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Carpets, aliens and why banking is best for bonds

With the help of some interesting metaphors Rathbone bond fund manager Bryn Jones explains why banking is ethical and high yield is doomed.
October 14, 2015

Bryn Jones, manager of Rathbone Ethical Bond (GB00B7FQJT36) and Strategic Bond (GB00B6ZS1L87) funds, is talking about carpets. "When interest rates are low Mrs Jones is asking for money for new carpets," he says. "Then rates go up. Mrs Jones wants more money for carpets but I'm spending it on the mortgage. That means the carpet company starts receiving zero and their top line gets hit. Then if they've borrowed money on a floating basis and interest rates rise they end up getting squeezed at the top and the bottom."

The manager isn't explaining a decorating predicament but his gathering concerns over the future of the high-yield corporate bond market, which he thinks could be heading for a fall. And while most bond managers have been biting their nails over interest rate rises eroding the value of their bond holdings he is more worried about the volume of companies borrowing cheap debt who could find themselves on the brink of collapse when rates finally rise.

"M&A is running at an eight-year high, leveraged buyouts are increasing and companies are borrowing to pay dividends," says Mr Jones, in his fast-paced patter. "That is all fine as long as the music plays, but when it stops some could find themselves left without chairs."

"And the problem with the high-yield market is that there are lots of tourist borrowers now," he adds, stabbing a graph in front of him impatiently. He is referring to the long list of borrowers unable to find income in a low rate environment so tempted over to the high-yield market. Those investors are the ones to be seen running for the exits when rates rise but finding themselves trapped.

This has not been a popular view in bond circles over the past year. Since the start of the year investors have been clamouring for high-yield bonds and strategic bond fund managers piled in. The prices of high-yield bonds soared way above the performance of other bond sectors including the Investment Association (IA) Global Bond sector and the IA Sterling Strategic Bond sector, reaching a peak in June. That trade unwound last month with a sell off but high-yield bonds remain above all other bond sectors.

Mr Jones is quick to point out that his concerns are for the future, not right now. He holds 23 per cent of the strategic bond fund in high-yield, but if rates rise that could change. The manager is unable to buy high-yield bonds for the ethical fund but is able to hold on to it if something gets downgraded. Currently over 15 per cent of the fund is invested in -BBB bonds.

His selections for that fund, the second-best performer in the IA Sterling Corporate Bond sector over three years according to Trustnet, are "ideas-driven". "You come up with an idea and then look at the credit, then look at the valuation," he says, asserting emphatically that he wouldn't buy into any stock with a "pony valuation".

He has moved the ethical screen to the end of the process. "If you pick something purely on the basis of it being ethical you are blinded by the ethical thing," he says.

A stock needs one positive ethical factor to make it in and cannot be chosen if it clocks up any of the team's negative screens (including things like porn, gambling or animal testing).

One of his favourite ideas is the world of banks and subordinated insurers, which he invests in via both funds. Holdings in the ethical fund include Standard Life (SL) and Principality Building Society (PBS). He is determined that financial stocks have been unfairly maligned. "Financials are less exposed to the deflationary pressures that would ravage defaults," he says.

"Imagine an alien comes down to earth in 2011 and is given a bank balance sheet and a corporate balance sheet and gets to analyse and is then asked which bond he wants to buy. He obviously wants to buy the bank bond. They are building up their balance sheets to protect bond holders. Look at the corporate balance sheet. The corporate has issued debt to buy back equity or pay a dividend and is pushing the leverage so the alien would say no."

"I always tell people my alien story and no one will ever publish it," he finishes with a chuckle.

One of his favourite stocks is Nationwide (POB), which he holds in both funds. "Companies like Nationwide have core tier one capital (an amount held in capital against the bank's risk) of over 20 per cent. It is an exceptional business with a net interest margin (which measures earnings on savings and loans) of 163 basis points and non performing loans of just £52."

While most bond fund managers are worried about rate rises he says deflation is his biggest worry for the ethical bond fund. "In a default environment I would really struggle," he says. "If you get a default and I have to sell because something gone down, that would be bad." Though he counters: "But I don't want anyone to be saying 'Bryn's going around saying all his companies are going to default'." His wife's favoured carpet company might be fine for now, then.

 

Performance (cumulative total returns %) of Rathbone bond funds

3-month6-month1-year3-year5-year10-year
Rathbone Ethical Bond Fund0.45-2.052.9822.1441.2465.18
IA Sterling Corporate Bond 0.9-3.161.7912.2125.4446.86
Rathbone Strategic Bond Fund-0.07-1.70.7512.31n/an/a
IA Strategic Bond -0.29-2.681.312.0924.6349.35

Source: FE Trustnet, as at 13 October 2015