It has been a difficult year for investors in government bonds. Yields on ten-year issues are very low (1.6% in the US, 1% in the UK, just positive in Japan but just negative in Germany) but rising as prices fall, hitting capital returns and turning total returns negative. Most debt funds, however, have not only generated positive, if modest, capital returns but also paid dividends with a yield of more than 5%.
Typical are the two listed funds of TwentyFour Asset Management: the £575m Income Fund (LSE: TFIF) yielding 5.7% and the £180m Select Monthly Income Fund (LSE: SMIF) yielding 6.4%. The former invests in UK and European “asset backed securities” such as packages of mortgages and secured loans; the latter in the debt of UK and European banks and insurance companies as well as asset-backed securities and other high-yielding debt.
TFIF takes no “duration risk”, investing in floating rather than fixed-rate debt. SMIF’s investments are fixed-rate but with an average of just 3.2 years to redemption. Both funds focus on credit, buying debt offering a yield premium over risk-free government paper that they think is attractive. If this “spread” narrows, the capital value will appreciate, in addition to which a relatively generous yield will be collected.
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“I am much happier owning credit than interest-rate duration,” says CEO Mark Holman. “The fundamentals for credit are rarely, if ever, this good. Corporate earnings are fantastic, interest rates are ultra-low, there is fiscal stimulus like you’ve never seen before and default rates have plunged. They are likely to be below 1% in the US and Europe by the end of the year.”
Quality credit is vulnerable to higher interest rates “so this is the time to fish further down the risk spectrum in more lowly-rated credits. There are two to three upgrades for every downgrade, with downgrades focused on areas like retail, autos and property facing structural reform.” As for upgrades, he thinks bank credit is attractive. “Banks had the best part of the pandemic and are now a massive part of the recovery but spreads over risk-free are still 300 basis points (3%). There is further to go as spreads have been just 100 basis points in the past.” Secured loans also represent good value with margins of 600 basis points over risk-free rates.
In terms of geography, Holman prefers eurozone credit as it offers better relative value. The UK is next as there is still a Brexit premium; the US last. The same order of preference applies to bonds as he expects the US Federal Reserve to start tightening monetary policy soon. “I don’t understand why they are still engaging in quantitative easing”.
By mid-2023, he expects them to start raising interest rates with perhaps six or seven rises in 12 months to reach a peak of around 2%. With ten-year Treasury yields likely to reach 2.5%, this would be “painful for bond investors but the price in terms of inflation of getting jobs back is acceptable to the Federal Reserve”. History shows that “the peak in yields happens well into the hiking cycle so we are a long way from wanting to own Treasuries.”
The Bank of England “is likely to be the first to raise rates in the first half of 2022” but the European Central Bank “might not be able to get rates above zero”. The Federal Reserve is still insisting that inflationary pressures are “transitory” but the professed uncertainty and hence pragmatism of the Bank of England secures Holman’s approval.
What could go wrong with this relatively benign thesis? Consumers are catching up on the spending lost in the pandemic but higher prices and taxes will squeeze net incomes. This could lead to a slowdown or even a recession next year, which would be positive for bond markets but not for credit spreads. TwentyFour might not see this coming but their record, annualised returns of 7% for TFIF and 8.4% for SMIF over five years, suggests otherwise.
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