By Philip Matthews, co-portfolio manager of the TB Wise Multi-Asset Income fund
It is often said the sky is darkest before the dawn. And while most investors would agree the macroeconomic outlook is particularly gloomy at present – with heightened geopolitical risk, rising rates and surging inflation weighing heavily on sentiment – the optimists are much fewer and farther between.
While this is unsurprising, given global equity, bond and even commodity markets have witnessed considerable declines over recent weeks, the scale of this correction has unearthed a compelling opportunity. In particular, we believe the rising rates environment is ushering in a new era for income investors – one in which debt market returns will be far more attractive moving forward.
A changing picture
While a sizeable allocation to fixed income is typically a key component of any balanced multi-asset portfolio, it has been difficult to justify a meaningful exposure to bonds over recent years. For more than a decade, bond and credit yields have been incredibly low, reflecting an unchanging monetary policy environment of low rates and persistently low inflation across developed economies.
Furthermore, it seemed to most that central bankers would always stand ready to purchase bonds should an episode of financial volatility arise, and investors were subsequently in no position to demand attractive levels of yield when investing in bonds. Essentially investors were taking on reward-free risk when allocating towards fixed income.
However, the mood music has now changed. When it recently became clear central banks would be forced to continue raising rates, with inflation continuing to surprise to the upside, fixed income markets experienced a sharp sell-off across the board. The most poignant example was found in UK gilts, whose yields soared to historic levels in part due to the UK government’s not-so-mini-budget, which indicated fiscal discipline might be totally abandoned in blind pursuit of economic growth.
As such, from a risk-free standpoint, longer- dated UK government bonds have risen to levels which are now much more reflective of where investors expect interest rates topping out, with the 10-year UK government bond recently sitting at more than 3 percentage points above where it was at the start of the year. Meanwhile, credit spreads are discounting a highly negative scenario for defaults and imply a worse outlook for credit impairments than seen in any 5-year period over the last 50 years.
On the front foot
With prices and yields currently at highly attractive levels across fixed income markets, particularly during the period of stress in bond markets that accompanied the short-lived Truss-led government, investors need to move quickly to take advantage of the opportunity at hand. We have accordingly built a 16% allocation towards bonds and alternative fixed income funds – the first time we have done so in many years.
We recently added to our holding in the Vontobel TwentyFour Strategic Income Fund. This strategic bond fund’s diverse credit exposure is looking particularly attractive at current levels, and the fund managers also have the ability to actively manage the duration in the portfolio. As such, the fund should offer a good degree of upside over the coming months, while having the added benefit of providing some portfolio protection.
In addition, we have added to our holding in the GCP infrastructure trust, which has a good level of credit exposure and should generate attractive returns moving forward. At present, the yield on the portfolio sits at over 7% with an element of inflation protection.
Looking further afield, the rising rate dynamic has also unearthed a compelling opportunity in property investment trusts. While we are not blind to the fact higher bond yields make property less attractive by comparison, we believe the current discounts to net asset value – in some cases approaching 50% – more than reflect the recent step-up in bond yields.
Moreover, the structural supply-demand dynamics underpinning many property subsectors, such as student accommodation, industrial warehousing and care homes, should be supportive for rents over the coming months. Investors should also take comfort from the fact many property trusts have spent the last couple of years tightening their portfolios and strengthening balance sheets. Unlike the experience of 2008, balance-sheets are sufficiently robust to withstand falls in capital values without the dilutive forced-selling of properties then needed to comply with loan-to-value debt covenants. Earnings will come under some pressure as debt costs rise but we do not expect the downward spiral to earnings estimates witnessed during the Global Financial Crisis.
And it is not only property trusts that have been quick to discount the murkier macroeconomic outlook. Many trusts operating the private equity sphere have also fallen to highly attractive valuations over recent weeks, with several trading at near 40% discounts to their net asset values. The portfolio exposure within these funds is in most cases focussed on profitable, resilient companies exposed to structurally growing end markets, such as education, healthcare and technology. These are not unprofitable, early-stage technology platform companies dependent on future funding rounds to remain viable but established software businesses with strong recurring revenue business models. Whilst strong performance in recent years has benefitted from higher leverage than would be acceptable in public markets, the bulk of the performance has come from earnings growth rather than financial engineering that will prove harder to replicate in a higher interest rate environment. We expect valuations to come down and impact net asset values for these businesses but take comfort that the valuation methodology used appears conservative as evidenced by the significant premiums to book value historically achieved at the point these holdings have historically been realised. As such, these discounts appear anomalously wide whilst the trusts diversify our exposure to attractive sectors that are increasingly poorly represented in public markets.