healthcare is a social good. The US healthcare system can, at times, seem to challenge this basic assumption. The system has well-publicised issues with costs and a mind-bogglingly complexity that seems egregious to anyone who hails from a country with a healthcare system like the NHS. Be it rocketing drug prices, or paying for your ambulance journey to the hospital, or even $5,000 ‘discharge’ fees, at least you’re okay if you have health insurance, right?

Possibly not. Health insurers in the US often specify hospitals and services as ‘in-network’ and ‘out-of-network’. If they’re in-network, the insurers will pay a bigger portion of the bill. If not, patients might have to foot the whole bill themselves. So if you have to be rushed to the emergency department, you want to make sure you’re going to an in-network hospital. That way, you get to be “in-network”, treated by a doctor, released and all is well. But then the bill comes. Turns out, you’ve gone to an in-network hospital that outsources its emergency department to Envision Healthcare, and its doctor treats you, and all of a sudden…sorry, you’re out-of-network.

Indeed, the health insurer UnitedHealth is in a very public spat with Envision. UnitedHealth has even dedicated a portion of its website to calling-out Envision Healthcare’s billing practices. They estimate that the average charge for Envision’s doctors is three times higher than what Medicare would be for the same service. There’s also a working paper recently produced by Yale University. This paper suggests that Envision actively ups the number of out-of-network procedures when it takes over an emergency department and that its out-of-network charges are significantly higher than competitors’ out-of-network billing. The New York Times has also published a scathing piece on Envision’s practices that has sparked a US Senate investigation, as well as shareholder lawsuits.

Analysis of the company’s financials demonstrates the outsized profitability of charging individuals directly rather than via insurers. So-called ‘Self-pay’ constitutes just 13% of procedure volume, but contributes towards 46% of revenue. Moreover, the sheer size of these bills means they often aren’t paid in full (or at all), so Envision takes massive provisions for uncollectible charges.

Envision is moving more of its revenues to “in-network”. It argues that insurers are trying to avoid paying providers a reasonable rate and that they are trying to shift costs to the patient. But for us, this business model seems to take advantage of those who either don’t know to, or aren’t able to specify an in-network doctor, at an in-network hospital.

In our view, cash flows that seem to depend on opacity rather than transparency will be inherently less sustainable, and are not what we want in any portfolio.

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Inverting yield curve dogma

Short rates have gone up in the US. Longer rates less so. The yield curve has flattened; is flattening; and conventional wisdom has it that this will continue. In due course, short rates will yield more than long rates. Think of, for example, two-year bonds at 3% and 10-year bonds at 2.875%. No problems with the maths, but does it mean anything?

The second part of that conventional wisdom is that as the yield curve inverts it is the amber light for a forthcoming slowdown. However, unlike the amber traffic lights which are typically set at five seconds, there is no predetermined time after which there has to be a recession, indeed if it all.  It could be a year (as we saw in 1990) or many years (as we saw in the late 1990s). That is the stuff for bond fund managers’ debate – but there is a determinism here. What if the patterns over the past hundred years are wrong? What if it is different this time?

Enter analysis from BNP Paribas. Its research shows that up until the 1930s the yield curve was almost always inverted (i.e. it’s not different this time, it’s just that we haven’t seen this for a long time!) Perpetual Gilts traded at a premium to short dated “call” money. It is worth thinking of it like this: Those people who had money didn’t want the hassle of chasing higher yields from the lightly regulated banking system. Stay safe with Gilts and let those who really needed money squabble for it at higher yields. No doubt a simplistic view of the materially less regulated world of late 19th Century bond markets, but there are parallels with today. Regulation demands that a whole chunk of pension fund money is locked away for the long term in safe assets almost irrespective of the cost of “call” money, which is creating ( as we have seen many times and continue to see in long Gilts) an inverted yield curve.

So why debate this now? The Fed is spending a lot of time worrying about what an inverted yield curve might mean for expectations as well as economic reality. As the graph below shows: the pre-1930 world was far choppier in terms of recession and expansion.

US Yield Curve Versus RecessionsSource: Macrobond, BNP Paribas

Todays’ sophisticated world of central banking and generic 2% inflation targeting provides stability; but as Quantitative Easing stops and the unwind drips the stock of bonds back to the market we are in unchartered territory. It might just be a little too easy to assume an inverted yield curve means upcoming recession.

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Beautiful inside my portfolio forever

It has been 10 years since Damien Hirst sold 233 lots at Sotheby’s raising $198m – entitled “Beautiful inside My Head Forever”. The sale was conducted on September 15th & 16th and the timing proved an odd counterpoise to the destruction and collapse in financial markets. It helped highlight the surreal nature of financial markets when compared to the “real world”.

To prove to the art world that financial types don’t, well, understand art, I thought it would be useful to compare how Hirst’s art had done compared to the global high yield bond market. As even us financial philistines know – there is no visual pleasure in ownership of a high yield portfolio, but there is in Hirst’s dots or sharks.

Here’s the back of a pharmacy cabinet analysis. Hirst’s $198m put into the global high yield bond market would have more than doubled over the last 10 years – let’s call it $400m bar the shouting. A Google search of Damien Hirst’s price index shows a peak prior to the financial crisis and values are currently around one third of those in 2008. Hirst’s $198m sale would now, in theory, only raise in the region of a paltry $65m.

So I guess that’s asset allocation for you, or simply the power of carry. Or maybe the moral is to be a rich philistine or a poor artist. Or alternatively be Damien Hirst.

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World Cup Picks ‘n’ Pans

Excitement is brewing as the World Cup begins today in Russia. Here are the Kames Fixed Income team’s top 5 picks for the tournament.

