By Jeremy Wharton, Church House Investment Management CEO
There have been significant losses for some bond investors so far this year and we have, like doubtless many others, been asked how we have protected our holdings from the worst of the volatility.
Proactivity in protecting holdings, either through curve positioning (the duration), credit quality or more explicit interest rate hedges via floating rate bonds, is crucial. It keeps our powder dry to embrace higher yields enabling us to avoid the risk of the Sterling credit baby being thrown out with the bond bathwater. Government benchmark yields have indeed risen sharply and holders of too much duration have certainly paid the price. But bear in mind though the opportunities that this readjustment has created.
Only a few months ago the short end of the Gilt curve was almost negative, now we have two-year Gilts offering a mighty 1.3%. Not that attractive in itself, but when you add a credit spread on top, we are now able to access a fair yield on a total return basis. There are now a number of quality bonds, issued last year when yields were low, that are trading well below par (remember that bonds are redeemed at par,100p). A good example is a green bond issued by Berkeley homes last year (the proceeds of this issue can only be used for the construction of new housing stock that qualifies for the highest rating of EPC). These bonds are currently trading at 87 offering a yield to redemption in nine years’ time of over 4% and we have been adding exposure.
Another fine example is a sustainable bond from Tesco (well ahead on reducing their carbon footprint since 2015). These five-year instruments are investment grade and pay a coupon of 1.875% – we can buy them at around 93 which therefore gives us a yield of 3%.
The other weapon that we have been utilising is floating rate instruments. Typically issued by financial institutions, supranationals and governments, and, as the name implies, have a variable (floating) coupon rate.
We aim for the highest quality, mostly covered, AAA bonds secured by on-balance-sheet pools of residential mortgage loans. The coupons of these bonds refix on a quarterly basis using a spread above SONIA, the LIBOR replacement, and therefore the capital value of these bonds does not go down as yields rise.
There is no need to sit there and take all the unpleasant medicine in the way that some may have in bond markets. Whilst it has not been possible to have completely mitigated the downside, we have contained it through judicious curve positioning and interest rate hedges. The opportunities now abound for achieving a decent yield from fixed or floating bonds.