Bond chief battens down the hatches
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After two extraordinary years, will the corporate bond market return to normal? As he visits advisers to explain what happened, Chris Bowie of Ignis says there are still reasons for caution.
Never tell a client that corporate bonds are safer or less volatile than equities, using that old formula that they sit somewhere on the low-end of the risk scale between deposit accounts and equities. Otherwise how will you explain the behaviour of some of the biggest bond funds over the past two years?
Sitting at the top of the one-year performance tables is Stephen Snowden’s £750m Old Mutual fund, ranked first out of 98 peers. Yet it’s also bottom decile over three years, ranked 80th out of 87.
Likewise, Ignis Corporate Bond. Top quartile over one year, bottom quartile over three. It fell 23% in 2008 but then rose 22% in 2009–a pattern mirrored by all the top 10 funds ranked over one year.
Chris Bowie, the Ignis manager, is going out on the road to explain to advisers what went on. No one will be surprised to hear the word “bank” mentioned time and again. More surprising are the words “Tesco” and “Sainsbury”.
The biggest holding in the Ignis fund is Highbury Finance 7.017% 2023. It’s one of those apparently meaningless names one sees on bond fund lists. What it is in reality is a commercial asset-backed security (CMBS) that, like everything else in the asset-backed securities market, got hammered when Lehmans went under. (article continues below)
But it is also a prime example of how quality assets can be trashed when sentiment turns against a sector. Highbury had none of the subprime mortgages so popular in other asset-backed securities (ABSs). All it had was the supermarket stores occupied by Sainsbury’s, with its credit rating directly linked to that of Sainsbury’s. But when liquidity froze, it was marked down as heavily as everything else.
”What we had never seen before was the cash prices of bonds that hadn’t even defaulted go from 100p to 20p”
In 2009 the market woke up to the fact that Sainsbury’s was hardly likely to default on its obligations, and Highbury soared.
Bowie is the first to acknowledge that 2008 and 2009 were the most extraordinarily eventful years in bond management that most of us will ever witness. He admits that part of his portfolio was “toasted”. But he wasn’t going to dump some of his prime assets (he also held a Tesco CMBS) just because the market was so indiscriminate in its sell-off.
“This was a problem by association,” says Bowie. “Every ABS was stigmatised, and put into the same bracket as the excess-leveraged collateralised debt obligations and structured investment vehicles. Yet the assets of the supermarkets are fantastic. Tesco launched at 8% but got to a 14% yield. We took the pain - but we started adding as well, and Highbury became our biggest holding.”
But the Ignis fund was not just the victim of marketmispricing. It was also overweight a lot of financials just as the crisis struck. “We were overweight Lloyds and HBOS, and we had what turned out to be high-risk subordinated debt in RBS, but we didn’t have any Icelandic banks or the pure investment banks,” says Bowie.
Then came the crunch. “It was outside any yardstick of reasoning. We had seen the Russian debt crisis in 1998, which was the worst year for many investors to date, as spreads widened by 3%. What we had never seen was the cash prices of bonds that hadn’t even defaulted go from 100p to 20p. In the old days, even a bond that defaulted would go to something like 40p.
“We thought subordinated debt was half-way to equities. Actually it was 90% of the way to equities.”
At one point you could have bought RBS debt for 15p. Today it is 70p. But, in truth, buying was not really an option as bid/offer spreads went to extraordinary levels.
Weirdly, Bowie’s best-performing holding last year was a Lehmans bond. Yes, that’s right, Lehmans. At default the bonds fell to 5p, but the failed bank did, of course, have assets on liquidation. Bowie sold his holding for 20p in December 2009. It’s quite heroic to think that anybody made money out of Lehman in 2009, but Ignis did.
Bowie also turned up his nose at the re-financing deals offered in the wake of Lloyds’ takeover of HBOS.
“In March 2009 we said ’no’ to the exchange deal,” he says. “We were being offered around half the amount but with a bigger coupon. We thought it would erode value too much and we didn’t participate. We were told that if we didn’t do it we would be left with an illiquid piece of paper that you couldn’t trade. But since then cash prices have gone back up to 60p-70p.”
Not all of them have bounced back, though. Bowie also held Bradford & Bingley tier 2 debt that is now worthless. But he rails against the behaviour of the government, which treated holders of Northern Rock differently to Bradford & Bingley.
So, after the two most sensational years in bond management, are things going to return to normal? Don’t count on it. Maybe the ultra-low volatility and ultra-low default years before the crunch will now be regarded as the abnormal bit.
Bowie reckons that defaults will start to rise. “Defaults had fallen to virtually zero because of the availability of cheap financing. My feeling is that default rates will rise again at the back end of the year, especially in high yield.”
He has gone underweight on the banks. “We have made enough money back from our subordinated financials, yet they still have a lot of issues and are going to have to work through a lot of their commercial property exposure.”
Ignis has also dumped its lower-quality ABSs, such as the pubcos (venture capitalist-backed pubs) in favour of more plain vanilla water utility bonds.
Evidently Bowie is taking a defensive stance for a few months. His chief concern is a hung parliament, which he sees as increasingly likely, and how that will spark a run on sterling. That could force the authorities to raise interest rates earlier than expected.
But he is not massively bearish. He runs a total of £10 billion in bonds at Ignis and over the past year has put £600m into new issues. For Bowie it’s just that, recently, prices have become a little fancy–he points to a Telecom Italia bond at swaps-plus-1.7%. What a shame, then, that the London Stock Exchange should choose last week to launch its bond trading platform for small (and naive?) investors.