World cup ranking (1)
The ultimate tournament team – serial winners and current holders of the cup, they have a knack for peaking at exactly the right time. A blend of youth and experience should see them progress but with the fitness of “sweeper-keeper” Manuel Neuer key. Germany’s credit quality is rock solid but the end of ECB QE will mean some caution is required…
World cup ranking (2)
The nation has won the most World Cup tournaments, but suffered a humiliating 7-1 defeat by Germany in the last tournament’s semi-finals. The South American side will be out for revenge. Despite positive momentum for the World Cup, the outlook for bonds is not as constructive as the country tackles strikes, a weak currency and upcoming elections.
World cup ranking (3)
The side is teeming with youthful talent but lacking that much needed experience. Despite this, a successful coach and strong team morale on the back of second place at the Euros in 2016 should see the team do well. Meanwhile, since the election of Emmanuel Macron in 2017, French debt has been very popular and has performed well.
World cup ranking (4)
Probably Lionel Messi’s last shot at the competition he has never won, but Argentina’s preparation has been chaotic, including a 6-1 loss to Spain in a warm-up friendly. Meanwhile, at home the country is also in chaos and has had to call on the IMF for support. This could work out in bonds’ favour, at least until domestic politics intervenes.
World cup ranking (5)
A fresh team of quality players (and extremely new coach) have emerged after a disastrous Euros in 2016, however we think the team are a few years early for a World Cup win. For bonds, the market is long Spanish risk and political risk is increasing again. Better quality is available elsewhere in Europe.

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Poor PreferencESG

Preference shares took centre stage on the financial pages and Aviva press cuttings during March. It looks like we haven’t seen the end of the shenanigans with reports of further FCA digging. So what was all the fuss about?

Firstly, a bit of relevant background. These preference shares look like a bond (pay coupons) but have no fixed maturity i.e. are irredeemable. They also look like equity, carrying voting rights. Issued back in the early 1990s, at the time they added to the capital of the issuer and have traded like ultra-long bonds. Indeed as the instruments were issued with dividends (coupons) in the ball park of 8%, it is no surprise they have traded materially above their 100 issue price. The Aviva 8.625% bond was trading at 175 before the Aviva announcement.

So why did Aviva make its proposal to cancel these preference shares? Since the financial crisis there have been myriad changes to banking regulation and one of the outcomes of this is that these preference shares are not as useful as they were in counting towards capital as set down by regulators. Thus, Aviva, not unreasonably, sought to figure out how it could redeem the irredeemable preference shares.

Nothing wrong so far except for the plan. The plan proposed was in essence to amalgamate the voting rights of ordinary shareholders with those of the preference shareholders, ensuring the preference shareholder voice was drowned. Or put another way: propose a legal scheme by which the small minority (the preference shares) who are receiving those 8.625% coupons are made to vote equally with the vast majority of shareholders, who are in essence paying the 8.625% coupons. Good for ordinary shareholders because the proposition was to buy the preference shares back at 100 – where they were issued over 20 years ago – rather than the current market price of 175.

Even more succinctly, the scheme proposed a compulsory property purchase at 1990s prices (100) rather than today’s price (175). How could that “clever” scheme have been proposed? Who thought that that could be a good idea for ALL stakeholders? Forced appropriation of assets at below market price isn’t the stuff of equitable governance. No wonder there was uproar; the proposal had all the hallmarks of inward looking self-interest and absence of broader scrutiny.

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Why ESG is not new to EMD

At Kames our approach to emerging market debt shares some of the underpinnings of ESG investing. Moreover, this focus has always been integral to investing in emerging markets, long before its strands became as widespread as they are today in developed markets investing. In emerging markets, numbers have always been only half the story. Below are some thoughts and examples of what else counts.

The most important ESG factor in emerging market debt is governance. At both the sovereign and corporate level, bad governance in emerging markets can impair an investment well beyond the level typically possible in developed markets. Simply enough, the backstop of the rule of law, relied upon by investors in developed markets, is much less tested in emerging geographies. This means that the quality of the people (whether government ministers or management teams) and organisations (Ministries of Finance, Central Banks, and the like) involved is vital.

A good example at the sovereign level are the two West African countries Senegal and Cote d’Ivoire. Both score well on the highly-regarded Ibrahim Index of African Governance. Both are members of WAEMU, the West African Economic and Monetary Union, with its emphasis on co-operation, stability, and its ties to France. In addition, Senegal arguably has a stronger democratic tradition than many of its regional peers. Such indicators of governance strength are critical pillars of the credit cases in these names.

On the negative side, our view of Russian private banks and corporates is consistently held back by the encroachments of the state on the business interests of independent actors there. Notwithstanding the fact that there are, and have been, some high quality, non-state owned banks and corporates in Russia, it is hard to see past the Russian government’s centralising instinct, and its controversial foreign policy decisions, which have rebounded heavily on the Russian economy in the form of sanctions. These factors act as a persistent drag on the investment case for Russian debt.

As emerging market debt is often driven by, or linked to, commodities – oil & gas, metals & mining, agricultural commodities, and the like – and as the production of these very often has a lasting impact on geographies and populations, the questions of environmental and social factors should not be ignored, either.

For example, investors in credits exposed to Nigerian oil and gas should be aware of the controversial history of foreign involvement in the Nigerian energy space. Whether it is the industry’s environmental impact, its record in employing locals, or the imperfect nature of contracts signed, the sector is steeped in environmental and social challenges that, from our perspective, significantly raise the bar for investment in it.

More constructively, it can be argued that a positive example of social change is currently to be seen in Saudi Arabia. Under the new Crown Prince, steps are being taken to ease restrictions on the country’s large young population. These include the easing of segregation between sexes, investment in entertainment venues and the marginalisation of the religious police. There is no doubt that Saudi Arabia faces multiple challenges of other sorts under Mohammad bin Salman – a still heavily oil-dependent economy, an aggressive foreign policy, among others – but the steps being taken undoubtedly strengthen the investment case for Saudi Arabia.

It is very important to stress that questions of governance, as well as social and environmental challenges, are far from black and white issues in emerging markets. Politics are imperfect; social norms vary widely; economies are resource heavy. Indeed, an attempt to enforce a ‘one size fits all’ approach to these matters in emerging markets would be both ill-informed, and a mistake. That said, at Kames we closely consider these factors when buying emerging market bonds. In emerging markets, numbers have always been only half the story.

