There are investment opportunities in unloved areas of the market such as emerging market bonds and the oil and gas sector, according to Torcail Stewart (pictured). 
Both areas of the market have had a torrid time of late, with the huge falls in the oil price putting swathes of energy companies at risk of default. Emerging Market debt, on the other hand, has witnessed a multitude of headwinds ranging from China’s slowing growth, falling commodity prices and the potential impact of tighter monetary policy in the US.
All told, the IA Global Emerging Market Bond sector has comfortably underperformed developed market debt over recent years with substantial drawdowns.
Performance of sectors over 3yrs
Source: FE Analytics
However, the co-manager of the Baillie Gifford Corporate Bond fund says that he and Stephen Rodger choose long-term holdings through individual stock selection, which they believe allows them to pick out the inefficiencies in the market which will eventually correct.
“There has been distress in emerging markets and in oil and gas companies, but we’re seeing opportunities in both of them,” Stewart said.
“You often find that some of the strong businesses sell off with the weak ones when you get fear in a particular sector and these have become oversold, so we’re identifying opportunities there and have been adding selectively to certain businesses.”
The manager adds that stock selection, which has always been part of his investment process, is now more important than ever due to the series of headwinds across markets globally.
One factor that investors need to bear in mind, according to Stewart, is the fact that the world is in a non-traditional recovery phase, and that the global debt-to-GDP ratio is at an historically high 290 per cent.
“The US is carrying a greater magnitude of debt than it had in the onset of the 1930s for example, if you include all of the components,” he said.
Another headwind that Stewart says to watch out for is the amount of displacement in the market, which could easily lead to bubbles.
“China basically saved the world, but they did so by adding $21trn of new debt. House price-to-income ratios in tier-one cities hit 25 times, above that of both New York and London,” he said.
“We’ve seen the housing bubble, we’re now seeing the equity markets bubble pop, but we think the correction is just at the beginning, and there’s a good chance we could see a significant amount of deflation coming round to western geographies on the back of devaluation of the renminbi – many economists think that a 15 to 20 per cent depreciation is required.”
Other headwinds such as deflation and low consumer prices indices are also concerns for the manager, but he points out that both investment grade and high yield areas of the market have grown considerably over the last decade, which means there is more choice.
As a result, he believes it is now easier to navigate tricky areas of the market and choose strong companies from out-of-favour, cheaply-valued areas of the market.
Baillie Gifford Corporate Bond is able to invest in both high yield and investment-grade bonds, but has a 50 per cent cap on the number of high yield stocks it can hold.
Performance of sectors over 5yrs
Source: FE Analytics
At the start of the year, the £537m fund had a 43 per cent weighting in high yield assets, although this has since been trimmed slightly.
“We looked at second-order effects of the Chinese slowdown, so we sold a Chilean cable company, we sold a South African asset manager, and also a French cyclical that had done quite well and took profits on that,” Stewart said.
“We do move allocation around but we don’t flip-flop - the average credit rating has been BBB since inception and it is between that BBB and BB interface that we see the best opportunities for long term returns.”
While Stewart believes that BB and BBB-rated bonds offer the best risk-adjusted returns, he says that higher-yielding CCC bonds look “appalling” relative to long-term default rates, and that investors must be wary of searching for yield without considering the quality of the asset.
According to data from Baillie Gifford, the average credit loss rate per annum among CCC-rated bonds is 12.91 per cent and an average yield of 9.1 per cent, whereas BB-rated bonds have 18 times less credit loss on average and have an average yield of more than half that of CCC bonds.
This emphasis on risk-adjusted returns spans across all areas of the market that Stewart is invested in. In his emerging markets allocation for instance, he has no exposure to Turkey, South Africa or Chile, and adopts a thorough geographical screening process before investing.
“The search for yield is something that people have to be very cognisant of. If you start seeing funds offering very high headline yields, how are they actually achieving that? You have to be careful because, in effect, the further down the depths of the high yield market you go, every so often, there’s quite a material default cycle that comes through,” he warned.
“You have to be quite selective when you’re moving into emerging markets, so the process is to look at specific geographies such as the likes of United Arab Emirates, India and Mexico, that’s where we’ve got some ideas. We also look at emerging market countries on a liquidity basis and analyse their short-term debt-to-foreign exchange reserves, their solvency, external debt to GDP, their domestic credit growth, and we look at their economy.”
Another area of the market that Stewart likes is the industrials sector, as he says it offers greater diversification than other areas of the market.
Currently, Baillie Gifford Corporate Bond’s biggest overweight is in industrials –the fund has a 51.4 per cent weighting in the sector, which is 9.9 percentage points more than its benchmark’s weighting.
Not only is the fund unafraid to stray away from the benchmark, it is also fairly high conviction, as approximately 35 per cent of the fund is in positions that make up more than 2 per cent of the portfolio.
This has stood the four FE Crown-rated fund in good stead as, over eight years, which includes the financial crisis of 2008, the euro crisis of 2011 and the Taper Tantrum of 2013, the fund has significantly outperformed its peer average and achieved a top-quartile Sharpe ratio, which measures risk-adjusted returns.
Performance of fund vs sector over 8yrs
Source: FE Analytics
“We believe that stock selection is very important and inefficiency is greatest at the stock selection level,” Stewart said.
“Longer term inefficiencies generally correct with time, the fundamentals ultimately win out and that’s the philosophy that we’ve been sticking to and it seems to work.”
Baillie Gifford Corporate Bond has a clean ongoing charges figure of 0.53 per cent and yields 4.2 per cent.
