Artemis: Strategic Bond: A time for circumspection...

If President Trump has any success in reducing taxes, he will boost an economy that is already performing well. The consequence is likely to be inflation. James Foster, fund manager of the Artemis Strategic Bond Fund, explains why.

The fund delivered a return of 3.6% over the six months to the end of September, a healthy measure of outperformance relative to our peer group, where the average return was 1.9%. Of far greater importance to us, however, is that returns over the longer term remain strong too. Since the fund’s launch over 12 years ago, we have outperformed our average competitor by nearly 30 percentage points, putting our fund safely in the top quartile of its peer group.

* Data from 30 June 2005. Source: Lipper Limited, class QI data from 30 June 2005 to 7 March 2008 reflects class QR accumulation units and from 7 March 2008 to 30 September 2017 reflects class QI accumulation units, bid to bid in sterling. All figures show total returns with net interest reinvested. Sector is IA £ Strategic Bond.

Review - As the challenges facing the UK multiply, we look overseas...

Theresa May’s gamble in calling an early general election failed spectacularly. She lost her working majority and must now depend on the support of the Democratic Unionist Party and fringe elements in her own party, weakening her negotiating stance in the Brexit talks. The reaction of the UK bond market, however, has been surprisingly muted – perhaps because there are countervailing forces at work.

On the one hand, if May were to fall, a Labour government led by Jeremy Corbyn would be expected to increase expenditure significantly and so is perceived as extremely bad news for gilts. But on the other hand, Theresa May is regarded as beholden to fringes of her party and the DUP and so less likely to get a good deal with the EU. The expectation is that this will slow the UK economy, meaning less pressure on interest rates to rise – which would be helpful for UK government bonds.

Over the period the markets focused more on the potential for rates to rise in the short-term, with the result that UK government bond yields edged up by about 20 basis points. Given the political turmoil, this was hardly a dramatic change.

As ever, movements in the US bond market are of greater significance: where America leads, the world follows. As expected, the Federal Reserve raised rates in June. Sentiment regarding the prospect of further increases fluctuated over the period. Politics interfered here, with Janet Yellen’s future as chair of the Federal Reserve being reviewed by President Trump.

On the other hand, the market has been kept alert by the war of words with North Korea. An outright nuclear war would, quite apart from the catastrophic loss of human life, be devastating for the global economy, leading to sharp cuts to interest rates and lower bond yields. Under normal circumstances, the chances of such a conflict would seem remote. But with president Trump in charge, the market has to give the idea some credence. Overall, we would suggest that because of the heightened political risk, yields are lower than they would otherwise be, primarily in the US but in other parts of the world too.

Away from politics, the most important factor has been economic growth, which has been strong, especially in the US but picking up in Europe. Quantitative easing (QE), which has generated negative government yields for German government bonds, is going to be scaled back gradually. In the US, the Federal Reserve is even selling some of the bonds it has accumulated, reducing the size of its balance sheet. Clearly, that makes conditions for government bonds more challenging. Despite this, US Treasury yields were broadly unchanged over the six months while yields on European government bonds were up by around 15 basis points.

Turning to investment-grade bonds (those rated BBB and above), the last six months have brought a bonanza of issuance. Companies are taking advantage of strong demand and are gearing up. The issuance has been broad-based, coming across all sectors and with yields that we have often found very unattractive. We have avoided nearly all of this new issuance. The main exception has been some banks: our exposure to banks’ riskier junior bonds has risen. While we are aware that risks in the portfolio have increased as a result, these holdings have done wonders, providing a reasonable yield and some capital gain. Similarly, our insurance holdings have generated strong returns, although some were a touch weaker at the end of the period due to an exceptionally violent hurricane season.

Brexit has begun to have an impact on our decision-making: a greater percentage of the fund is now invested in the bonds of overseas (European and US) issuers. We have been reducing domestic-oriented businesses, and, in particular, UK banks. The housing market is showing signs of weakness; and if it weakens further, fears about banks’ profitability and the sustainability of coupons on their junior bonds will spread.

We believe the chance of banks not paying a coupon is remote, but the mere thought of it has been enough to weigh on our UK bank bonds.  Our European banking positions have outperformed.

Lastly, high-yield bonds (those rated below BBB) have been stellar performers. Having over 50% of the portfolio invested in this asset class has proven wise. Yields, however, are now down to unprecedented levels. In Europe, the high yield index yields about the same as 10-year US Treasuries. That is madness. The risks associated with holding US Treasuries are obviously far smaller. But QE in Europe has created forced buyers and so is distorting the market. We have been taking advantage; and are gradually selling our positions in Europe and reinvesting the proceeds in the US. 

We have been increasing the fund’s exposure to bonds issued by oil companies. The oil price has been weak and investors fear another rout, with defaults by oil companies rising. We think this is unlikely: the last collapse in the oil price wiped out the sector’s weakest companies. Those who survived should prosper.

