Central banks around the world continue to unleash quantitative easing (QE) programmes to fight the economic fallout caused by the coronavirus lockdown.
But large QE programmes don't come without its difficulties, which was apparent in the taper tantrum of 2013 and again in 2018 when the Federal Reserve tried to bring rates back up and unwind its balance sheet.
Peter Doherty, manager of the Sanlam Hybrid Capital Bond fund, said: “The problem now is that it has become so large that shrinking it would be a challenge.
“If you could imagine yourself in a world with no QE at the moment, what would it look like?”
Ultimately, he reckons QE is here to stay and despite the ultra-low interest rates, there will always be buyers of government bonds.
“The system supports government bonds being held in very large amounts by pension funds, insurance companies and banks,” he said. “These rules drive non-economic holding of these assets, so there’s going to be a lot of demand for these assets even though there's very low yield.”
“You’re going to have negative real returns for a long time.”
The manager said that governments will need to finance the crisis and finance systemic change, “but as a private investor, someone who needs a return on capital, they're forcing you into risk assets and that's not going to change.”
Doherty believes this underscores credit’s role in an investor’s portfolio: “There’s only so much equity you can hold, and if you can find differentiated credit opportunities, it's a good thing to have.”
He argued that this is especially important after the number of equity income funds that have been hit by companies cutting their dividends, either due to their own initiative or due to pressure from governments.
Performance of global equity income funds v strategic bond funds year-to-date
Source: FE Analytics
“Anyone who has taken state aid, they are prevented from paying dividends but everything in our fund is still paying interest,” he explained.
Doherty’s £127m Sanlam Hybrid Capital Bond fund specialises in subordinated debt, investing lower down in the capital structure of high-quality A and BBB issuers.
By investing lower in the capital structure, the bond is rated lower but pays the investor higher returns. “They automatically knock stuff down for one two three levels of subordination. I think that's a bit formulaic and frankly kind of overstates the risk in some ways,” Doherty said.
He argued that investors actually get a disproportionate benefit from owning the lower-rated debt of an investment grade business.
“Data shows there’s a significantly lower default rate and net realised loss (risk) in a BB security issued by a A or BBB issuer than in direct or senior BBs,” he explained.
“Aviva, Nationwide, Aviva, National Grid, HSBC, Barclays: these are the names that people want in their portfolios as bond investors and they would like to have the yield associated with subordinated debt.”
“No one thinks Barclays or HSBC is going bust, but there aren't that many easy ways to access the market, so I set up the fund deliberately to allow retail investors this access via a UCITS fund.”
Despite the fund’s small size, Doherty said this sometimes comes with advantages, highlighting the fact that it was able to participate in the £50m tier 2 10-year bond issuance with a 8.875 per cent coupon from Jupiter Asset Management to raise capital as part of its acquisition of Merian.
He said: “They had to do it at not a great time, a small issue of only £50m, but if you’re a bond manager running £500m, you’re not likely to take £5m of a £50m issue.”
Another reason why Doherty prefers subordinated debt is because of the fact that regulations discourage banks and insurers from buying into the asset class.
“The universe of buyers for subordinated debt is lower than you might think because banks and insurers are excluded from directly buying it,” he said.
“This is because A, BBB or BB corporate bonds can be bought by insurers or banks for subordinated debt of the same rating from a bank or insurer, but at a very punitive capital charge.”
This is to avoid banks and insurers owning each other's debt and allowing high levels of systemic risk in the financial system.
Yet despite this, he said most of this debt is usually very oversubscribed: “There’s a big demand from pension funds and fund managers in the industry.”
He added that due to the complexity of some of the issuance that include various levels of subordination, contingent convertible bonds (CoCos), and legacy tier 1 debt, “in general you get a nice premium for your risk”.
Some of the funds in the IA Sterling Strategic Bond sector do occasionally buy subordinated debt. But Doherty said: “We’re very good at what we do in a complex area, we’re not hybrid tourists, dipping in and out”.
Describing Sanlam Hybrid Capital Bond, he said: “You know it's going to be a five to six year duration with a 5 per cent net income and that's it. We’re not trying to make massive calls or rates or credit spreads.”
He prefers to remain invested during times of volatility and “sticking to his guns”.
This meant that the fund was not spared from the bond sell-off in 2018 and in March this year. However, in 2017 it was the top-ranked fund in the sector and again in 2019.
“I know for a fact that many managers in 2019 were always slightly underinvested because they couldn't bring themselves back in at what was then a new high price,” he said.
Even though the fund remained fully invested during the sell-off, Doherty said he increased some allocation to certain legacy debt during the sell-off: “A lot of bond managers were facing redemptions in February and they wanted to sell anything that had a price on it.
“Legacy bonds could be trading at 120 and it's going to get bought back at 130, and as long people could par back they were happy, so there were bonds coming out at 10-15 per cent below the market just to get liquidity, and that gave great opportunity.”
Commenting on his outlook for corporate credit, the manager said he favours insurance over banks: “We think if there's going to be net realised losses coming through the system on commercial property or consumer, it's most likely going to hit the banks.”
Performance of fund vs sector since launch
Source: FE Analytics
Since inception in August 2016, Sanlam Hybrid Capital Bond has delivered a total return of 22.54 per cent compared to 11.62 per cent from the average IA Sterling Strategic Bond member. It has ongoing charges of 0.89 per cent.