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Watering down tax structures

On 28 July 2010, the United Nations General Assembly explicitly recognised the human right to water and sanitation. It will also come as no surprise that in the UK we have enjoyed clean water for generations. Investing and supporting companies that deliver clean water certainly falls into ESG investing.

However, ownership of the assets that deliver water and sanitation has become political in the UK. As investors in bonds issued by water companies, we are keen to ensure that we maintain the value of our investments. There are three strands to our analysis. First is the effective management of these companies. Second, is the ability to reinvest in assets to deliver future cash flow and returns. Finally, exploring the social, regulatory and political environment in which companies operate.

It is this very last point that has recently become more material in our assessment of the UK water companies. At the start of February the Social Market Foundation issued a report claiming that the nationalisation of the water industry would cost in excess of £90bn. Water and its ownership have become a political issue; the election campaign in 2017 saw the Daily Mirror run this headline: “The Labour Party claims the water industry has been used for tax avoidance and says it’s time to bring it back into public ownership”. The use of offshore tax structures have become a political issue for an industry that has spent, and needs to spend, billions investing and delivering water in the UK.

Our fixed income team, together with our ESG-research team, has penned a letter to a number of major bond issuers in the UK water sector. We wrote that the nature of delivering clean water infrastructure requires further investment but that past and future investment should be conducted in a tax framework that, in itself, gives confidence to the public as consumers. There was no accusation of tax evasion but that certain efficient tax structures are not publically acceptable in times of strained public finances. We wrote that “Perceptions of what is acceptable have undoubtedly changed in recent years” and encouraged issuers to review tax structures that offer the perception of “cute” financing arrangements.

As investors our responsibility remains to the value of our investments. As such, and as our letter stated, “It is our responsibility to balance any reputational issues that adverse publicity may create within our overall risk assessment”. The rights and merits of public or private ownership are not ours to judge, but where we can influence to reduce uncertainty and volatility in the value of our assets, that is in our gift and interest.

Transparency builds trust and goodwill with all stakeholders (including investors). We hope that in some small part we can encourage transparency in how the companies we invest in manage their arrangements and in doing so, ensure effective delivery of water to all in the UK.

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Five things to remember from 1994

The bond market’s memory is arguably short, but 1994 remains vivid as the last time that interest rates were raised in an aggressive, systemic fashion led by the US Federal Reserve.  The effect was dramatic with a near doubling of 2 year Treasury yields to over 7.5%, with Fed Funds moving to 6% from 3%.

Here are some other facts from 1994 that still reverberate today.

1) Amazon was founded in 1994. Now with a market capitalisation of $700bn, it has had a huge impact. It has disrupted and undermined traditional market assumptions across a whole range of sectors from real estate to retailing. As a barely profitable organisation it has grabbed huge market share and decimated inflation.

2) Lehman Brothers was floated having been spun out of the Shearson Lehman Hutton combine. In under 15 years Lehman’s aggressively leveraged balance sheet collapsed with spectacular results, ensuring the rapid dismemberment of its $680bn balance sheet in a disorderly fashion.

3) NAFTA was signed in 1994. Even if it isn’t completely revoked it is viewed as helping Donald Trump to the White House. The politics of around a fifth of US cars in effect being produced outside the US lingers, despite a fourfold increase in overall trade and an ongoing cap on inflationary pressures in the US.

4) US Debt. The US Budget deficit in 1994 was 2 1/2% of GDP; and outstanding US Treasury bonds totalled a rather paltry (by 2018 standards) $4.6trillion. Fast forward to 2018 and the Federal Reserve alone has amassed almost that amount of bonds for its Quantitative Easing programme. The amount of outstanding Treasury bonds has quadrupled whilst GDP has only doubled, leaving debt to GDP double at 100%.

5) None of the above takes away from the dramatic market sell off in bonds during 1994. An index of the treasury market would have lost almost 3.5% in total with most of the damage being done in the first quarter of 1994.

Market participants rightly fear a return of such bear sentiment, but a rerun is not on the cards.

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Video: Carillion and other areas of the market investors should be wary of

Adrian Hull and Stephen Snowden share their views on Carillion and other areas of the market investors should be wary of.

‘It’s obvious that retail is going through a very difficult period of time and will continue to do so. The internet has just killed traditional retailing as we know it and the pressure will only get worse.’

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Video: A view from the US

In this short video, Adrian Hull discusses the outlook for the US market.

‘Certainly a lot of people think there will be a material repatriation of overseas assets for US corporates which will feed in to the US economy…’

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The small print view of 2018

Life as a journalist covering fixed income is usually easy in January. They will wheel out last year’s article about the imminent collapse of bond valuations and head off to the pub or the gym. If you are lucky you will get a Bill Gross soundbite for a headline! This year has so far been no different, and the Kames fixed income team is keen to avoid such hyperbole and instead offer a more grounded and realistic viewpoint. So, what do we expect?

Government bond yields will continue to remain low but the most likely outcome is that they drift a little higher in 2018. That is likely to be true across all the major markets. Today, 10-year US bonds are at 2.65%, 10-year gilts at 1.35% and 10-year bunds at 0.57%. Fixed income, like all markets, doesn’t move in a straight line, but we are most likely to be managing rates risk within portfolios, anticipating that we could see 3% on US 10s, 1.6% on gilts and potentially up to 1% on bunds during 2018 (mindful that along the way yields may well be lower than where they are today). As active investors we will change exposures and there is a fair chance that 31 December 2018 does not represent the highest point in yields.

What does that mean for short rates? We think it is unlikely that short rates head higher in the UK or Europe. That is most likely a 2019 event and the UK has to deal with the headwind of Brexit. European economies fared better in 2017 but will want to cement their growth path before looking to increase rates. As we have seen from the US, the rates path is slow and shallow. We could see further rate hikes in the US and the market anticipates between two and three increases of 0.25% in 2018. Inflation is set to remain tame by recent standards; US and European inflation could nudge up towards 2%, while UK inflation is likely to retreat from RPI above 3%.

