Outlook for the next 6 months

We approached the first 6 months of the year with caution in face of an uncertain electoral landscape, the first 100 days of a new US president, fears of populist results in French elections and local elections in Germany. We had not expected this to be compounded by yet another unfortunate election in the UK. In addition, several countries suffered unsettling terrorist attacks. 

Despite this turmoil our area of investment rode these storms relatively unfazed. A realization that the growth policies of an ebullient US president would be hampered by the failure of the repeal of ObamaCare in February saw yields in the US fall back from their highs. Similar low inflation and tepid growth in Europe and the UK allowed bond yields to remain low.

With this as background, we look forward towards the next 6 to 12 months.

There are two important sources of return for the fund. The first which is significant and always positive is the yield from the underlying bonds. Yield is the most important component of the fund, with a current yield to maturity of 5.60% p.a for the USD fund, 4.89% p.a for GBP fund and 4.36% p.a for EUR fund.

On a quarterly basis this is not necessarily the predominant feature but it should not be underestimated. The second component of return for the fund is capital gain or loss. In itself this can be broken down into realized and unrealized gains or losses. In general as the fund follows a buy and hold strategy, this component of the fund is largely the result of prices being marked up and down.

So when asked for our outlook, the income flow is quite predictable at around 35–45 bp a month and the question is what could move prices up or down.

During the last six months prices moved up as we saw improvements in the results of many of our companies, and also as economies seem to be strengthening. We continue to see economies moving on a steady upward trend; even if not at the pace that might have been expected a few months ago, there are few signs of recessionary clouds.

One issue that has troubled the market for some time and seems to have dissipated is the fear of contagion from very weak banks in Italy and in the European periphery.

The last few weeks saw several high profile bank failures that did not cause contagion and this was reassuring for our strategy.

To give some detail, the swift and successful intervention by the European Central Bank’s Single Resolution Board, only 2 years old, saw the failing Spanish bank Banco Popular dealt with overnight with the aims of Basel III regulations boxes ticked: 1) No too big to fail, 2) No taxpayer money 3) No systemic contagion and 4) Depositors protected. Shareholders and Junior debt holders were wiped out as designed and the banking institution itself carries on under another management and owner. 

A few weeks later a similar system was applied to two weak Italian banks. Three out of four of the goals here were achieved as the Italian authorities did use taxpayer money to take over their bad debt. But no contagion: and depositors protected.

A few years ago, such events would have caused major disruption to the whole market. In this episode the opposite happened – the prices of some other banks went up. If these tests have been passed with such equanimity, this bodes well for the next few months.

One lesson to learn, however, is the importance of being very selective with our investments. No longer can one lump all banks into ‘an overall view’, or ’just buy a basket’. This plays to our strength of bottom-up company analysis. 

Another concern in the market is interest rate rises

While US strength has disappointed expectations, there are signs of growth momentum in Europe and fears of inflation in the UK. As those who have followed our fund for a while will know we try to be relatively interest rate insensitive by investing half in fixed rates and half in fixed to floaters, so interest rate moves tend to be a much tamer influence on our performance, compared with other bond funds whose performance is dependent on forecasting the level of rates.

Should there be a gradual rise in rates, we would view this with relative equanimity.

In fact, if rates do rise gradually we would look forward to that, to be able to lock in to higher yields on the fixed-rate part of our fund when reinvesting coupon income, buying new issues or investing the proceeds from maturing holdings.  

A third concern in the market is the beginning of tapering in Europe

We do indeed expect a gradual tapering in Europe over the next twelve months as the as economies improve. The expectation is often that when the ECB stops buying bonds, prices will fall. Our main area of investment in subordinated financial debt was excluded from the ECB’s list of bonds that they could buy so we would not face the potential ‘selling’ pressure that many holders of senior debt might have to cope with. The experience in any case from the US when it started reducing bond purchases was that there wasn’t a 'cliff edge' fall in prices – prices tend to be set by the level of government bonds.

Given that, we try to be rate-indifferent as mentioned above, we do not expect tapering to have a large impact on our portfolio.

Indeed nor did it during the US ‘taper tantrum’ in 2013. In that respect you must make a distinction between our bond fund and ‘the bond market’.

Those are some of the known unknowns. As to the unknown unknowns we try to prepare and protect ourselves from the unexpected by concentrating on top-quality companies and wide diversification across different types of bond: junior, senior, short dated, long dated, fixed, floating, and fixed to floating to help us ride out different market conditions. Also, to protect against idiosyncratic credit events which affect individual holdings, such as a credit event, some unexpected bad news, we diversify across a large number of holdings (the unexpected can also be good news – a bond called at a premium to the current price, or a takeover by a stronger company, examples of both of which we saw in the first half of 2017).

Should we run into an exogenous event or systemic crisis, in our experience, this affects the pricing of our bonds for a while but rarely has a longer-term impact on the bonds themselves or the coupon income we earn; so we try to use these episodes to lock into good yields in bonds we like at their lower prices, selling some higher-priced bonds and aiming to come out from such episodes with a stronger portfolio.

In summary, as we said at the beginning our performance tends over time to be driven by our coupon income which is predictable and accrues daily. While prices move up or down, our performance over time should approximate the yield on our fact sheets for the long-term holders of our funds who can enjoy what Warren Buffet refers to as ‘the single most powerful factor behind investing success – Compound Interest’.


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