Outlook - A time for circumspection...

This is a time to be wary. Any company (or government) – even the most poorly managed – can raise money in a market flush with cash. For example, Argentina recently issued a 100-year bond with a 7.125% coupon. It has defaulted eight times in the last two centuries – and twice in this century alone. Such exuberance will inevitably lead to disappointment. So we are being much more selective.

A number of areas of the market are of particular concern to us. First, government bonds. We have made little mention of inflation in this report – but that doesn’t mean it has gone away. Good economic growth in the UK with record low levels of unemployment will lead to wage inflation. Add to that increasing political influence of resurgent unions and a European workforce less prepared to work in the UK (because of uncertainty about Brexit), and higher wage inflation is a risk. As we expected, interest rates in the UK rose in early November (although we don’t expect them to go much further).

In the US, similarly, the path towards higher interest rates seems set to continue. Unemployment is at record lows. If President Trump has any success in reducing taxes, he will boost an economy that is already performing well. The consequence is likely to be inflation - which the Federal Reserve will counter by raising rates.

After years in the doldrums, Europe is generating much better growth, especially on its periphery. The European crisis is over – for now. Our predictions that Greece would drop out of the eurozone proved wrong. Obviously there are political tensions in Spain, but the overall picture for the banks and insurance companies is improving markedly. The need, therefore, for the generous and extensive QE programme to continue is unclear. It is to be scaled back in the coming months. European government bonds will struggle as a result. Negative yields on German government bonds seem ridiculous and should correct to more sensible levels.

Personal credit is another area of concern. Provident Financial’s woes have been well documented (its share price is down approximately 70% this year). To be fair, this is probably as much due to mismanagement as it is to pressures in its market. But sub-prime lending is a dangerous place when inflation is rising, when real wages are being squeezed and when regulators (and politicians) are getting nastier.

Related to this is a risk that may have slipped the beneath the radar of the regulators: car financing deals. Personal contract purchases (PCPs) now account for over 80% of car sales. We have a number of concerns. First, we question whether adequate credit checks are in place. If not, the credit providers could be at risk because the FCA tends to favour the consumer. Second, they are guaranteeing the future value of these cars. A whole generation of diesel cars is being shunned, as the world realises that diesel is a dirty, noxious fuel. Petrol cars, meanwhile, are likely to be replaced by electric cars, albeit over a long time scale. The future second-hand value of the car may not match the rosy expectations of the seller. In that case, the guarantors will be on the hook for any shortfall. Those guarantors are certain banks and the car manufacturers themselves (and their finance arms). We are concerned the liabilities could be enormous so are avoiding these accordingly.

Clearly, the list of areas that worry us is quite long. But we are finding value. In Europe, high-yield bonds are yielding very little – but banks are yielding a lot more. So we are happy to retain many of our holdings in European lenders and are generally increasing our positions here, having sold some of our UK banks. More broadly, our exposure to European companies is falling in favour of US high-yield which looks more attractive. In particular, some parts of the US energy sector offer good value. We expect this trend to continue over the coming months.

Although the performance we have delivered to our unitholders since launching the fund in 2005 brings us considerable satisfaction, we are far from self-satisfied. Preserving and extending that record is our most important job. There is no doubt that if we stay heavily invested in high-yield bonds for too long, we will damage our performance. So we remain alert to the risks they face. The real catalyst for change is likely to be rising defaults. For now, however, the situation remains very benign.

In the meantime, our primary concerns surround government bonds. As inflation rises and interest rates push yields higher, government bonds are likely to be the main source of grumpiness, losing investors’ money. We are well placed for that eventuality: we have sold futures in both US Treasuries and German government bonds. If yields rise, those positions will profit. We appreciate that our forecast for higher yields in the short term has yet to be borne out – but we are confident in the longer term outlook. Furthermore, should there be a sell-off, we have enough cash and near-cash assets to adjust the portfolio quickly.

A number of challenges lie ahead. But we feel confident that our portfolio of bonds is both well-placed to meet them and to continue to prosper.

Please remember that past performance is not a guide to the future. Source: Lipper Limited, bid to bid in sterling. All figures show total returns with dividends reinvested.

James Foster and Alex Ralph manage the Artemis Strategic Bond Fund; visit the fund page for further information about the fund, its performance and current positioning. 

THIS INFORMATION IS FOR PROFESSIONAL ADVISERS ONLY and should not be relied upon by retail investors.

The fund may use derivatives to meet its investment objective, to protect the value of the fund, to reduce costs and with the aim of profiting from falling prices. The fund may invest in fixed interest securities.The fund may invest in higher yielding bonds. The fund holds bonds which could prove difficult to sell. As a result, the fund may have to lower the selling price, sell other investments or forego more appealing investment opportunities.

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