The majority of our assets in fixed income remain invested in credit markets. Credit markets performed well in 2017 and it is unlikely we will see that same level of outperformance in 2018. Nonetheless the extra carry and returns from actively managed portfolios will add performance, and we hope to do better than just the coupons received. We have noticed an increase in events that have the potential to unnerve credit markets, but currently they have only gently rippled into sentiment. We start the year more mindful of that risk, but without a dramatic change to how portfolios were positioned before Christmas.

Each year there tends to be an event that gives us the opportunity to change our risk profiles and add to performance. Having said that, the most exciting opportunity in 2017 was early in the year during the run up to the French elections. 2017 was atypical and our expectation is that we see some events creating more material volatility in 2018. For example, that may be around the Italian elections in spring. Or a further reduction in bond purchases by central banks could inject material concerns into markets. Tax reform in the US could change some behaviours. Other geopolitical events may add to volatility. The current tentative rapprochement on the Korean peninsula may be short lived. Iranian politics could spike oil prices. Eastern European politicians may be less willing in EU plans than currently indicated. There are a host of challenges and the chance is that none of the above capture the market’s imagination but other factors do. We continue to endeavour to be ahead of events.

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Not the South Sea Bubble

Christmas allows the opportunity to pull a book off the shelf and read. This year’s thriller was “The Great Swindle” a dated (1960) historical account of the South Sea Bubble.

It’s all in there for today; credit, greed, hubris and collapse. Winners and losers. A number of parallels caught my eye. Back in 1720 there were many “bubble” sceptics and these included Britain’s first Prime Minster, Robert Walpole and the then Archbishop of Dublin who wrote “..I am not concerned in it, for I think, if the debts of the nation may be paid by th[is] folly…it will be very well for the public”. Indeed, many felt that the transfer of the public debt burden onto individual stock holders was a good thing. No need to go into the particulars of what the scheme was, but in modern day parlance it was a “debt for equity swap for UK plc”.

Skip forward almost three hundred years and many of the debates of the 1720 are today’s debates, but in reverse. Today, it is generally accepted that government debt issuance to fund the state is a good thing – the exact opposite to the purpose of the South Sea Company. One of the overriding structural changes of the last ten years has been the transfer of debt from the private to the public sector. Today’s balance sheet increase – QE – has its critics, but few argue that that response didn’t soften the impact of the 2008 recession.

South Sea led to asset price inflation as those who profited and exited South Sea investments bought carriages, houses or land. A similar comparison could be made of asset owners over the last ten years, who are seen as having benefited from QE and zero interest rates. Today’s zero interest rates has impacted materially savers solely reliant on negative real return deposits.

The South Sea Company proved to be a get rich quick scheme despite the veneer of Parliamentary respectability seeking to reduce the country’s debt burden. The timeline of today’s ZIRP is in stark, prolonged contrast and very different to the flash in the pan of 1720. Wiser punters such as Sara, The Duchess of Marlborough saw that “this…project must burst in a little while and fall to nothing”. Whilst Walpole stabilised the South Sea bubble in late 1720, it wasn’t until 1733 that the Company was divided up and over another hundred years before South Sea successor companies closed. Maybe an interesting thought to the timeline where by QE is unwound in today’s G7 economies?

At peak valuations in 1720, the value of the South Sea Company was more than the total of Great Britain’s national debt at £50m, and GDP at an estimated £64m. It makes the UK’s asset purchases of £435bn by the end of 2016 – being a mere c.25% of GDP – look rather tame by comparison. Both post 2008 and post 1720 the issue of the day was stabilisation and dealing with deflation caused by bubbles.

So what does this all tell 2018’s investors? If there is a bubble out there, likely it’s called Bitcoin or tech. Bitcoin, like tech stocks, offer exciting chances of betting on a new, different future – much the same way as the South Sea Company did in 1720. But more pertinently it’s not the bond market. Whilst government bonds most likely drift higher in yields in 2018, it’s not a bubble – there will be more to worry about elsewhere.


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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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Why a disorderly queue is worse than an orderly QE

The UK’s reputation took a further plunge as investors queued outside the Bank of England yesterday (see below) demanding payment in either gold or other hard currencies in exchange for the pound.

The currency took a further lurch lower in value after another frantic day’s trading on currency markets. Following the Governor’s refusal to bail out the UK’s major banks in 2008, the UK has failed to break from its cycle of recession after the catastrophic effects of the collapse of an effective payment system in 2008. The subsequent widespread economic hardship was exacerbated by The Bank of England’s refusal to allow Quantitative Easing (QE). The policy of QE has been aggressively pursued by other major central banks since 2009, leaving the Bank of England an outlier. The European Central Bank incrementally added its QE programme which saw a rapid solution to its “Euro crisis” in 2011.

This scene from yesterday, outside the Bank, is reminiscent of Northern Rock’s collapse 10 years ago, which saw then Chancellor Darling bail out that bank, but encouraged him and the Prime Minister to not support further bank rescues in 2008.

Yesterday’s demand was from a disparate collection of private individuals and investors, and marks the further increase in tensions as the currency slipped to further all-time lows against both the dollar and euro. As overseas investors continue to shun the UK government bond market, double-digit gilt yields further undermined equity market confidence.

Last year’s vote to leave the European Union only exacerbated the already weak financials. Conditions continue to worsen as net immigration to Europe and the rest of the world reaches levels not seen since the 19th century. The government aimed to reassure investors, but with an ounce of gold costing sterling-based investors over £10,000, it is difficult to see normal conditions returning to the UK anytime soon…

Or rather, is it just a queue of collectors keen to have one of the new Jane Austen £10 notes launched today?

My counterfactual history of events 10 years on from the financial crisis is clearly ludicrous. But whilst QE may be bad, it is like Churchill’s remarks on democracy: QE is the worst form of policy, except for all those other forms that have been tried from time to time.

