03 Jul 2023
Hubris: it is a strange word that conveys over-confidence. In last week’s journal I talked about Aviva and its 16% fee for a consent solicitation it was seeking on one of its bonds – a great result for us. News from Thames Water was the opposite.
Last Tuesday the CEO of Thames resigned and there was speculation that an equity injection was required to stave off Special Administration, a process specifically designed to ensure continuation of service provision by critical infrastructure whilst in administration. Whatever the outcome, it is a good illustration of why diversification is important in credit portfolios.
Security is valuable
Events such as Thames reinforce my view that security is a key credit enhancement, providing tangible backing to enhance bond recovery should a company default. However, its true value is more nuanced. By investing in bonds with the right type of security, both in terms of legal enforceability and appropriateness of collateral, dovetailing with protective covenants, such as early triggers that require issuers to supplement collateral pools as values fall, we can inject more dynamic protection into our credit portfolios. In an increasingly uncertain world, and in an asset class with asymmetric risk and return profiles, the enhanced control from secured lending is hugely beneficial.
Buying secured bonds is not a free ride. The analysis cannot be delegated and gaps in third-party ESG data must be plugged. Each bond is unique, whether due to the underlying assets or cashflows or different covenant packages and issuing structures. Accordingly, secured bond documentation is more complex and comprehensive than that for unsecured bonds. But this is a good thing. What is more, as security and covenants are permanent over the life of the bond, the extra effort required to fully understand the investment is efficient. As a market leader in this area, with multi-cycle experience, we have great insight and practical knowledge of the protections provided by covenants and bond structures.
Whilst the origin of our secured lending was initially in the unrated market, at a time when investors favoured security over credit ratings, there has been a big shift. Now, most of our secured bonds are publicly listed and rated by one of the major agencies (S&P, Moody’s, and Fitch). Infrequently we may invest in a new unrated bond, assuming we can extract offsetting benefits, in which case we will apply our own long established internal rating methodology. With the addition of securitised issues (such as Residential and Commercial Mortgage- Backed Securities) to our range of secured bonds our strategies offer clients a more comprehensive approach to secured lending. We do not see securitisation as a separate asset class – just another way for corporates to borrow in secured form. We believe it is our ability to offer a diversified credit portfolio that gives our approach to secured bonds a competitive advantage.
Market update
Back to events last week. Revised Q1 data from the UK showed that business investment has been a bit stronger than previously thought, reflecting the imminent expiry of the super-deduction investment allowance. The household saving rate saw a fall from 9.3% to 8.7%, and real household disposable incomes fell 0.8% over the quarter. As government support is reduced there are likely to be further strains with less scope to dip into savings. Here it is worth noting a blog written last week by my colleague Melanie Baker, our Economist, on timelines and monetary policy (Rate hikes: How long are the lags?). In more detail than I have set out in my Journal it explains why the lags of monetary policy may have lengthened and why interest rates are now less effective in slowing developed economies. It chimes with my view that we are still not at ‘peak rates’ and that we will see slowdowns and lower inflation later in the year.
Bond markets were on the back foot last week as we saw a rally in risk assets – particularly growth orientated equities. Yields on 10-year US treasuries rose by 10bps to above 3.8% whilst German equivalents nudged 2.4%. In the UK hit rates moved higher across the maturity spectrum with 10-year yields approaching 4.4%. Overall, these moves reflected some firming of interest rate expectations – a trend most noticeable in the US where investors are now seeing scope for further hikes. Investment grade credit spreads were little changed although high yield markets saw a spread narrowing.
A lot has been written about the need for UK pension funds to get bigger and invest more into UK infrastructure; it seems a popular refrain of politicians. But investing in infrastructure is not risk free, as events at Thames demonstrate. It is up to pension funds and their managers to assess risk. Let’s hope this idea is dropped. It is not for government to tell pensions funds how to invest; it is not their money.
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.