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“For the first time in nearly eight years, adjusted yield on an index-linked government is positive, the compensation for investors corporate bonds over government bonds attractive levels, and the market dynamics growth trends in certain subsectors have

VOLATILITY AND OPPORTUNITY

ALASTAIR POWER | INVESTMENT RESEARCH MANAGER

Labelling the past few weeks as ‘volatile’, in both the political and financial sense, could be considered a dramatic understatement.

Former Chancellor Kwasi Kwarteng’s controversial mini-budget sent shockwaves through financial markets, causing significant moves in government bond prices and a leg downwards for Sterling in the currency markets. The Bank of England intervened with a short-term bond buying programme aimed at stabilising the government bond market, and the International Monetary Fund unexpectedly weighed in with concerns of its own. In the aftermath, leading economic research institute the Institute for Fiscal Studies noted that the Truss-Kwarteng partnership hit on the right problem of low growth, but their solutions failed to add up. So badly were the new economic policies received, the Conservatives were forced into a dramatic reversal of some policies which ultimately ended in Kwarteng’s demise just thirty-eight days into the job, making him the secondshortest-serving Chancellor in the postwar period. Jeremy Hunt’s appointment as Chancellor makes him the fourth to hold the post in 2022, with his first act a quick dismantling and reversal of nearly all the proposed policies of his predecessor.

Amidst the volatility, political party conferences provided insight into potential future policies. Labour’s economic growth plan appeared to be well received, with the prospect of an £8bn National Wealth Fund in the pipeline as part of an ambitious outlook to turn Britain into a green growth superpower. Meanwhile, Liz Truss and

her then Chancellor doubled down on their “growth, growth and growth” outlook, but ultimately failed to quell the fears of party members and financial market participants. Unable to recover from her precarious political position, financial markets reacted positively to Liz Truss’ resignation with yields declining and Sterling stabilising. Rishi Sunak’s subsequent appointment has been well received by many, yet significant hurdles remain in the run-up to the next general election.

In periods of heightened market volatility, opportunities begin to present themselves. For the first time in nearly eight years, the inflation-adjusted yield on an index-linked government bond is positive, the compensation for investors buying corporate bonds over government bonds trades at attractive levels, and the market dynamics driving growth trends in certain subsectors have strengthened. The rise of “Generation Rent” is one such trend explored, with higher mortgage costs and reduced discretionary spend at the hands of inflation looking set to keep the younger generation in a supply constrained rental market.

As we approach the latter stages of 2022, financial markets looked to have entered a period of calm. While difficulties continue and the outlook for many remains nervous, enough opportunities are becoming apparent to improve a riskto-reward profile within portfolios.

GILTS AND THEIR IMPACT ON THE UK

BEN STANIFORTH | RESEARCH ANALYST

Normally a talking point saved for those within financial circles, gilt yields, or the return on government-issued bonds, entered the fore of the UK general public’s attention in recent weeks. Their importance comes from being a base point for the pricing of other interest rate related products, such as mortgages and credit cards for the consumer and borrowing facilities for business. While bond yields decline, the benefits are abundantcheap money flows and asset prices typically head higher. The reverse scenario, however, as we are currently experiencing, proves to be a significant challenge.

Mortgages remain the interest rate product most within the UK find themselves exposed to, likely to account for the largest monthly expense. The vast majority find themselves on fixed two and five-year deals as part of a multi-decade refinancing cycle to outright ownership, making the prospects of higher mortgage rates a daunting one. The US system differs significantly, with thirty-year mortgage products offering the opportunity for a household to lock-in a rate for the lifetime of the loan. Both systems have seen significant rises in the rates on offer, with a UK two-year fixed-rate rising from a little over 2% to in excess of 5% and the US 30-year rate jumping

Source: Factset

from 3% to over 7%. As higher levels of inflation look to be settling in, this differential makes US consumers far more resilient in their ability to absorb higher prices and maintain discretionary spending power. With mortgage rates on the rise and discretionary spend being pinched, market dynamics look supportive within the private rented sector as the younger “Generation Rent” find the goal of home ownership delayed further. Numerous Real Estate Investment Trusts (REITs) offer exposure to the sector, but could potentially be experiencing difficulties of their own.

