Letter To Investors – 18th March 2020

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As we approach the 10th anniversary of running our Multi-Sector Bond strategies, we have once again hit a period of remarkable market turbulence that has broken records in terms of how quickly prices have deteriorated across markets including fixed income. Consequently we thought it would be useful to share some more detailed thoughts with you on what will be my fifth occasion of writing such a letter. We hope that you find it useful.

By way of background, as we began this year we thought markets were already quite expensive, as the US economic cycle broke longevity records and stock indices hit new highs. In fixed income, government bond yields were low and credit spreads were tight. Additionally investors seemed generally optimistic as some of the geopolitical headwinds that we faced in 2019 had been removed. These higher valuations and the rapid change in sentiment have both contributed to making the recent falls all the more spectacular.

We had been positioned for expensive markets but not for a crash and a global recession, which is what we believe we are now facing. Positioning for expensive markets meant we owned shorter dated credit and had focused on avoiding the lowest rating categories, as well as holding around 30% of government bonds to help provide some protection and additional liquidity. This has helped us, but it was nowhere near enough to protect us fully from the market environment we have so far endured in March. We have been active though as you would expect. For example, when we realised that COVID-19 had rapidly spread to Europe and South Korea, we saw this as a game changer to the extent that the virus would impact people, economies and companies. We increased our duration, and we increased it again when the US Federal Reserve took the highly unusual step of cutting rates by 50bp outside of its meeting cycle, the first time it has made such a move since 2008.

Central banks can add a combination of confidence and liquidity to markets, as well as loosening or tightening financial conditions by moving rates. The latter was important as conditions had tightened sharply in previous weeks.

The Bank of England followed suit with a smart combination of measures, including a 50bp rate cut, a new Term Funding Scheme aimed at lending to SMEs, and an important dropping of the counter cyclical buffer for banks. These actions in concert would mean that banks have virtually unlimited liquidity at no cost, provided they keep lending, plus a freeing up of capital that they can lend against. All they would need alongside this is risk appetite, which I will come back to later.

The central bank actions are highly important and will aid the recovery, but what is really needed is fiscal stimulus and direct measures to deal with the economic situation caused by the authorities’ attempts to curtail the spread of the virus. The policymakers here have also acted swiftly, with huge volumes of cash being made available, though we are still lacking an awful lot of detail, which does take time. During the financial crisis in 2008 the aid packages that came through were all brand new and once-in-a-lifetime, and it took a lot of ingenuity to devise them and then deliver them. They did not appear overnight. The same is now true. While we are facing a global medical crisis, we believe that we will also be facing a global corporate crisis on the same scale as that seen in 2008.

Back in 2008 the banks were the core of the problem, and as BoE governor Mark Carney put it last week, this time they can be the core of the solution; they have built up significant resilience, and with the extra capital and unlimited liquidity unlocked by the BoE they have the tools to continue lending. However, lending will be challenging and it is here that the authorities have more to do. The banks are going to be required to lend to formerly profitable customers that have become temporarily insolvent as their businesses face temporary closure or a collapse in revenues. This is what I mean by risk appetite, and I don’t think without aid that they will lend in the way that the businesses or authorities would like them to.

Hence what we need are targeted programmes and government guarantees on loans. This of course will help the banks to lend and economies will be given the chance to recover. The French president, Emmanuel Macron, came out first with powerful messages that targeted exactly these things. He said no companies would default as a consequence of the actions to contain the virus, government guarantees would be available for companies who need them, and a national fund would be set up for employees who temporarily lose their jobs. Although quite specific, still more details are needed.

The UK then followed suit, pledging a whopping 20% of GDP in aid packages of various types, including direct lending facilities for large corporates via the central bank. The US has pledged up to a staggering $1.25 trillion of aid to corporates and consumers who are affected by the virus. This is exactly what the companies and economies need, and in some cases this lending actually circumvents the banks and goes directly to the end users, thereby the worry about risk appetite from the banks is mitigated.

In summary, a huge amount of ‘shock and awe’ has so far been poured out by the authorities, and more is to come.

