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Jenna Barnard: the Keynesian animal spirit threat to bonds

As anyone who has heard us talk in recent years will know, the primary threat to investment grade bond returns is from rising gilt yields.

The correlation between these two asset classes is 85% over the long term* as moves in gilt yields drive the majority of the return for investment grade bond funds that do not actively manage their duration (interest rate) sensitivity.

Animal spirits

This has been enough of a challenge for most investment grade funds in the last six months. However, there is another risk to investment grade bonds, one that we have not seen for a number of years – the return of Keynesian ‘animal spirits’.

Simply put, as investors and companies become more confident we see more corporate activity, which aims to juice up returns for equity investors at the expense of top-quality bond investors.

Taking on greater amounts of debt to make aggressive acquisitions is typically done by private equity firms. The effects can be dramatic if you hold the wrong investment grade bond as holders of the Heinz 6.25% GBP 2030 bond can testify to – these bonds lost over 14% in value in two days last week when the Warren Buffett and private equity combined bid for the company was announced.

It is not just baked bean and sauces that have been the target for leverage‑driven acquisitions in recent weeks. Virgin Media and Dell are two other household names, which have been targeted and caused significant losses on investment grade bonds.

Many of these bonds trade at a price which is at a significant premium to par and on correspondingly low yields. The higher yield needed to compensate investors for the greater risk in a highly indebted balance sheet involves significant price falls.

For the few investment grade bonds that do have a covenant, which demands the bonds be repaid at par if taken over, that is of limited protection if your bonds trade at 113p in the pound, as holders of the 5.5% GBP 2021 Virgin Media bond discovered when the price of these bonds fell to 102p in the pound after the takeover was announced.

The clock face

Where did this activity come from and is there more to come? 

Many have used the analogy of a clock face to describe the investment cycle; the clock face is broken up into four quarters: recovery, growth, boom and recession.

For the last two years, due to the macro volatility, we have been wildly oscillating between recession, recovery and growth. The recent frenzy of corporate activity has pushed the market into the boom phase of the credit cycle – animal spirits are back.

Cheap debt has been available for some time but it requires the crucial ingredient of confidence to take advantage of this.

With this in mind it is worth noting that US private equity firms have been sitting on $200 billion of cash raised in 2007 and 2008 and over the next few years the majority will have to invest or return cash to investors before their investment period ends.

The difference in this cycle has been that whilst previously we saw a ramp up in deal size from $15 billion for Hertz in 2005 to $44 billion for TXU in 2007, and the associated leverage creep up, this time around we have 2006 and 2007-sized potential transactions announced in the form of Heinz and Dell already.

These transactions have large shareholders supporting the transaction and may not be representative of a typical buyout, but a new trend appears clear: merger and acquisition (M&A) activity should be expected to pick up in the coming year fuelled by cheap debt.

Where are the best returns?

At the start of the year, we, like many of our investors, were scratching our heads looking at fixed income wondering where we could seek out returns after the stellar performance of investment grade and high yield in 2012.

With a flexible mandate, the Henderson Strategic Bond fund can seek out areas of the market which are less sensitive to rising rates: floating rate loans for example, whilst hedging out interest rate risk with derivatives when necessary and focus on areas of the bond market which still offer value.

Indeed at this stage of the cycle, event risk, which is so negative for investment grade bond holders, can actually be positive for high yield bondholders where the companies are already leveraged and have better legal protections.

For example our holding in Kabel Deutschland bonds recently rose on speculation that investment grade Vodafone was interested in buying it.

Although the loans can be repaid at par at any time, the high yield bonds have price upside potential reflecting the premium Vodafone would have to pay to redeem these bonds. Clearly, selectivity is key at this point in the market cycle.

Focusing on areas of the bond market that still offer a sensible income, maintaining a flexible approach, and being patient enough to avoid the excesses created by a grab for yield mentality, is the focus for 2013.

With that in mind, it is quite possible, if not likely, that the current vintage of highly leveraged high yield bonds coming to market to fund the acquisition activity will not be one that we are interested in investing in.

*BoA Merrill Lynch, Henderson Global Investors, correlation of weekly returns over ten years (7 February 2003 to 25 January 2013), sterling non-gilts and UK gilts indices.

Jenna Barnard (pictured) co-manages the Henderson Strategic Bond fund wuth John Pattullo. According to Lipper, the fund has returned 23.8% in the three years to the 18 February. This compares to a 26.1% gain in the Citigroup United Kingdom WGBI TR index.

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