13 Apr 2023
Jonathan Platt, Head of Fixed Income
I could write about the relative stability of bond markets and the unwinding of some of the more aggressive interest rate cut calls.
However, as today (11 April 2023) marks the 20th anniversary of the launch of the Royal London Sterling Extra Yield Bond Fund, I will depart from my usual weekly update.
The fund arose from an idea proposed by Eric Holt (Senior Credit Fund Manager). For those who know Eric it should not be surprising that this offered something new in the marketplace – as Eric has never been one to follow the herd.
The concept was simple. The opportunity set in fixed income is massive but there are clear inefficiencies. The fund was devised to go anywhere, to seek out inefficiencies and find undervalued debt on a global basis. Being aware that most potential investors, at the time, were sterling orientated we determined that a maximum of 25% could be held in non-sterling bonds.
This ‘go anywhere’ mentality pre-dated the unconstrained strategies that have developed in recent years and was based upon the view that bond markets offered the active manager significant scope to add value. Eric felt that having the ability to combine investment grade, high yield and non-rated bonds was the best way of achieving strong long-term returns.
I remember the debates we had internally about what was the best benchmark for the fund. In the end we decided to forego a credit index and just target a yield advantage over UK government bonds. In this way Eric was not beholden to any credit benchmark and could pick the securities we most favoured.
I will not comment upon the performance of the fund over the last 20 years – this is a matter of public record. What is more interesting is how this has been achieved and why others have not mimicked this strategy. We ourselves have built on demand for the fund through Royal London Global Bond Opportunities, a strategy that follows a similar approach but with no sterling bond constraint. Eric and Rachid Semaoune work together as co-managers on both funds.
The key driver of the portfolio has been the Royal London Asset Management credit investment philosophy – but just taken a bit further. Yes, this does mean more risk, as demonstrated by the drawdowns experienced during the Great Financial Crisis (GFC) and the early Covid period. But I believe that the longer-term benefits of compounding superior income generation speak for themselves. I think credit is a great asset class, with attractive features, but it should not be regarded as a place to park short-term cash. Leave that to specialist liquidity funds.
What the Royal London Sterling Extra Yield Bond Fund has done very successfully is to combine secured and unsecured debt whilst offering a significant income premium over investment grade credit – and indeed many pure high yield strategies. In part this reflects investors’ underappreciation of the merits of secured debt. Often this is because they see no credit rating. By being prepared to invest in non-rated bonds the fund has tapped into an under-researched and less efficient market of the global credit market. Let’s be clear, secured bonds have risk and the profile of secured debt held by this fund differs from our mainstream credit portfolios. In particular, there are positions in Nordic offshore oil & gas companies, less exposure to the big real estate issuers and more idiosyncratic positions – some that lie outside the comfort zone of benchmark constrained strategies.
But this fund is not just about secured or unrated debt. The added factor in Eric and Rachid’s approach is to also capture the out of favour, undervalued investment grade bonds, complemented by an exposure to sub-investment grade bonds. And the high yield bonds we hold are not a replication of high yield indices; they reflect a genuine diversification from sub-investment grade benchmarks. Let’s not duck a key issue. Does this approach mean that liquidity is sacrificed? My response is that through the 20 years of its life, the fund has always offered daily liquidity to our clients. And those conditions were a really good stress test: GFC, Euro crisis, Brexit, Covid and the recent banking turmoil. Indeed, liquidity is a difficult concept to define – it is a point in time assessment. The most ‘liquid’ bonds can become illiquid when bad events happen.
Why did others not go down the same route? I think there are several reasons. First, there needs to be a mindset to challenge conventional thinking. The benchmark orientation of many investors can be like a comfort blanket: thinking outside the box is not required as the universe is defined by the benchmark. Second, there are the insights gained through managing strategies in tough times. Eric and Rachid are hugely experienced managers, whose approaches have been tested by severe economic and market events. What experience delivers is an ability to see a bigger picture, underpinned by a core investment philosophy. In short, the confidence not to be blown off course by events. Finally, there is the backing of our wider Fixed Income team, comprising analysts and fund managers who are prepared and encouraged to seek out credit market inefficiencies.
As passive strategies gain ground, I believe that the advantages of our investment philosophy, which reaches its most intense form in these two strategies, become more apparent. These funds offer a clearly differentiated approach and over 20 years, the Sterling Extra Yield Bond Fund has demonstrated how this can work to the benefit of our clients. Can it remain successful in the future? You can guess my view.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.
Fund Risks
Investment Risk The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested.
Credit Risk Should the issuer of a fixed income security become unable to make income or capital payments, or their rating is downgraded, the value of that investment will fall. Fixed income securities that have a lower credit rating can pay a higher level of income and have an increased risk of default.
Derivative Risk Derivatives are highly sensitive to Derivative Risk changes in the value of the underlying asset which can increase both Fund losses and gains. The impact to the Fund can be greater where they are used in an extensive or complex manner, where the Fund could lose significantly more than the amount invested in derivatives.
EPM Techniques The Fund may engage in EPM techniques including holdings of derivative instruments. Whilst intended to reduce risk, the use of these instruments may expose the Fund to increased price volatility.
Exchange Rate Risk Changes in currency exchange rates may affect the value of your investment.
Interest Rate Risk Fixed interest securities are particularly affected by trends in interest rates and inflation. If interest rates go up, the value of capital may fall, and vice versa. Inflation will also decrease the real value of capital.
Liquidity Risk In difficult market conditions the value of certain fund investments may be difficult to value and harder to sell, or sell at a fairs price, resulting in unpredictable falls in the value of your holding.
Emerging Markets Risk Investing in Emerging Markets Emerging Markets Risk may provide the potential for greater rewards but carries greater risk due to the possibility of high volatility, low liquidity, currency fluctuations, the adverse effect of social, political and economic instability, weak supervisory structures and accounting standards.
Counterparty Risk The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.
The Royal London Sterling Extra Yield Bond and Royal London Global Bond Opportunities Funds are sub-funds of Royal London Asset Management Funds plc, an open-ended investment company with variable capital (ICVC), with segregated liability between sub-funds. Incorporated with limited liability under the laws of Ireland and authorised by the Central Bank of Ireland as a UCITS Fund. It is a recognised scheme under the Financial Services and Markets Act 2000. The Management Company is FundRock Management Company SA, Registered office: 33 rue de Gasperich, L – 5826 Hesperange, Luxembourg and is authorised and regulated by the Commission de Surveillance du Secteur Financier (CSSF). The Investment Manager is Royal London Asset Management Limited. For more information on the Funds or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.com. Most of the protections provided by the UK regulatory system, and the compensation under the Financial Services Compensation Scheme, will not be available.