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Nothing to fear except price itself?

Is the real challenge for fixed income markets solely their valuations? Most measures from the global real economy point to stronger PMI, lower unemployment or increased GDP – all suggesting that rates should be higher. So why are Treasuries at their lowest yields this year?

US rates are in the tug of war between bond bulls and bears, with bulls currently having the upper hand. There is little doubt that the 1% increase since the end of 2015 has done little to dampen the US economy; the counter to this is that the economy has not run away either, seemingly regardless of significant swings in the dollar’s value. Cheap debt has fed into all aspects of rates and credit markets as financial repression reduces yields across markets. Are we in a goldilocks scenario? Or should we fear more than price itself?

There are signs of individual sector stress that aren’t as noticeable at an asset class level. Carmakers, typically with higher credit quality, are selling fewer units, while online retailers are redefining valuations for second-tier shopping malls. Credit market quality is also a subject of debate. Looking back to 2005/06, many corporates have slunk to lower credit ratings. But for the most part debt serviceability is not materially impaired, and financials’ credit quality is demonstrably stronger.

Maybe North Korea offers the opportunity to shake things up? Spread widening reactions so far to missile tests have been measured in Richter scale numbers (single digits) rather than nuclear equivalent, tonnes (hundreds). This points to markets with lower volatility, but could be an implicit bull signal. Certainly if it is only a war of words and further sanctions achieve the removal of uncertainty, this could prove bullish for credit markets.

Of course central bankers are really key to whether we should expect more of the same or not. They have been hyper-proactive in support of monetary policy and balance sheets have grown dramatically. We are now headed into a period where a reverse is the case. The Phillips curve and other econometric models that tell us to expect inflation to materialise from current levels of unemployment and growth are being challenged. Central bankers are the pilots frantically tapping their instrument gauges, knowing they need to land but have to do it on their own as well as negotiate the crosswinds of investor sentiment.

Markets expect an orderly removal of stimulus over a long period of time – and that orderly process is captured in current market valuations. A disruption to this view could cause meaningful market volatility and a back-up in valuations.

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Back in the summer of… 2011

As fund managers interacting with our clients, the team often gets asked, “What’s the holding period for a trade”? And, given our strong belief in active management, we typically respond by explaining how we rotate our portfolios’ credit and rates exposure across issuer / sector / quality / currency to find the best value in the market. It’s not often we say “six years” and leave it as that.

But for those of you that have followed our strategic bond funds over the years, you will have noticed that we recently closed our long-held position in US Non-Agency Residential Mortgage Backed Securities (RMBS).

The aftermath of the great financial crisis created many opportunities for us as active managers. One of these transpired back in the summer of 2011, when we started to establish a position in US RMBS. These were bonds secured on pools of US mortgages that had been originated in the years 2006 and 2007 and were trading at very distressed prices (on average in the low 60 cents in the dollar). This reflected a US housing market still in a state of flux following the financial crisis, and an expectation that these bonds would experience losses as home owners defaulted on their mortgages.

At the time we believed that the pricing of the bonds reflected too pessimistic an outlook for the US housing market, pricing in significant further declines in average home prices. In our opinion, we were nearing the bottom of the housing cycle, and these bonds would perform well as the US housing market recovered. With the benefit of hindsight, we were six months too early in our entry point as US house prices didn’t trough until late 2011/early 2012. But as long-term investors and given the scale of the subsequent recovery, it is harsh to quibble about the exact timing.

Source: Bloomberg

We recently took the decision to exit this position. With average US prices now above the level they were before the financial crisis, we believe we have seen the bulk of the performance from the trade. That is not to say we believe there will be a downturn in US house prices, rather the bonds now more accurately reflect the outlook.

One of the skills we must have as active managers is the discipline to take profits on a successful trade. These bonds have been an excellent investment for our clients, with some positions generating an average return of close to 8% each year since our initial entry. They have also provided excellent diversification benefits for the funds, exhibiting very little correlation with other parts of the global fixed income market. In this case, it was well worth an extension to our typical holding period of a trade.

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Bank credit should be top of the list for income investors

The Global Financial Crisis (GFC) triggered fundamental changes to how the financial services sector operates. A slew of legislative frameworks ensued across most developed markets in an effort to prevent such a scenario from happening again. In the following years, the sector was subject to a plethora of new regulatory directives and frameworks on a global, regional and local scale. The common theme was ever higher capital requirements; the difference was how these would be met.

Fast-forward 10 years and most major global economies are in recovery mode (with varying degrees of activity picking up and unemployment falling). But the economic pain that followed the GFC is not forgotten – especially by the financial regulators. New and stricter rules require banks to hold ever more capital; it seems that each time the capital target is hit, the goal post is moved further away. From a credit investor point of view, this perpetuates a goldilocks scenario in bank credit: bank fundamentals are improving, but a large-scale redistribution of excess capital back to shareholders is constantly delayed due to the need to reach each new milestone, lowering the risk in bank credit.

As per the above, we are still in a regulatory convergence mode, and the end game is not yet in sight. What is certain is that banks’ fundamental profiles have strengthened significantly in the meantime. Most institutions now hold three times as much high quality capital compared to 2007, but this is not reflected in bond valuations. The spread on the junior-most capital layers of bank debt (the riskiest type) is five times more than senior unsecured bank credit (the safer layer), compared to just two times more in 2007. In terms of annual returns, the Bank of America Merrill Lynch Contingent Capital index achieved 5.8% in 2014, 6.9% in 2015, 7.3% in 2016 and 10.9% over 2017-to-date. The handsome yields on offer are also higher than bank equity, but with a lower volatility.*

As well as offering an attractive return profile, junior bank credit tends to have little discernible correlation to ‘traditional’ fixed income credits, as it is positively correlated to inflation and negatively correlated to interest rates. This offers investors significant diversification benefits using a building block fixed income approach.