Much like consumers, businesses also experience a cost of capital increase with rising yields. With capital no longer as cheap and risk attitudes toned down, a capital cycle approach to investing could lead to the view that high-growth sectors of the economy reliant on cheap capital could struggle going forward. The capital cycle approach to investing, championed by London-based Marathon Asset Management, builds off the idea that high returns will attract excess capital and hence competition, until high returns are competed away.

Following earlier comments on REITs, the Investment Trust sector experiences its own difficulties associated with rising rates, although some have the ability to mitigate the effects. Unlike their open-ended counterparts, a listed investment trust can enhance returns of the strategy through borrowing, in the form of a bank-offered credit facility or by issuing bonds. With rates on the rise, the cost of these facilities increases due to their floating-rate structures and bond investors will demand higher rates of return for new issuances. Within the incomefocused REIT sector, investors’ desire for yield means a tighter margin of investment income over borrowing rates can have more pronounced implications. The arrow in the quiver for

the REITs remains their ability to ‘hedge’, or remove, the impact of increasing yields on their cost of debt, maintaining the income margin received. This is a benefit of the structure, but within the underlying asset class an issue of relative value remains. Investors must surely be wondering whether a leveraged portfolio of properties yielding 5% is worth the risk now index-linked government bonds are trading at positive real yields again, enabling them to lock-in a yield over the rate of inflation for the remaining life of the bond.

Having risen sharply post the controversial mini-budget, yields have pulled back since the change of Conservative leadership and the dramatic U-turn of the mini-budget; a vote in favour of the fiscally responsible stance of Rishi Sunak and Jeremy Hunt from the financial markets. While the Bank of England looks set to continue raising its reference rate of interest to combat inflation, higher costs of borrowing look set to remain for the foreseeable future.

REGIONAL REIT

OSCAR SHEEHAN | INVESTMENT EXECUTIVE

As many who follow financial news will know, the bond market has had a bit of a bumpy ride recently. With inflation at a 40-year high and interest rates rising, many bonds have seen their prices enter free fall. While this has caused some serious damage to the fixed income portion of portfolios around the world, it also presents us with some exciting opportunities as yields rise and bonds start to trade below par value, creating the opportunity for increased returns when they reach redemption. This type of volatility is not normally what we look for in our fixed-income investments; that said, there are several opportunities available in the space that are starting to look attractive. Bonds that are closer to maturity, such as the unsecured 4.5% fixed-rate bond issued by Regional REIT that redeems in 2024 (RGL1), are a good example of this.

Short-dated bonds tend to experience less volatility than their longer duration counterparts. Bonds are considered short-dated

if the date at which the bond holder will receive their principle sum back is approaching, typically within the next five years. The prospect of this payment stops the price of the bond from fluctuating too much. As a result of this, RGL1’s price has fallen only 6% this year, unlike longer dated securities, such as the treasury gilt TG41, which reaches maturity in 2041, and which has seen its value fall by 43.14%. You could argue that the large drop in value and the corresponding increase in yield for TG41 make it an attractive investment, and you would be right. An annual return of 4.89% certainly seems appealing, particularly by recent standards. However, there is no guarantee that the price of the bond will not fall further given the political and economic instability that we have experienced recently. Meanwhile, RGL1 offers a return of over 5%, with the cash you lent being returned to you significantly sooner than if you held the long-dated gilt. On top of this, its short duration means that as the bond approaches maturity, investors benefit from a ‘pull to par’, the phenomenon by which a bond starts to trade upwards towards the value of which it will be paid back to you, typically 100p. This then, of

Bonds such as RGL1 could act as something of an anchor for portfolios over the next few years.

With a recession looking inevitable and Goldman Sachs forecasting a 1% contraction in the UK economy next year, the cashflow offered by such bonds could be invaluable.

course, provides a degree of stability for portfolios at a time when they need it most.

