Being flexible
Looking further back, Strategic Bond’s flexibility was a major positive in the credit crunch, with Pattullo and Barnard able to hedge out many of the spiralling risks.
Although the fund was still down around 13%, the average loss in the sector was over 20% and Pattullo highlights several positions that helped limit losses. Paramount among these was a 40% short in credit derivatives for much of the period, with a 20% stake in cash and duration up at 11 years. Moving into 2009 – as the market bottomed on 15 March – the team reversed many of these calls, moving long risk using physical bonds and credit derivatives.
After benefitting from the market’s strong bounce, Pattullo suffered something of a blip in 2010, taking a short position in interest rates on the view the global economy was refating. “In fact, markets suffered a mid-year slowdown on the back of weaker data coming out of the US and we did not close our short position quickly enough,” he adds. “At the time, stock markets were going up and inflation and rate expectations were rising but the correction stopped that.”
With the eurozone situation becoming increasingly dominant last year, especially in the second half, the team cut exposure to credit that would potentially be hit by the crisis. This was most evident in a significant reduction in European banking positions over 2010/11, with Pattullo and Barnard selling French and Irish names as well as Santander. Banking exposure fell from 26% in June 2010 to 12.5% a year later (and has continued to drop since, standing at 7% today), with remaining positions focused in UK names such as Nationwide and Lloyds. “We would admit our financial positions have been slightly high in recent years and of 20% exposure now, 13% is in lower-beta and less volatile insurance names,” adds Pattullo.
Legal and General and Bupa Finance are both in the fund’s top 10 holdings. “European banks clearly need to restructure and in Spain, junior bondholders are likely to lose out as debt has to be equitised,” he adds. “We are much further down this path in the UK, with taxpayers effectively supplying the necessary equity to banks, and countries like Spain are years behind. Overall, financials no longer dominates our portfolio as it has in the past and 20% in what remains a high beta sector contributes around the same to overall risk as our 40% in high yield.”
Looking at Strategic Bond’s long-term physical portfolio, Pattullo and Barnard continue to favour high yield at just over 40% of assets, split 25% BB debt and 15% B. Although these are not investment grade bonds, the pair focuses on solid businesses and seasoned, proven issuers in defensive sectors such as cable television – as part of a 20% TMT allocation – and food packaging. “Given continued uncertainty surrounding the economic cycle, we are avoiding cyclical industries such as autos, shipping and heavy industrials and have negligible CCC exposure,” adds Pattullo. “These businesses are highly leveraged and need to grow both their top line and profits to service this, which is difficult in a tough environment.”
He seeks bonds offering sensible carry, with yields in the 4-8% bracket, avoiding the elevated default risk on paper above 10%. “It is getting harder to make money in bonds but we remain confident in the companies we own, which are largely well-financed, well-run businesses such as Virgin Media,” adds the manager. “We see Virgin for example as better invested than Thames Water: the former has a modern fibre network it can monetise, while the latter is having to overhaul its pipes.”
Not looking so cheap
Pattullo says that while high-yield spreads continue to discount a recession, prices are not so cheap. “Spreads are recessionary but prices are not and we see this year’s vintage of high-yield issuance as fairly poor quality, buying less than 20% of deals in 2012.
Several deals coming to market are issues done in loan markets back in 2005-2007 that are attempting to refinance and we are rejecting many as the business models are broken.”
Looking at the macro picture, Pattullo and Barnard remain cautious on peripheral Europe, preferring to focus on areas such as UK, Germany and the Netherlands. “Markets have turned their attention to Spanish solvency again and there are also real fears about Greece. Markets could continue to trend lower and some sort of policy response from the ECB will be necessary. Haircuts are likely on some of this debt, with bondholders expected to take more of the burden in peripheral Europe than taxpayers.”
The managers highlight the high-yield market remains open with default rates low and will look to buy quality bonds in this area at attractive yields and prices.
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