Markets though have collapsed and continue to do so. The very latest price action, which continues to be negative even after the extraordinary actions, may seem surprising but some very strong technical factors are still playing out. Let me elaborate on what we are seeing in the markets. Passive funds and ETFs are partly to blame, as while they claim to add liquidity by creating an instrument that does not have to flow through the narrow plumbing of the investment banks’ bond trading books, when buyers and sellers cannot be matched up close to the underlying NAV then units have to be created, or as is the case now, redeemed. When they are redeemed, it results in cash bonds being sold through the same plumbing as the rest of the bond market, therefore sucking up a lot of liquidity. In effect they provide liquidity when no one needs it and they take it away when they do. So forced selling from these sources has exacerbated the moves. Similarly mutual funds have experienced significant outflows and they must execute these daily regardless of value, and then in anticipation of further outflows, many will hoard cash. Lastly I have to mention leverage, which is particularly relevant to Asian investors who tend to like a leveraged play in fixed income and recently have been facing margin calls, making them forced sellers into a market with low liquidity. This I think should be over shortly, as leverage is not particularly high in fixed income generally.

So where are we now, and what may happen next?

As I write the markets are in, and have been in, panic selling mode. The authorities have finally been coerced into panic reaction mode. A global recession in Q2 this year looks inevitable, but we think with the policy action taken and with a return to work when it comes that the recovery could be very sharp on the upside. Markets aren’t expected to wait for this to happen though, their reaction will likely be much quicker, and the levels we see today can offer material future upside. Additionally it is worth commenting on the enormous cost of these rescue packages, which will almost certainly result in ultra-low yields and official rates near zero for the next decade. In the years to come, we expect to be looking back at this current period as the best entry point for many years. So we would urge investors not to panic from here. In our experience, long term investors such as pension funds will be looking at today’s bond yields very positively. Shorter term investors will not be far behind.

Let me give you some examples of some of the yields out there currently. I would prefer to use indices but since even these are not correctly priced, I will use specific bonds instead from companies that you may recognise, starting with banking. Nationwide Building Society issued a 5.875% AT1 bond in September at 100.00. Today it can be purchased at 79.00, a yield to expected maturity in 2024 of 11.75%. In the insurance sector, Direct Line’s 4.75% perpetual call 2027 is trading in the high 50s, a yield of 13% for a Ba1 rated credit. Axa’s 3.25% bonds, meanwhile, are down 25 points this month. In BB rated corporates, even the lower beta telecommunications companies have had falls of 20 to 25 points. Telenet, the largest cable operator in Belgium, has 3.5% 2028 bonds now yielding 8.5%. Instrum, the biggest European debt collector, has 3.125% 2024 bonds now yielding 12%. In the investment grade ABS world, BBB rated Together Finance’s RMBS bonds have today traded at 89 cash price, giving a yield of Libor plus 735bp. BBB rated CLOs now yield around 600bp over, with BB notes yielding around 1000bp over.

Another sign of the extreme stress in credit, which does not tend to last long and reflects the need to hoard cash, is that some bonds which have been called and are imminently due to pay back have yields in excess of 10% .

On the flip side of the risk spectrum, it is questionable just how much further government bonds can help portfolios more than just holding cash. On several occasions the negative correlations that they normally offer have broken down and with governments all over the world looking to commit so much firepower to helping businesses and consumers, there may be fundamental supply reasons too why government bonds aren’t expected to fall much lower in yield. Additionally, central banks have virtually taken their policy rates to the lowest they can go, and they will all want a positive yield curve to assist the banks.

All of this makes investing in the short term extremely challenging. Pricing securities is exceptionally difficult and has resulted in wildly swinging net asset values (NAVs) on many funds across fixed income, which does not help investors make rational decisions. We have been as active as we could be in terms of trying to navigate markets, but have also suffered drawdowns that we are disappointed with. We think that once the forced selling stops, which we hope is soon, that markets will find a bottom from which we can see a meaningful recovery. We aim to have portfolios that are well tilted to this recovery. Our strategies have been focussed on maintaining liquidity, which we will look to use wisely to see us through this downturn and to help deliver upside when that turn comes. Our government bond holdings should be very useful to deliver portfolio changes in this regard.

Like many of you we are operating a substantial remote working policy, which is working well for all of us, though our London office does remain open. We have tested this many times in the past but had not expected it to be used in this way. It does mean that face-to-face meetings are difficult at best to arrange, but the remote options are surprisingly good. Please bear with us, and we look forward to seeing you all in person again soon.

In the meantime I would like to thank you all for your patience, and do please keep your questions coming, they are useful to us as well as yourselves.

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