Generally, corporate bonds are considered riskier investments then government debt and, as such, it is important to pay close attention to the financial condition of the issuer and the state of the market in which they operate. From this perspective, Regional REIT is in good shape. As of the 30th June 2022, the trust had generated over £28m in profit before taxation for the previous year, which is comfortably ahead of its expenses of only £8.5m. The REIT also stands to benefit from shifting dynamics in the office real estate sector as companies continue to encourage their employees back to the office. Due to hybrid working, companies now require smaller, higher quality office space and this should help to drive a continued recovery in Regional REIT’s net asset value due to the focus on premium office space.

Regional REIT’s extensive use of gearing is one of the things that sets it apart from its competitors. Fund managers ‘gear’ their portfolios by borrowing money to increase the total amount that they can invest.

As of June 2022, the trust held £443m in debt, just over 43% of its total value. The RGL1 bond forms a portion of this debt. This gearing has the potential to enhance any positive returns generated by the portfolio, but as the debt needs to be serviced it can

also magnify any negative returns and this is part of the reason that Regional REIT has seen its share price drop more than 33% year to date. It is important to note that buying the bond is very different from buying the REIT itself; the trust’s use of gearing may have provided something of a headwind on performance recently, but unless the trust defaults on the debt, which would have serious ramifications for any future borrowing it wishes to engage in, this will not affect the bond from generating returns. With profits comfortably outstripping expenses, and a large property portfolio at its disposal, the bond appears to be at minimal risk of default.

Bonds such as RGL1 could act as something of an anchor for portfolios over the next few years. With a recession looking inevitable and Goldman Sachs forecasting a 1% contraction in the UK economy next year, the cashflow offered by such bonds could be invaluable. The recent crisis in the inflation-linked bond market has reminded us that there is no such thing as risk-free investments and, while RGL1 is no exception to this, it could provide ballast for portfolios at a time when other assets are seriously struggling to generate returns.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned.

The UK’s political crisis deepens. In 2022 alone, the country has seen four different Chancellors of the Exchequer and a third Prime Minister, Rishi Sunak. Liz Truss’ leadership lasted just forty-four days, shorter than the election campaign which saw her take the job and crowning her with the unenviable title of shortest serving PM in British history.

September’s disastrous mini-budget is undoubtedly the catalyst for recent political events. Unlike the government’s annual budget, mini-budgets aren’t required to undergo scrutiny from the Office for Budget Responsibility (OBR), a non-departmental public body funded by the UK Treasury. Swathes of unfunded tax cuts caught markets off-guard, producing dramatic intra-day swings in bond markets and reactions from key institutions such as the Bank of England (BoE) and International Monetary Fund. Unveiling such a dramatic plan for growth without scrutiny or backing

from the OBR highlights a significant failing within the Conservative Party, leaving it on the shakiest footing in the run-up to the next general election, for which polling already shows a commanding Labour lead.

Financial markets look to have calmed somewhat following the dramatic reversal of policies by Chancellor Jeremy Hunt and the appointment of Sunak. Government bond yields declined on the news and Sterling moved slightly higher in a sign of approval. While a positive step, and a small rally in prices is welcomed, challenges remain for the UK. The next fiscal statement, detailing government plans to reduce the fiscal deficit over the next five years, accompanied by OBR forecasts, has already been delayed to November 17th. A conservative move, but one which has the potential to cause issues with Bank of England Monetary Policy Committee set to meet in the meantime. Away from the headlines, UK inflation figures continue to climb with recent year-over-year core Consumer Price Index (CPI) figures coming in ahead of expectations at 6.5%. Mortgage rates continue to rise to reflect the expectations of further rates increases, with the average two-year fixed-rate loan costing 6.53%, according to Moneyfacts. Add in the watering down of the Energy Price Guarantee, now expected to end in April 2023, and the outlook remains strained for the UK economy.

