Strategic Bond Q4 investment update

 

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As with any investment, your capital is at risk. Past performance is not a guide to future returns.

 

Sandy Jones (SJ): Welcome to the Q4 2024 Strategic Bond update. My name is Sandy Jones. I'm an investment specialist on the Income Team, and I'm joined by Robert Baltzer, co-manager of the Strategy.

As a reminder, this is a global best ideas portfolio, benchmarked against a composite index comprising 70% investment-grade bonds and 30% high-yield bonds. We seek to add value through bond selection and active management of portfolio credit risk. In addition to talking about quarterly performance and annual performance, we're going to discuss our best ideas and outlook for 2025.

In addition, we have a team update this quarter. We have appointed Theo Golden as co-manager of the strategy alongside Robert and Lesley Dunn. Theo joined us as a trainee and has impressed as an analyst and chair of the Corporate Credit Macro Meeting. Theo joins a long tradition of promoting our most talented analysts into management positions at Baillie Gifford, and we expect Theo to join Robert and Lesley and contribute strongly to the decision-making group in the years and decades ahead.

Robert, welcome. Let's start by talking about recent performance. Q4 2024 saw pretty flat returns from corporate credit markets. So, income and tightening credit spreads offset the impact of rising government bond yields. How did the strategy perform in this environment?

Robert Baltzer (RB): So Q4 was a microcosm of the year as a whole. Happily, the strategy performed well in Q4 and across the full year. If we break that down into the sources of return, the three core sources of return to the strategy are government bond returns; secondly, the extra performance of corporate bonds at asset class level; and then thirdly, our stock selection and value added. And the story of both Q4 and the full year was, as you've teed up there, a disappointing return to government bond investors yet again after a run over the last few years of negative returns.

Again, in Q4 and for the full year, the corporate bond asset class healthfully outperformed, getting us to roughly flat for the quarter, but a positive outcome for the year as a whole. And then finally, our value added through stock selection was healthfully positive both in the quarter and for the full year.

SJ: So, in summary, in the final quarter of the year, bond selection has really helped the strategy deliver a positive return relative to a flat return from the composite index.

I want to dig into 2024 performance in a bit more detail. If I go back and look at our outlook for 2024, we were optimistic about corporate credit as an asset class, specifically BBB-rated bonds. So bonds at the lower end of the investment grade credit rating spectrum. We also picked out European property names and insurers, so the likes of Admiral in the UK, as positions in the portfolio that we expected to perform strongly in 2024. How did our predictions play out in practice?

RB: We were absolutely spot on, and I hope we can keep that record up! Although getting it right most of the time is what we're striving for. So, BBBs were the source of a really big chunk of our value added through this year, and specifically the real estate and insurance sectors. So, Admiral, that you've called out, is just a really strong credit, which was recognised increasingly through the year without any specific news flow.

The European real estate sector was thematically out of favour at the start of 2024. Our holdings there are diverse, but each of them contributed positively. The two names I'd call out there are CPI, a continental European name, which we've talked about in several of the recent updates, through each quarter of the year contributed positively.

And Annington, which came good in Q4 of this year. It's actually been a slow burn. It's been a long-term holding in the portfolio. We've had an investment hypothesis for the last three years that A sale of the business was a very likely outcome. A sale to the government, who are the major tenant of the portfolio, was likely to happen. We didn't know when or exactly how. It's been a long, drawn-out process, but our patience has been rewarded. It was the key driver of stock selection added value in Q4 and features prominently for the year as a whole.

SJ: So again, in summary, a strong year in 2024, driven primarily by the bond selection effect. Knowing that I'm going to come back and revisit this in 12 months' time, which positions in the portfolio are you most optimistic about looking ahead to 2025?

RB: I would call out three different groups. So, firstly, the higher-yielding holdings, where we are being paid for risk, but we think these are resilient businesses that will generate those good high single-digit type returns. These are typically sub-investment-grade holdings, things like Brightline East, the Florida railway, Domestic & General, which is a warranty provider for your Sky box, your fridge, your boiler. and Evri, the parcel delivery company.