Overall we believe that bank credit offers an excellent solution for those income investors that can look through short-term volatility and focus on annual total returns. As always, issuer and structure selection are key to avoid losses and capture the best income opportunities. At Kames we have a long history of successfully avoiding the losers in our high yield franchise, while our team combines over 30 years of fundamental bank analysis and research.

*Source: Bloomberg as at end July 2017, local currency returns. Bank of America Merrill Lynch Contingent Capital index ticker is COCO.Bank equity refers to EU Bank Equity Index’ dividend yield SX7P

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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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Masterly manipulation

“Masterly manipulation” it was called by J.M.Keynes in secret papers in the 1920’s. Today we call it QE. 

A fascinating and only recently discovered entry in old Bank of England ledgers revealed that in 1914 the Bank was forced to purchase Gilts for itself as there was insufficient demand for its new issue. The issue of the £350m “War Loan” in 1914 was reported as being a success; press articles of 1914 talk of demand ”pouring in” for the deal. Yet, £250m of the transaction was never sold and quietly shuffled away on to the Bank of England’s ledger – or balance sheet.

So what have we learnt from this historical discovery?

1) Just because the newspapers (social media, today) say it’s a good deal it doesn’t mean it is a good deal. Having some healthy scepticism is “stock-in-trade” for the Kames Fixed Income team, and we trust for our readers.

2) QE will happen in extremis but ultimately it is about delivering confidence. In 1914 it was about financing a European war and failure to be seen to be doing so would have had huge political ramifications. Similarly, in 2009 confidence in the financial system was shot and QE helped rebuild confidence in the system. Something had to be “done” and globally central bankers responded by tripling their balance sheets over the next eight years.

3) It has taken over 100 years for the “masterly manipulation” of War Loans to come to light. Despite some disquiet, Gilt purchases in the UK or purchases by other central banks have been done in an open, transparent and formulaic fashion. With today’s QE there is no obfuscation with the purchase process but QE’s unwind is less clear and a matter for public debate. Institutional transparency is a part of the confidence we have in our system. We may not like QE but it’s a whole lot more transparent than a hundred years ago.

(Thank you to the authors of the excellent bankunderground blog: https://bankunderground.co.uk/2017/08/08/your-country-needs-funds-the-extraordinary-story-of-britains-early-efforts-to-finance-the-first-world-war/#more-3230)

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Reports of my death have been greatly exaggerated – the Sterling corporate bond market continues to thrive

More than a year has passed since the Bank of England announced its £10bn Corporate Bond Purchase Scheme (CPBS). While the scheme was completed by April, much more quickly than originally anticipated, its positive impact on the market has been lasting.

Prior to the Bank’s intervention the importance of the sterling corporate bond market was under threat, in part due to poor secondary liquidity and a lack of supply from borrowers drawn to the depth, convenience and competitive pricing of the euro and dollar markets. Even UK-centric borrowers such as Royal Mail favoured the euro market over their home turf.

The backstop bid that the Bank’s scheme provided gave market makers the confidence to increase secondary liquidity through tighter bid/offer and larger size. There was concern as the scheme drew to a close in April that the improved liquidity would diminish but this hasn’t happened. Higher volumes have persisted and market participants are more confident trading larger blocks. A marked increase and greater variety of new issuance over the course of this year (gross issuance year to date has already surpassed full year 2016 volumes) has also helped to define market levels and encourage further secondary activity.

To this end, the Bank’s intervention has been a great success. A more dynamic market presents further opportunities for us as active managers to express views and add value to portfolios for the benefit of our clients.

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Does the unreliable boyfriend ever want to be Action Man?

The Governor of the Bank of England (BoE) has just said, as it released its Quarterly Inflation Report, that it expects to reduce stimulus more than the market is currently pricing.

Yet the bond market rallies.

The BoE reduced growth and wage expectations for next year, while still predicting above-target inflation three years out, and keeping alive the prospect for a rate hike. One way to square that circle is if it has lowered its assumptions about the potential growth of the economy – meaning that even if we beat trend growth just a little bit, we will be reducing slack in the economy, enough to warrant a reduction in stimulus. In other words, the UK has an even lower bar to beat. This could be seen to be hawkish.

Yet the first reaction of the market was one of scepticism, pushing out rate hike expectations even further. The Monetary Policy Committee (MPC) may now face a communication problem. It has to convince the market that it is serious about raising interest rates, after the hawkish noises heard earlier in the summer were not followed through in today’s vote (as per our earlier article, http://bondtalk.co.uk/macro/monetary-policy-soft-or-hard-approach-not-just-a-political-dilemma/ Haldane could have made it 5-3, yet the vote was 6-2).

Perhaps the best way for the MPC to communicate that it wants the market to price higher interest rates is to actually deliver and reduce the stimulus put in place last August – that will certainly get the market’s attention.

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Valuations Sour the Green Apple

This week saw the issuance of Apple’s second green bond, a $1billion 10-year transaction to help fund its goal of running 100% of the company’s operations on renewable energy. The issue builds on $1.5billion of green bonds sold by Apple a year ago, the biggest ever green bond issued by a US corporation. Whilst Apple has plenty of cash on its balance sheet the company’s issuance has helped fuel a surge in dollar green bond issuance last year, with 2016’s supply doubling 2015’s total issuance. This year so far, around $120billion worth of green bonds have been issued by corporations.

Apple has an agenda, epitomised by CEO Tim Cook attempting to persuade Donald Trump not to leave the Paris Climate Accord. Apple is committed to making the future iPhone solely from recycled materials but currently only a small percentage of the current iPhone is made from them. Apple has identified a number of materials used in their products which can be recycled and used in new products, for example aluminium that is used in the current iPhone 6 can be melted down and used in Mac computer cases.

December 2016 also saw Apple investing in four subsidiaries of China’s largest wind turbine manufacturer, Goldwind, taking 30% stakes. They are targeting directing power from the wind turbines to Apple manufacturers based in China. The company is currently using renewable energy in 96% of their stores and factories with the goal of increasing this to 100%. Apple scores very well in the E component of our ESG scoring but controversies still lie around their supply chain management, use of child labour and hazardous chemicals usage.

