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GAM credit opportunities manager fears for mainstream bonds

GAM credit opportunities manager fears for mainstream bonds

GAM Star Credit Opportunities manager Anthony Smouha is backing sub-ordinated debt and discounted floating rate notes to power performance in 2013.

Smouha, who works for Swiss-based bond boutique Atlanticomnium, says the credit market continues to offer opportunities – even if bonds are nearing the end of their 30-year bull run.

He adds that investors must look beyond the mainstream, with subordinated and undated financials debt offering attractive valuations and yield opportunities. The fund currently holds undated debt issued by Aberdeen, Bank of Scotland and Barclays – the latter two yielding over 8%.

‘Mainstream bonds in our view are not a great place to be, as you are getting very small returns. We think rates will stay low for some time but one day they will go up; you know mainstream bonds will not be very good so we avoid a lot of them,’ Smouha says.

Playing the recovery in financials

He now works alongside his brother Jeremy Smouha (pictured), a co-founder of GAM, who has joined Atlanticomnium to grow its new London office.

Jeremy says: ‘Our approach is to look at a good quality company and a bit like an equity analyst, we say: “What if things go well?”

‘Most bond managers look at investing in a bond and say, “If something goes wrong, what will I get?”. We look at “if something goes right, what do I get? So that allows us to do a Warren Buffett-type margin of safety analysis of an equity and then if we are reassured or have a strong view that a company, and the junior debt,  is going to survive, then we are quite happy to take the extra yield,’ he says.

While some investors have benefited from banks’ share price gains since the summer, Smouha highlights how the fund has accessed improved capital adequacy and gradual recovery in the UK and European banking sector over the past three years through credit opportunities, which he says can offer a less volatile way to access the recovery.

‘We have liked the story of self-improvement, of coming out the crisis at the major clearing banks Barclays, Lloyds and RBS – where you have to move to make these banks more safe and solid,’ he says.

‘I call it the virtuous circle. You want the momentum. There are always going to be reports of scandals and fines but you want the banks to be moving, cleansing from the crisis. It is a cleansing process and this is happening, which has been good for the shares in the recent while, but we are dealing with the credit, and the credit is becoming safer.’

Debt issued by Direct Line, Scottish Amicable and Rothschild currently feature in the fund’s financials exposure, alongside global franchises including HSBC and AXA.

Locking in yields

While the market looks ahead and prepares for an eventual pick-up in interest rates, Smouha believes the best way to prepare for this – alongside the bond market’s potential pre-emptive reaction – is to lock in higher yields now. Likewise, floating rate notes have helped to drive returns in the fund, and the bond specialist anticipates they can continue to buoy performance.

‘They say they are going to keep interest rates low. In our experience, bonds start anticipating a pick-up in short-term interest rates a good 12 months ahead and we want to be prepared for that by having a proportion in high current coupon, and a portion in the fixed and floaters so that our duration is half the benchmark, so you have a higher yield to maturity and a lower duration,’ Jeremy adds.

Alternative to index-linkers

Floating rate notes can offer a viable alternative to index-linkers, which are offering a negative real return at the moment, according to the duo.

‘I prefer to buy a Barclays floating rate note perpetuals at 100 over libor in the mid-50% range than to buy index-linked,’ Anthony says.

His brother adds: ‘We are happy with the discounted floating because they offer the opportunity of a capital gain when interest rates go up.’

Over the past 12 months, the Star Credit Opportunities fund has posted a 26.5% return and has a yield of 7.2%, while the Citigroup UK WGBI index rose 2.7% over the same period, according to Lipper. Looking ahead, although Smouha anticipates it will be tricky to replicate the solid returns of 2012, he expects some individual holdings have ‘further to run’, particularly if markets improve.

‘We will try to take advantage of different moves [in the market], so some capital gain. A lot in the coupon. We do not expect another 2012; that kind of return would be almost worrying if it happened again,’ he says.

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