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Richard Woolnough: UK market losing out to US

UK's capital markets are becoming less important, says M&G bond fund manager who believes a wave of cash will lift US bonds.

 
Richard Woolnough: UK market losing out to US

The UK’s treasured stock and bond markets are losing their appeal in comparison to the US, according to M&G bond fund manager Richard Woolnough.

‘The UK capital markets are getting less important in the world, as a value investor in corporate bonds what do I want to do? I want to be where the value and interesting things are and there is more value and interesting things for me to do in the US and Europe than the UK,’ he explained.

With this in mind, Woolnough (pictured below) has increased exposure to the US in the £16 billion M&G Optimal Income fund . These include long-dated bonds issued by AT&T, Microsoft and Verizon. The fund invests primarily in bonds but can also allocate to equities.

When it comes to the UK equity market, the fund manager believes it is also losing its competitive edge, particularly if companies delist from the London Stock Exchange as a result of the UK leaving the European Union.

‘The UK stock market is becoming less and less of a focal point of capital around the world. As a responsible investor, you try to find where else to go. The UK is losing that, irrespective of before or after Brexit, it is not as important a capital market as it was. The US is dominating,’ Woolnough said.

The US’s growing importance as a global capital market cannot be ignored in his opinion, given that new industries start there and it is home to some of the biggest companies in the world.

‘It just has the economies of scale, which drives everything else,’ he added.

Repatriation for bondholders

Supporting the fund’s allocation to US bonds, he thinks president elect Donald Trump’s plans to lower corporation tax and repatriate cash held by US corporates could spell good news for bondholders.

‘There will be attempts to make the corporate tax rates lower, which is good for corporates because it means they have more money. That is advantageous for a variety of issuers,’ he noted.

When US corporates borrow money they are able to offset interest payments against their earnings, which means they don’t have to pay the full coupon. If taxation is lower, it makes this less effective. However, on the plus side it means that companies will have more equity on the balance sheet than debt.

‘This is great for bondholders because it means there will potentially be less debt issued in relative to historical norms. This is good for bonds because it means there is less supply,’ Woolnough explained.

He suspects that a lot of the cash that is repatriated will be returned to bondholders because historically corporates have issued debt in the US and taken their assets abroad. This means that the assets will be brought back to the US to clear debt. This solves a historic tax problem that US multi-nationals have faced and again reduces their need to issue more bonds.

‘From a portfolio positioning point of view, we are thinking about whether taxation and repatriation will help US credit a bit more than people think, which has encouraged us to own the US and he is doing things that help US businesses,’ he added.

Buying cyclicals

The fund invests primarily in bonds but currently has 5% in equities. Following the Brexit vote, Woolnough said the team was drawn to attractively priced, cyclical European stocks exposed to the economy, such as BMW, Daimler and Bayer. He also refers to Louis Vitton as the strangest stock the team bought during the summer. It appeared on their screen as looking cheap. Woolnough thinks this happened because investors classified it as a ‘Chinese cyclical’. It has since rallied and has been removed from the portfolio.

Woolnough is maintaining a ‘negative duration’ position on UK debt. Expressed in years, duration is the measure used to show a bond fund’s sensitivity to interest rate changes.

The overall duration for Woolnough’s £15 billion M&G Optimal Income  fund is currently at a low of around two years, reflecting the view that he expects interest rates will rise the developed world.

Rising interest rates are bad for bonds because it makes their returns look less attractive. Rates also tend to rise when inflation is increasing, which erodes the fixed income that you lock into when you buy a bond.

‘I personally think interest rates are too low. The yield curve should be steeper. There should be a term premium for lending long,’ he said.

By this, Woolnough means that yields for longer-dated bonds – for example those that have a maturity of over 10 years – should be higher to compensate investors for the risk of higher interest rates.

High yield, less credit-worthy, bonds are an area where Woolnough feels more positive. He has around 34% of the portfolio in high yield bonds because he thinks they look more attractively valued in comparison to higher quality investment grade bonds.

Monitoring liquidity

The fund has experienced significant outflows over the past two years, dropping from £25 billion to £16 billion. Commentators have expressed concerns about liquidity in corporate bond markets and given the significant size of the fund, this remains a priority.

‘I probably know more about liquidity than anyone else by now,’ Woolnough joked.

The fund manager said that liquidity is monitored by numerous risk committees at M&G. He adds that having a diverse and international client base helps to stabilise flows in and out of the fund. The team also keep 20% of the fund in government bonds and credit default swaps, which can easily be traded.

The fund manager has been at the helm of the fund since launch 10 years ago. Over this period, he has returned 98.4%, which compares to 67.2% by the average manager in the strategic bond sector versus a sector average of 67.

However, over the past three years, the fund has returned 12.1%, less than the 15.4% sector average. The last time Woolnough had a Citywire 'A' rating for his performance was August 2014.

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