Sustainable out performance and a dangerous game of Monopoly

Rathbone Ethical Bond is the top-performing fund in the Investment Association (IA) Sterling Corporate Bond sector over one year with a return of 8.4 per cent and fourth over five years with a return of 41.9 per cent. It beats the majority of corporate bond funds, most of which don't have an ethical mandate, and its yield of 3.9 per cent places it among the top 10 yielders. 

Mr Jones says that's because some of the most sustainable companies are the best investments. "Think about all the things that have gone wrong with companies in recent years, from the Enron scandal to [the emissions scandal at] Volkswagen (VW:SWX), [the oil spill in the Gulf of Mexico caused by] BP (BP.), the Co-operative Bank and Provident Financial (PFG)," he explains. "Those companies have all been doing something that's not ethical, not good governance and not good for society."

And the world is changing.

"If I was a regulator and you came to me now with a product that made you cough in the morning and stink, and potentially gave you cancer, I'd tell you it was a terrible idea," says Mr Jones. "In the next 20 years, my grandchildren's generation will not be smoking.  And carbon burning won't look the same in the next 25 years so car manufacturing is changing – hence we don't hold [bonds issued by] car manufacturers." 

This includes electric car maker Tesla (TESLA:NSQ). "I think it's an amazing company but I cannot see how it survives on the current cash burn it's doing," he explains.

Instead, Mr Jones and his team identify investment themes, such as the need for clean energy, and analyse the ethical credentials of bond issuers in that space. Companies involved in industries such as alcohol, animal testing and gambling are excluded, and companies they do consider must have at least one positive aspect, for example, their human rights impact.

Areas in which the team is backing bonds include cyber security. "Cyber risk is a massive story," says Mr Jones. "[Shipping company] Maersk is set to lose $300m from the worm virus [a cyber attack that took place earlier this year]. And global law firms were down for five days – it was a mess. Under European Union General Data Protection Regulation coming into force in May 2018 if there's a breach of data companies can get fined up to 4 per cent of global revenue."

Rathbone Ethical Bond is playing the the cyber security theme via bonds issued by insurers Beazley (BEZ) and Chubb (CB:NYQ).

"At the last set of results both companies made a big chunky old line out of this stuff primarily because only 2 per cent of companies are insured against cyber attacks, according to the Institute Faculty of Actuaries," he explains. "More and more companies are going to be seeking insurance and as they do, premiums will be high because demand is high, but only a few businesses are writing it. It's a very profitable business so far and the whole market is really starting to grow."

Debt issued by financials accounts for over 70 per cent of the fund's assets, partly because banks have repaired their balance sheets. The fund's largest holding is a European Investment Bank bond accounting for 2.6 per cent of assets and Standard Life Aberdeen 6.75% Perpertual bond accounts for 2.2 per cent. Bonds issued by insurers also feature in its top 10 holdings.

An area Mr Jones is not keen on is the Australian property market, so he has reduced his exposure to Bupa's (BUPF) bonds and entirely sold out of QBE Insurance's (QBE:ASX) bonds. 

"About 50 per cent of Bupa's revenue comes from Australia and New Zealand," he explains. "I'm not saying the Australian property market is going to go belly up, but I am saying I'm not being compensated for the risk."

A number of investors are concerned that corporate bonds are very expensive and illiquid, and earlier this year the Bank of England suggested that an investor surge out of corporate bonds just one-third greater than during the 2008 financial crisis could push the market to "breaking point".

"The Bank of England should have said it was worried about which investors had bought the corporate bond market," counters Mr Jones. "Central banks have created a hunt for yield by buying corporate debt and forcing yields down. This squeezes out the normal investor, pushing everyone into higher and higher yielding assets, which is a danger because investors who shouldn't be in those markets, are.

Quantitative easing (QE) has also created an artificial environment that has propped up poor companies. 

"If we played Monopoly one of us would go bust eventually, because the game is designed on a certain form of QE," says Mr Jones. "Every time you pass Go you get £200 to spend inflating asset prices, but eventually asset price inflation exceeds QE. But if you then got an extra £50 every time you passed Go, we'd be sat here until Christmas and none of us would go bust. And that's what QE has been like. So if we go back to the old game there will be defaults.

"We've been in a situation of all boats rising with the tides since Lehmans [went bust in 2008] and the sovereign debt crisis. Because you've had central bank buyers we've been living in this wonderful world. But that won't last as interest rates rise and QE is turned off."

Mr Jones has invested Rathbone Ethical Bond with this in mind, meaning the fund could benefit from volatility. The fund has a lower duration – a measure of interest rate risk – than its peers because it invests in corporate bonds with a shorter duration, but from higher-quality issuers with higher yields.

And as bond yields rise it should become easier to obtain higher yields without taking as much credit risk.

Performance

Source: FE Analytics as at 24 October 2017