The second group is what we think of as undervalued, investment-grade holdings that have the potential to do well from here. So, International Workplace Group is one example. It's performed well, but I think it has further to go. Likewise, one of our friendly local rivals here, Abrdn, a fund management company.

And finally, the third group, which is perhaps most exciting, is the event-driven stories, which are idiosyncratic. Each one is different to the next but has the potential for capital appreciation driven by specific events, which might be company reorganisations, asset disposals, rating upgrades. I'm thinking there of companies like OCI, like CK Hutchison, which owns the Three telecom network, or some of the pub companies like Mitchells & Butlers, and our recent purchase, Marston's.

SJ: So a diverse range of best ideas that hold the potential to really help drive relative performance in the year ahead. We've talked about some best ideas. I want to move on and talk about positioning and outlook. When I look at the market today, it feels like we're in quite a similar position to where we were 12 months ago.

So broadly, the market environment is supportive for corporate bonds. Company fundamentals are in reasonably good shape, market level, and we expect continued support for the asset class as investors seek yield. The asset class offers attractive yields at the moment. However, credit spreads are tight. So, in other words, valuations are high. How are we thinking about positioning the portfolio for the year ahead in this context?

RB: Almost bizarrely, given how much has changed, how many things have moved over the course of 2024, we find ourselves today at a very similar starting yield to where we were 12 months ago. I think we've said consistently that the starting yield is a really good indicator of what a patient investor can expect to earn on a multi-year horizon.

So, we started last year with yields of around 5.25% on that composite index, and that's where we start this year. The return last year was around four, four-and-a-bit, to the market. So, we think a mid-single digit return expectation over the coming years is a fair one, given today's starting point.

Now, the sources of return may well be different this year from last. I don't think government bonds will continue underperforming to the extent that they have. There should be a more positive return to be had, likely, from government bonds.

Conversely, corporate bonds, which have contributed very strongly and consistently over the last couple of years, probably don't have quite so much to give at an asset class level. So the mix of returns will be different. Clearly, we're expecting to add value through stock selection, through all different market conditions.

SJ: That's a very positive note on which to finish. If we could very briefly touch on positioning in a bit more detail. How are you thinking about corporate credit risk or credit risk at portfolio level in a little bit more detail?

RB: So with that observation that we're at relatively high valuations, that we've had a good run of returns from corporate credit, we have reduced our exposure to credit risk in the portfolio. That is principally through the use of CDS contracts, derivatives that protect against movements in credit spreads. What that means is we're able to remain invested in our best bond ideas and capture the value from stock picking, but with the protection against adverse moves in credit.

 We also have dry powder in the form of both high-quality bonds in the portfolio and shorter maturity bonds, so we are able to be nimble and respond to changes in market conditions.

SJ: Thank you, Rob. So, in summary, market valuations are high. And what we've done is taken action to reduce portfolio credit risk in order to protect investors from the possibility of downside risk.

 think that is a good point on which to finish. Thank you very much for your time. And if you do have any follow-up questions, please don't hesitate to get in touch with your Baillie Gifford contact.

 

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Annual past performance to 31 December each year (net%)

	2020	2021	2022	2023	2024
Strategic Bond Composite	5.9	-0.6	-16.1	9.6	6.2
Strategic Bond Benchmark*	6.7	-0.9	-15.5	10.2	4.2

 

Annualised returns to 31 December 2024 (net%)

	1 year	5 years	10 years
Strategic Bond Composite	6.2	0.5	3.0
Strategic Bond Benchmark*	4.2	0.5	2.7

*The composite's benchmark is composed of the following: 70% ICE BofA Sterling Non-Gilt Index, 30% ICE BofA European Currency High Yield Constrained Index (Hedged to GBP). The benchmark is re-balanced quarterly.

Source: Revolution, ICE. sterling. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 1 year figures are not annualised.  

Past performance is not a guide to future returns.

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