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Be worried about high yield bonds, says Ian Spreadbury

Bond investors have grown complacent, says Fidelity's Ian Spreadbury
August 29, 2017

The bond market is looking as risky as it did before the last major financial crisis, according to Ian Spreadbury, bond stalwart and manager of IC Top 100 Fund Fidelity Strategic Bond (GB00B469J896). He says investors are loading up on too much bond risk to get their income fix.

"Investor attitude does worry me," he says. "Investors have forgotten that there is this trade-off between yield and safety and correlation [to equities]. In a downside scenario I think may investors will realise that actually they have more equity correlation or more volatility than they thought they had."

Mr Spreadbury says spreads (the amount of yield offered over and above government bonds) are approaching the low levels they hit before the financial crisis, which preceded a raft of defaults, indicating market complacency.

"The global economy is a lot more sensitive to changes in interest rates than before, given the high level of debt, and there is a level of systemic risk that is not being fully recognised by markets," he says. 

The manager has under 15 per cent in high-yield bonds today – a total which was around 5 per cent higher two years ago – and thinks the high yield market could be an accident waiting to happen. The bulk of the fund remains invested in BBB-rated and above bonds and the fund’s top holdings are in government bonds.

"One of the knock-on effects of the low interest rate regime we’ve been in has been to support poorer companies. So in other words, if you were to have a downturn, the default rate would move up, and you would have a lot of volatility in high yield," says Mr Spreadbury.

 "The credit quality [of high-yield bonds] is a little bit better since the last financial crisis but there are more financials in the index now. So, on the one hand, from a rating perspective the debt is higher quality, but on the other hand, from a downside risk perspective, the risks are just as high this time [as before the last financial crisis]. If you get a credit crunch situation with a bank you could argue that the downside potential is very high.

"So I think yes, the situation is as bad as before 2007 and I think in a downturn we could see similar levels of volatility in financials."

"The search for yield will continue but we’ve got an eye on safety," he says. The veteran manager – who has been at the helm of his fund for 12 years – is known for his defensive stance. He runs Fidelity Strategic Bond with the aim of generating growth and income at low volatility and with a low correlation to equities. The fund is able to invest anywhere in the bond market, with a mandated limit of up to 100 per cent in government or quality corporate bonds and up to 50 per cent in high-yield bonds.

Mr Spreadbury chooses to invest instead in investment grade debt in areas such as asset-backed securities (ABS) and securitisations in order to find a reasonable yield, choosing to back companies he believes will survive in the event of crisis. These are more specialist areas, which demand high conviction, and are less liquid too.

The manager has invested in deals including a securitisation for Center Parcs, the sale and leaseback of military accommodation, Annington,  as well as deals from the AA (AA) and AT&T (T:NYQ) and British American Tobacco.

He says: "We’re looking for high conviction in the credit. AT&T made an acquisition (to buy Time Warner) and has reached peak leverage, which we’re expecting to reduce over time and so are looking for an improving credit situation. British American Tobacco (BATS) is a similar scenario and Annington Finance is stable and improving credit.

"We are getting paid well to hold regulated utilities and securisations like Center Parcs and the downside risk is covered well in those areas too."

In order to manage the liquidity risk inherent with those specialist deals, the fund has a liquidity buffer of easy-to-sell holdings which could be drawn on in the event of a sudden redemption rush. Recently the manager has tapped into that and reduced it by 3 per cent – it now stands at 14 per cent – in order to make use of buying opportunities but is planning on building it back up.

The fund has also been dialling back the duration of its bonds in order to reduce the risk that they will be affected by interest rate rises – it is currently on a duration of 5.5 years compared with around seven years two years ago.

However, despite much of the market’s belief that interest rates will rise in the US, Mr Spreadbury is buying long-dated bonds there, which make up his two largest holdings in the fund. Fidelity Strategic Bond has almost 20 per cent allocated to 10 year Treasuries in two bonds.

"The market got bulled up by Trumpflation and we think that’s probably overdone," he says. "Aalthough the growth outlook in the US might be better than the UK, you can get more than double the yield on US 10-year treasuries than on government bonds in the UK, which compensates for that." The yield on 10-year treasuries currently stands at 2.12 per cent, compared to a yield of 1.01 per cent on 10-year government bonds.

The fund also has a 2.34 per cent exposure to an Australian 10-year bond in its top 10 and the fund includes exposure to Mexican and New Zealand bonds.

FIDELITY STRATEGIC BOND (GB00B469J896)  
PRICE:32.33pMEAN RETURN:3.21%
IA SECTOR:£ Strategic BondSHARPE RATIO:0.66
FUND TYPE:OEICSTANDARD DEVIATION:4.11%
FUND SIZE:£1.8bnONGOING CHARGE:1.19%
No OF HOLDINGS:712YIELD:2.31%
SET-UP DATE:28.04.05MORE DETAILS:fidelity.co.uk
MANAGER START DATE:28.04.05  

Source: Morningstar, as at 29.09.17

 

Performance 

 1-year total return (%)   3-year cumulative total return (%)5-year cumulative total return (%)10-year cumulative total return (%) Yield* Ongoing charge* 
Fidelity Strategic Bond0.269.6124.9491.252.311.19
IA Sterling Strategic Bond sector average 3.5312.5327.1962.46na 

Source: FE Analytics, as at 29.09.17 *Morningstar, as at 29.09.17

 

Top ten holdings by issuer (%) 

United States           4.91
Dominion of New Zealand3.76
Electricite de France2.98
United Kingdom 2.28
At&T2.05
Ontario (Province of)1.67
World Bank Group (The)1.64
Annington Funding plc1.32
Aviva Plc1.15
Enterprise Inns1.08

Source: Fidelity, as at 31.07.17

 

Asset allocation (%) 

Treasury12.50
Index linked3.94
Investment grade (sovs, supras and agencies)6.50
Investment grade (financials)11.99
Investment grade (ABS)27.57
Investment grade (emerging markets)1.87
High yield 27.39
Index credit default swaps 0
Other1.99
Interest rate derivatives 0
FX/ Derivative PL-2.43
Cash2.65
Rounding adjustment 0

Source: Fidelity, as at 31.07.17