Liontrust hunts for returns caused by market anomalies

Describing the current climate for fixed income investments, there is a strong note of caution to the voice of David Roberts, head of global fixed income for Liontrust, the boutique UK funds house. Although he sees select pockets of return potential, it is certainly not a time for unbridled enthusiasm when investing in this asset class.

Bonds are expensive by most measures, at record levels according to some, he laments. Additionally, holding them in bulk adds risk to portfolios. “What people forget is [bonds] are also as risky, if not more risky, than they ever have been,” he adds.

He is talking specifically about interest rate or “duration risk” associated with quantitative easing as companies and governments have borrowed money for much longer than they have done historically. “That means that if there is a reversal in bond markets, then investors stand to lose potentially quite a lot of capital,” warns Mr Roberts.

His suggested solution is a simple one: avoid the direction of these risky, expensive bonds and instead try to exploit some of the opportunities that central bank manipulation has created for investor returns.

This means – for serious bond investors – getting inside the minds and understanding the psychology of politicians and central bankers. 

“I think it’s incredibly difficult to separate capital markets and a capitalist society from politics,” suggests Mr Roberts. “For most of the last year, Donald Trump very adroitly played the Chinese situation, particularly in terms of tariffs and trade, against [Fed chairman] Jerome Powell’s monetary policy.”

This leaves central bankers in a difficult situation. “We’re living in a world where the ability of politicians to influence market direction instantly, has clearly never been greater,” he says. “We need to be aware of that and especially if we are investing for the long term to try our best at times to look through those short-term tweets and comments.”

Time to trade

While bonds still offer some degree of protection, it is difficult to see any ability to generate either income or capital gains on a sustained basis over the next few years, leading to the conclusion that bonds no longer present a long-term investment, but rather a trading opportunity. For example, US Treasury bonds look “incredibly cheap” relative to their UK, European or Asian counterparts.

These are “interesting times” for bond managers, he suggests, as amid the doom and gloom, market anomalies are creating “alpha opportunities, which at the moment are probably greater than they have been in my 30-year career”. These opportunities, he says, are best captured by active rather than passive funds, which merely track risky indices.

Bond enthusiasts must however use the word “opportunities” carefully and explain the nuances, believes Mr Roberts. “People often think it’s just a case of blindly buying the market and for us, that’s where the dangers lie.” 

“The opportunities really are from doing a little bit of hard work and trying to subtly express views in the market. So, at the same time, we can capture some positive returns, but not take too much of that directional, dangerous bond risk for our clients.”

He also warns investors not to sacrifice liquidity in the all-out hunt for yield. “Some of those, dare I say, slightly darker, dingier, corners of the market that we have traditionally shied away from, may look quite attractive for those seeking yield,” ponders Mr Roberts. “But we do need to remember they are sacrificing liquidity for that return.”

The key sector which Mr Roberts and his team enthuses most about is high yield bonds, still relatively cheap and able to provide a naturally attractive income “if we are in the world of low interest rates for the next few years”. 

Investors, used to the “junk bond” sobriquet, tend to forget “that often, it’s dominated by large companies that pay an income, well above the dividend yield we might expect on equities”.

Mega caps

Most of these bonds are issued by listed companies, with respected market capitalisations, says Donald Phillips, fixed income manager at Liontrust. 

“The media isn’t writing articles about the equity market in junk and lacking quality and full of stress and danger,” he says, suggesting the same companies receive positive press coverage when it does not relate to their bonds. “Most of the high yield markets are an excellent asset class, full of mega-caps that guys like me and teams like ours invest in.”

He compares high yield bond performance to that of equities, with the former producing returns very similar to those of equity benchmarks, yet with a far lower drawdown in downturns than the FTSE, Nikkei and S&P indices.

Bond managers, especially in the high yield sphere, need to get used to bottom-up, almost equity-like company fundamental research, suggests Mr Phillips. 

“All the risk lies within the companies that you lend to, the companies you invest in,” he says. “Everything else around that externally is just noise, so a more equity-like approach in the high yield market is appropriate.”

When choosing which bonds to invest in, he looks for companies with a competitive advantage and keeps a keen eye on their stakeholders and the owners’ motivations, tending to shy away from private equity owners linked to leveraged buyouts, preferring the transparency of listed businesses.

Box office

Asked to name his favourite corporate bond holding, Mr Phillips has no hesitation in namechecking Netflix. “They are a non-advertising-based media company. Isn’t that fantastic? You don’t have to rely on the cyclical wind of how much businesses are spending on advertising,” he enthuses. “You have your clients paying you their monthly fee.”

He sees this as an excellent model for bonds issued by companies which can weather long-term economic vagaries. “I would argue that in the next recession – because Netflix hasn’t really faced one yet – people will probably stay at home and watch Netflix and not go to the pub, or to the restaurant, or the cinema perhaps. So you’ll find it’s actually quite a recession-proof business model.”