Each week, a professional investor tells MoneyWeek where he’d put his money now. This week: James Foster, co-manager of the Artemis Monthly Distribution Fund.
This summer’s news bulletins have been dominated by the shambles in Greece rather than discussions about interest rates. It’s understandable. The Delphic comments of central bankers cannot hope to compete with the drama of all-night meetings and high-level political horse-trading in Brussels. Yet the relatively small size of the Greek economy means that, whatever solution the eurozone eventually stumbles upon, its real significance will be political rather than economic. Globally, the more pressing question remains when – and at what pace – rates will rise. Although the first rate rise by the US Federal Reserve is already “in the price”, there is less certainty about the timing of the second and third increases.
This has implications for asset prices globally. The yield curve on government bonds represents the market’s best guess as to the future path of short-term interest rates. In turn, government bonds in general – and US Treasuries in particular – are the asset against which everything else is measured. So, as we saw during the “taper tantrum” in 2013 (when the Federal Reserve began gradually winding down its quantitative-easing programme), changing expectations around monetary policy can provoke extreme volatility.
So what can investors do? Some degree of diversification seems sensible. The correlation between equities and fixed income has been quite low during many previous interest-rate cycles. We adopt a straightforward approach to spreading our risk, with around 60% in fixed income and 40% in dividend-paying stocks. It sounds simple – but it has served the fund well since its launch. But even in a well-diversified portfolio, generating an attractive income without taking unacceptable risks means striking a balance. At one extreme lie the highest-yielding, riskiest bonds. At the other are government bonds, which are reputedly safe but low yielding and (as we saw earlier this year) potentially volatile.
Meanwhile, traditionally high-yielding, “safe” equities have enjoyed a significant re-rating over the last five or six years. Their rising share prices mean these companies no longer provide the yield they once did. How are we striking that balance today? Firstly, through a significant allocation to banks. They’re hardly popular, but banks aren’t the pariahs they once were. They will benefit from higher rates (which help their net interest margins) and are rebuilding their balance sheets. Some even pay dividends, a sign that the regulator believes they are in a good financial position. On the bond side we favour Virgin Money, a bank focused on credit cards and mortgages. It has a strong brand and none of its rivals’ legacy issues.
We also have significant exposure to high-yield bonds. The yield contributes to our income account, and with yields likely to move higher, they also have the advantage of being less correlated with government bonds than their investment-grade peers (in other words, movements in their prices are less closely tied to movements in government bond prices).
Our holdings include the AA. The company operates a duopoly in roadside assistance with the RAC, so it generates dependable revenues, and a refinancing earlier this year reduced its interest costs.
Cinema chain Odeon is another high-yield bond we like. Although highly leveraged, the company’s management team is getting to grips with this, and debt levels are falling quite sharply. Blockbuster films will help – the fourth quarter of this year will bring both a new James Bond film and the latest instalment in the Star Wars franchise. Cinephiles may demur, but Odeon’s bondholders can look forward to the autumn with optimism.