While the economic data continues to cause concern, it is important to remember the differentials in approach between economic data and financial market movements. Inherently backward looking, economic data moves with a lag, whereas the forward-looking nature of financial markets leads to the decoupling of the two. The key for investors is understanding the level of value currently being shown by the price. Taking a broad-based UK corporate bond index as an example, the 6.25% yield-to-maturity on the portfolio expected to mature in 9.5 years exceeds current pricing of inflation within the UK market of 4.03%, as shown by the 10-year break-even rate, highlighting positive inflation-adjusted returns on offer. With an element of calm restored to many financial market participants, there feels to be enough value on offer for highly selective movements within portfolios as attractive riskreward opportunities present themselves in the hunt for a positive inflation-adjusted return.

Financial markets look to have calmed somewhat following the dramatic reversal of policies by Chancellor Jeremy Hunt and the resignation of Truss.

PARTY CONFERENCE CONFLICT

JAMES EADES AND STEPHEN DONE | INVESTMENT RESEARCH

Both parties are clearly focused on growth of the economy, expecting it to be the key battleground in three years’ time.

Political party conference season kicked off in late September with the Conservatives hoping to quell member fears over the controversial mini-budget of then-Chancellor Kwasi Kwarteng and Labour hoping to capitalise on voter discontent with a clear plan for the UK’s future around the key battleground for the next election, the economy.

Following widespread criticism of the mini-budget, the Conservative footing looks to be shaky, with Liz Truss’ personal approval rating reaching the lowest ever recorded in an Observer Opinium poll. Then-Chancellor Kwasi Kwarteng’s speech should have been used as a platform for settling nerves around the recent mini-budget and reassuring members of the government’s

commitment to fiscal responsibility. Doubling down on the beliefs of low tax, high growth and fiscal discipline failed to alleviate market concerns, however. Leading UK research institute the Institute for Fiscal Studies (IFS) noted that the Truss-Kwarteng partnership had two important points right: growth matters, to the point where past governments should have been far more proactive in securing it; and redistribution shouldn’t be the benchmark against which policy is judged. While accurate on the problems, the IFS noted that the solutions failed to stack-up.

With Conservative Party ratings on the slide and public perception turning negative, Keir Starmer’s Labour party look to be in their best position for years. Recent polling from YouGov shows a marked uptick in the approval rating of the Labour leader, with 43% of respondents approving of his performance as of early October, up from 27% at the end of August. With promises from the Labour leader to fight the next election on economic growth, Shadow Chancellor Rachel Reeves’ outlining of the Green Prosperity Plan was a pivotal moment. Key to the plan, the creation of an £8bn National Wealth Fund earmarked for green investment, with the hope that government capital will attract further private investment into the UK’s renewable infrastructure. Investments from the fund into battery factories and cleaner steel plants are expected to see wealth flow back into local communities whilst driving economic growth. Perhaps the most important economic message from the party comes in its pledge for full costings of future expenditures as it sets sights on being the party of

fiscal responsibility - a stance well received in the face of large unfunded spending promises from the Conservatives which sent shockwaves through the financial system. Well received by many, from The British Chamber of Commerce through to industry names such as John Allan, Chairman of Tesco, Labour’s positioning looks to be strengthening as we approach the 2025 general election.

Both parties are clearly focused on growth of the economy, expecting it to be the key battleground in three years’ time. Damage to the Conservatives has been done by the “growth, growth and growth” outlook of Truss, compared to the seemingly more responsible Labour plans of a National Wealth Fund, which still requires clarification around its finer details. It remains clear that financial markets react badly to the notion of large increases in debt loads on national balance sheets, making fiscal responsibility the key factor for proposed economic policies in the run up to 2025. It’s not just financial markets experiencing large swings: the Election Polling website appears to show a large shift in Labour’s favour at the next general election, while Ipsos polling indicates Labour is being viewed as the best party for managing the economy for the first time since the financial crisis. While interesting, polling data tends to be skewed in times of economic distress as respondents assign blame to the party currently in power. The extent to which blame against the Conservatives is warranted remains open debate, but there is clearly a mountain to climb for the party in its bid for re-election.