As markets prepare for further Federal Reserve tapering, the duo say they are more comfortable going into the process, with 10-year gilt yields around 3% rather than the 1.75-2% level that has dominated over the
past few years.
‘We think there is quite a lot priced into the gilt market. It is hardly news that rates will rise at some stage. The market is saying this could be October or November and don’t be more bearish on gilts this year from higher starting yields,’ Pattullo said.
Potential entry point
While the managers currently have a zero allocation to gilts and have done for some time, in their view valuations are starting to look interesting. They said if yields reach 3.5% this could mark a potential entry point, dependent on how other parts of the bond market are priced at the time.
With 53% of the fund in high yield and corporate bonds and 7.5% in loans, compared to a 13.1% allocation to investment grade non-financial bonds, Barnard said the fund is the most sensitive to credit risk rather than interest rate risk than it has been since 2009.
‘The UK could be the biggest surprise in terms of economic growth and UK rates could rise ahead of American rates,’ Pattullo said.
The Strategic Bond fund currently has a duration of 3.6 years, with the duo saying that due to the underweight in gilt-sensitive assets in the fund, only one year of this actually trades with the gilt market on a daily basis.
‘The fund is most exposed to a sell-off in equities rather than in gilts,’ Pattullo added.
While they are positive on this positioning and have broadly benefited, they say an increase in investment grade and a move back into gilts could be on the cards, particularly if there is a further sell-off in the gilt market.
‘Quite a lot of our high yield bonds are likely to redeem this year, so the question for us would be: how do we reinvest the proceeds? Do we go back into investment grade or stick with high yield? It is impossible to say, but our inclination is there will be a good opportunity to go back into investment grade if gilts sell off a little bit more,’ Barnard said.
The managers are positive on financials, with a 27% exposure to subordinated financial debt, particularly the old bank ‘step’ tier one capital bonds, which are set to be phased out by 2021. Barnard said the fund had reaped the benefits from its holdings in this area, as a number of banks have been buying back some of these bonds at a premium.
While new contingent capital (‘coco’) bonds provide a cushion between the old ‘step’ tier one bonds, Barnard and Pattullo say fixed income investors must be careful with tier one cocos as coupons can be turned off earlier than expected. As a result, their preference is for tier two cocos.
The duo also took the opportunity to buy into Nationwide’s £550 million core capital deferred share (CCDS) issue last year, a rare type of issuance on account of Nationwide’s mutual structure. The preference shares paid out a 10.25% coupon and have since rallied some 18% in capital terms.
Debt issued by Arquiva, the privately owned mobile phone company, and the AA are also recent additions to the portfolio.The Henderson Strategic Bond fund has a distribution yield of 6% and posted a 22.1% rise over the three years to the end of December versus an 18% rise by the IMA Strategic Bond fund sector, according to Lipper.