1. BONDS BEATS – RESILIENCE FIRST BECAUSE THAT’S WHAT MATTERS

    NOVEMBER 2019
  2. When troubled US retailer, Sears, filed for Chapter 11 bankruptcy in October 2018, it was of little consequence whether investors owned their bonds due in 2019 or 2032 – all of its debt plunged in price leaving bondholders with a permanent loss of capital.
  3. The value of an investment in the fund, and any income from it, can fall as well as rise and investors may not get back the amount invested.

    High-yield bond investors navigate many such landmines. Recent high-profile examples include UK travel operator, Thomas Cook, Belgian zinc producer, Nyrstar, and German wind turbine manufacturer, Senvion. All had one common denominator: an inability to repay debt obligations to their lenders.

    The European high-yield bond market offers an enticing yield of 3.4 per cent. Relative to a 10-year UK government bond offering 0.7 per cent, this is an attractive pick-up in potential investment return.

    But the returns are generous precisely because high-yield bonds are issued by companies which have a risk of defaulting on their debt obligations. As defaults can materially curtail returns, we spend a substantial amount of our time analysing the credit risk of the companies to which we lend.

    We seek out resilient businesses with a strong competitive position, great management teams, solid environmental, social and corporate governance (ESG) credentials and an appropriate balance sheet for the business and industry risks that they’re facing. We stress-test our companies through ‘pre-mortem’ scenarios, constantly challenging our investment cases so that we avoid the losers and pick the winners. We are proud of the High Yield Bond Fund’s history of having much lower defaults relative to the market since its inception.

    While the importance of avoiding defaults seems pretty clear, where does this leave the impact of macroeconomic factors in a high-yield bond portfolio? We are constantly bombarded by seemingly important newsflow – whether it’s on Brexit, geopolitical tensions, oil price moves, central bank decisions or the ongoing US-China trade war. Surely that counts for something?

    In fact, the key risk for us is of distraction from our core task of credit analysis. Just because President Trump is currently favouring a trade deal with China, it doesn’t mean he will be supportive a few days later. In our view, it is best to acknowledge the resulting volatility, and move on. We have absolutely no macroeconomic overlays in our portfolios and no intention of introducing them.

    We only take exogenous factors into account if they could have direct impacts on a company’s underlying resilience. For example, we sold Jaguar Land Rover bonds not long after the Brexit vote because we were concerned about the company’s competitive position, given its UK-centric manufacturing footprint, the potential for tariffs from abroad as well as more broad-based concerns about management’s strategy and high diesel product mix.

    However, we continue to invest heavily in sterling-denominated high-yield bonds because we think companies like Virgin Media, Rothesay Life and the Co-operative Group are fundamentally sound. Brexit-related headlines are, all too often, a red herring.

    Another top-down theme attracting significant investor attention has been the trajectory of interest rates in developed markets. Taking a step back, there is a basic relationship in bond investing that says if interest rates go down, the price of bonds go up, and vice-versa. To benefit from movements in the discount rate, a bond investor can try to second-guess central banks.

    It was fashionable, particularly in late-2018, to express a view that interest rates must rise back closer to pre-crisis levels after the end of quantitative easing. Many investors tilted their portfolios to reflect that view by buying short maturity bonds (which tend to outperform longer maturity bonds in such a scenario). This was not a good idea, because the opposite happened. The 10-year German Government Bond, which began the year at 0.2 per cent yield, has reached deeply negative territory at -0.3 per cent.  

    The current ‘trendy’ bet is that the Federal Reserve will continue to lower interest rates given the increasing risk of a recession in the USA – hence, many fund managers rotating into longer dollar-denominated bonds in order to potentially benefit. But what if the USA avoids a recession or the Federal Reserve doesn’t follow through?

    Our approach to managing this challenge is simple – we take no view. Our analysis indicates that, for the high-yield asset class, these impacts are short-term, at best. We believe it is not worth our while trying to forecast which way interest rates will move next. We use the time we save by not worrying about macroeconomic analysis to pour our energy into researching companies who will stand the test of time when their bonds mature.

    We focus on one question – is a company resilient enough to repay its debt obligations in a wide range of scenarios? If the answer is yes, and the yield on offer covers our risks, we lend to it.

    Simple, really.

  4. IMPORTANT INFORMATION AND RISK FACTORS

    The views expressed in this blog should not be considered as advice or a recommendation to buy, sell or hold a particular investment and it does not in any way constitute investment advice.

    This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

    This blog contains information on investments which does not constitute independent investment research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.

    Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the fund invests may not be able to pay the bond income as promised or could fail to repay the capital amount.

    Issued by Baillie Gifford & Co Limited which is authorised and regulated by the Financial Conduct Authority (FCA).



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