For investors the new green bond was fully priced at +82bps spread over the US Treasuries curve. Initial price talk at +95-100bps would have offered investors some value at launch but final pricing left little to excite. In the basket of Apple bonds this wasn’t necessarily the one to pick and, whilst the ‘green’ label is to be applauded, for a company the size of Apple corporate responsibility is more material than the odd billion of green bonds.

UK election positives

It is early days yet but it looks like Theresa May is going to be returned as prime minister as the Conservatives form a government with support from the Democratic Unionist Party (DUP). On first glance it seems a bit of a mess but taking a closer look at the results there are some positives.

Firstly, the share of the vote taken by the mainstream parties has risen as a proportion of the vote. Or putting it another way, the share of the vote taken by the extremes has fallen. The country as a whole has moved towards the middle. In England, from Right to Left, in Scotland from independence (as supported by the SNP) towards unionist, and in some places, from Anti-EU (Tory) to EU (Liberal Democrats).
What does this mean for policy? Perhaps the same – moving towards the centre, compromising on the issues that the UK faces, which could be a positive outcome.

So for example, the probability of a second independence referendum in Scotland has been reduced.  Many SNP seats were lost on this issue. Scotland is not usually prone to voting Conservative but in this election they represented the strongest voice against Independence.

Negotiations with the EU will have to be less extreme, particularly as the DUP does not want a ‘hard border’ with the Republic of Ireland. You could make the argument that a cross-party team could be appointed to lead negotiations in the national interest, but maybe that is too farfetched. However, with the decline of UKIP, it doesn’t seem likely that the current position can move any further anti-EU.

With regard to tax and fiscal policy, we can probably expect some movement towards the left, i.e. higher taxes and higher public expenditure; the Conservatives lost badly on this issue to Labour. We can probably expect the pledges regarding minimum wages being fulfilled and some of the cuts that were floated (e.g. school lunches) being abandoned.

What does this mean for UK fixed income? Probably very little, with easier fiscal policy being outweighed by reduced extremist political risk. And sterling? It could be positive depending on the Brexit negotiating stance. Monetary policy is likely to stay stable thus supporting fixed income, sterling has depreciated a lot versus both euro and US dollar over the last year, so this political event – as messy as it is – in my view is unlikely to push sterling to new lows.

Europe not Spain executes Popular wind-up

Banco Popular’s equity and subordinated bondholders have been wiped out today. To come to this end, the EU’s Single Resolution Board (SRB) has exercised its power to resolve the Spanish bank after the ECB stating last night that the lender is ‘failing or likely to fail’. The exact mechanics follow a €9.1bn provisioning and capital shortfall being identified which necessitated the writing down of equity and AT1, as well as conversion of T2 debt into Shares of Banco Popular while simultaneously transferring that equity to Banco Santander for a total consideration of €1.

Some market participants have surely been taken aback this morning by the abrupt and radical way of dealing with a failing financial institution. After all, this is the first time when the relevant resolution authorities apply the widely-advertised Bank Recovery and Resolution Directive (BRRD) rules so in essence this is the first real-world test of the new playbook. As a reminder the BRRD was put in place a little over three years ago with an explicit target to limit market and public sector implications that have in the past ensued from a failing systemic financial institution.

In that respect, albeit relatively early to say, we can observe that the first attempt of breaking (or at least loosening) the bank-sovereign nexus seems to have been a moderate success. At the time of writing, the yield on the 10-year Spanish government bonds has hardly reacted to the event. In addition, not only are there no early signs of a broader market fall-out, both within the AT1 subset as well as across peripheral banks, but the broader market tone is actually constructive, with peripheral bank AT1s leading the gains.

The muted to positive market reaction to what many feared would be a catastrophe for a nascent asset class only one year ago illustrates several key facts; 1) investors are now much better educated on the risks and mechanics of the AT1 instrument 2) the regulators have come some way to address broader market concern regarding risks in these securities and 3) the strict application of the new resolution tools gives confidence that these are not just on paper but will actually be applied as intended in a uniform way.

That last point is very important in my view in restoring the ability to price risk in future similar instances and should reduce risk premia across the capital structure going forward. We still have fresh memories of widely diverging approaches in what looked like similar instances in the past (SNS Reaal, ING/ABN/KBC bailouts, Monte Paschi). It may well be too soon to say that these examples are surely a thing of the past, but for the time being the market seems to be taking exactly that view.

Taxi Driver – the sequel

Sequels are rarely good as the first. In Robert De Niro’s original 1976 film, Taxi Driver, Vietnam veteran Travis descends into New York’s low life as sexual infatuation and delusion overtake him.

As the original is based on sex it’s no surprise that the sequel is about money. In this case the cost of being allowed to buy a New York cab licence, known as a “medallion”, and its implications.

New York cabs is a regulated market with around 13,500 medallions allowed. As New York recovered from the 2008 financial crisis, the cost or value of a medallion increased dramatically to $1.3m in 2013 being driven by a combination of this restricted market and cheap money.

And today? Medallions sell for $241,000 as Uber decimates the existing regulated taxi business. This is not without implications. Clearly the disruption caused by technology – Uber in this case – has destroyed the value of the incumbent market by 80%. No wonder taxi drivers are angry.

The figures from Capital One – the US lender – show why it’s a problem. Most cabbies don’t have the cash to buy a medallion, so borrow it. Capital One has $655m of loans to cabbies and the non-performing loan rate of that part of its lending is 52.7% – doubling over the last year. For Capital One it is a huge hit in a tiny part (0.25%) of its overall lending. Evidently chastened by large write-offs in small areas, Capital One tells us it is “building a tech brand”: reading through Capital One’s annual stockholders’ presentation and its key (basically only) theme is “disruption caused by technology”.

Lenders are starting to understand this to ensure they can effectively manage exposures to sectors under stress (e.g. cabbies) to ensure their profitability. The lesson here is that the negative effects of disruption emerge in unexpected places.

Taxi Driver the sequel has a less happy ending than the original. De Niro runs out of bullets to shoot himself but I suspect the sequel sees the cabbie succumbing to his debts. For Hollywood, the villains will clearly be bankers, but the real – and unseen – villain is surely technology.

UK election; early thoughts

It seems a done deal that the Conservative Party will win the 2017 General Election and will increase its majority in the House of Commons. The Conservatives are around 17 points ahead in the opinion polls and the Labour Party’s election campaign to date can best be described as unfortunate. Senior party members appearing to have little knowledge of basic arithmetic and the leakage of the manifesto before the official launch haven’t helped.

The gilt market and sterling are heading into this political event with a reasonable sense of calm; unusual in the context of the last three years of potentially destabilising political events, starting back with the Scottish Referendum in 2014. The expectation appears to be that an increased majority in the House of Commons gives Theresa May the negotiating power to negotiate a ‘better’ Brexit. Many have interpreted this as ‘softer’ i.e. closer to the EEA (European Economic Area) or EFTA (European Free Trade Area)-type arrangements, rather than the imposition of hard borders and resorting to WTO rules regarding trade. This has led to sterling strength against the euro and the US dollar in recent weeks.

Unfortunately it is not clear what her Brexit negotiating stance is yet. On closer inspection of the opinion polls, we see that it is the UKIP support that has collapsed and switched to the Conservative Party. The Conservative manifesto has not been published (or leaked) yet so we are still to see if the currency and bond markets have made the right assessment of a ‘better’ Brexit. What we do know is that Theresa May is firmly rejecting the idea of Free Movement of Workers, with her commitment to reduce immigration to less than 100,000 per annum. This concept is completely at odds with the pillars of free trade in the EU, EEA and EFTA.

Sterling has appreciated over 2% on a trade-weighted basis over the year to date. Gilt yields have fallen from 1.5% at the 10-year maturity to closer to 1.0% as concern over imported inflation abates.   It seems to me that although the outcome of the election is of little dispute, the outlook for Brexit and the UK remains uncertain, and the risks rise again on 8 June.

Starting the Final Lap

The final lap of the race for the French presidency has started. Emmanuel Macron with 23.75% of the votes and Marine Le Pen reaching 21.53% will compete for the second round of the French presidency on May 7. Voter turnout was 78.69% versus 80.42% in 2012.

French sovereign and corporate bond markets rallied on the back of the first round results and investor political focus will now move to the UK in June and Germany in September.

For the first time under the Fifth French Republic, neither of the two traditionalist parties (Socialists and Republicans) will be present in the second round. The magnitude of this political earthquake is amplified by summing all the extreme votes together, leaving an elevated dispersion in the French political landscape.

After the preliminary results, most of the political figures called to vote for Emmanuel Macron and to form a republican front to preclude extreme ideas reaching the Élysée Palace. Jean-Luc Mélenchon kept his distance and refused to call to vote for any of the candidates.

Emmanuel Macron is the clear favourite for the second round. The polls place him above 60% with a low uncertainty component for his voters (only 8% are not sure of their choice versus 15% for Marine Le Pen). However, his score should be lower than Jacques Chirac in 2002, the last time that the extreme right party reached the final round of the French election.

It is important to note that the polls were extremely accurate, with less than 1% difference for each candidate and the correct order. This is a strong positive for the second round as given the level of accuracy it is hard to imagine Emmanuel Macron losing 20 points to Marine Le Pen.

After the second round, the legislative election will be paramount as the country could end up tough to rule without a majority in parliament. This is the biggest weakness of Emmanuel Macron which could lead to an incapacity to reform the country with every initiative blocked by the opposition.

Official results: French election first round

The coupon’s round trip

A few days ago we wrote about the possibility of the US Federal Reserve not reinvesting maturing bonds in its QE programme. Over time this would see the Fed’s portfolio of bonds reduce to zero (a very long time). This debate is about the reinvestment of maturities, but of course ignores those tricky little coupon things.

There are a whole load of technicalities around the administration of this, but it is in governments’ interests that the QE unwind happens slowly.


Let’s look at the UK. With the Bank of England (BoE) owning £435bn of gilts, Her Majesty’s Treasury (HMT) pays £15bn to the BoE.

If the BoE kept those coupons, the amount of bonds would compound by about £15bn a year, which, over time, would exponentially increase the nominal amount of bonds held by the BoE. This would lead to the BoE in essence being dominated by that relationship – which is not ideal for a central bank tasked with delivering independent advice.

Thus, the £15bn of coupons are sent back to HMT; a “round trip” that in essence means HMT has more money in its pot – and all of the political implications around that large dollop of money.

It is odd that this receives such little attention. It should be a charged and political issue given its enormity, but it gets lost in the vastness of QE.


On Tuesday we hosted a conference where we heard from our own team and a couple of economists. Chris Watling at Longview Economics takes a, well, long view. He is quite a proponent of Kondratieff. Who he? Starting at the end, he faced Stalin’s firing squad in 1938 at the age of 46. Prior to that he had held office in 1917 as deputy minister for supply before the second, October revolution of 1917 after which he moved to academia but ultimately falling foul of Stalin’s fanaticism and being sent to the gulag.

However, in 1922 he published his first book on the long cycle. A simplified explanation is that as capital is invested it creates monies which are reinvested in similar products that are produced more cheaply until this process leads to a loss of confidence and people hoard cash rather than invest. The long cycle is around every 35 years and the slide below suggests we are at a turning point, having seen new lows in government bond markets in 2016.

I don’t dislike this explanation of the world but it has its limitations as well as practical investment limitations. Bond yields may well be materially higher in the long term but as managers we are judged on monthly, quarterly and annual performance. As yesterday’s 10bps rally in 10 year US Treasuries AFTER the Fed rate hike proves, there are plenty of opportunities on the journey to slightly higher yields.

US 10 year bond yields – 1900 to present (showing Kondratieff cycles):