Leading Edge June 2018 by Royal London Asset Management

LEADING EDGE RLAM’S REGULAR REVIEW OF INVESTMENT MARKETS • JUNE 2018

Credit investing in 2018

After nine years of positive returns from corporate bonds, is credit still a winner? Head of Credit Eric Holt and Senior Fund Manager Paola Binns look to answer this question.

Sustainable investing: moving into the mainstream Head of Sustainable Investments, Mike Fox examines how millennials are driving the growing interest in sustainable funds.

Maximising the risk/ reward trade-off beyond investment grade

Head of Global High Yield, Azhar Hussain outlines how high yield can be used to maintain income while managing risk effectively.

Focus on corporate governance

When the corporate governance warning lights are flashing, the board and investors must not ignore them, says Ashley Hamilton-Claxton, RLAM’s Head of Responsible Investing.

For professional clients only, not suitable for retail investors.

Rob Williams

Chief Distribution Officer

Get in touch We welcome your thoughts on the e-zine and our communications with you in general, so please do give us your feedback by emailing: leadingedge@rlam.co.uk Tel: 020 7506 6500 Fax: 020 7506 6796 Web: www.rlam.co.uk For professional clients only, not suitable for retail investors. The views expressed are the authors’ own and do not constitute investment advice. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For more information concerning the risks of investing, please refer to the Prospectus and Key Investor Information Document (KIID). The Royal London Equity Funds (the “Funds”) have been developed solely by Royal London Asset Management. The “Funds” are not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). FTSE Russell is a trading name of certain of the LSE Group companies. All rights in the “FTSE Indices” (the “Indices”) vest in the relevant LSE Group company which owns the Index. “FTSE®” is a trade mark of the relevant LSE Group company and is used by any other LSE Group company under license. The Index is calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Fund. The LSE Group makes no claim, prediction, warranty or representation either as to the results to be obtained from the Fund or the suitability of the Index for the purpose to which it is being put by Royal London Asset Management.

Welcome

Welcome to this edition of Leading Edge. On 26 April, RLAM hosted its fourth annual Investment Conference, and our articles in this issue bring you the highlights of our fund managers’ presentations from the day. Touching on the full spectrum of asset classes, our managers review some of the themes and ideas that are impacting markets and investors today. The year began with a continuation of the economic conditions that have been broadly supportive for financial markets over the past 12 months. However, geopolitical events have dominated headlines with the most recent political crisis in Italy prompting concerns from bond and equity investors alike. In an environment that remains very uncertain, our investment experts highlight how they’ll be navigating this for the remainder of the year. One area that has been subject to much speculation is the corporate bond market. Our credit experts Paola Binns and Eric Holt examine the prospects for the asset class through the rest of the year. They consider how the outlook for global growth and inflation is impacting opportunities. Zilla Chan and Richard Nelson go on to analyse one particular area of the bond market: asset backed securities. They seek to demystify some of the thinking that surrounds these assets and look at how they can be used to enhance portfolios. Environmental, social and governance (ESG) considerations are coming to the fore, and a number of the articles in this issue pick up on that. Gail Counihan and Matt Franklin explore the benefits of a nuanced approach to incorporating ESG analysis into our credit research, Ashley Hamilton Claxton proposes that poor corporate governance practices can act as an early warning sign of potential corporate failures and Peter Rutter explains how integrating ESG into global equity portfolios requires more than just adding a binary filter, but a deeper understanding of how ESG affects valuations. While responsible investing is something that runs through all of our strategies, our sustainable funds in particular have ESG considerations at their heart. Mike Fox looks at the demographic trends pushing sustainable investing into the mainstream and also highlights some of the key themes his team are focusing on to identify compelling opportunities. For those of you that joined us on the day, you will recall the message from our key note speaker, Rasmus Ankersen, who urged companies to think differently if they want to maintain success. His warnings against complacency chime very much with our thinking, as I hope you will see from the articles from our investment teams. As ever, we’d love to hear your thoughts on the e-zine, so if you have any comments, feedback, or suggestions for future articles, please share them by emailing leadingedge@rlam.co.uk I hope you enjoy the issue.

Rob Williams Chief Distribution Officer

Contents Also in this issue P.10 Trevor Greetham considers how to avoid the hidden dangers in decumulation P.16 Richard Nelson and Zilla Chan demystify some misconceptions about asset backed securities

Credit investing in 2018

ESG and credit: sustainable outperformance

ESG in global equities: meeting clients’ needs

Responsible Investment Analyst, Gail Counihan and Credit Analyst Matt Franklin explore the role of ESG analysis in credit.

Investors increasingly want their investments to not only deliver returns, but to do so while adhering to positive environmental, social and governance (ESG) practices. Head of Equities Peter Rutter explores this trend.

Sustainable investing: moving into the mainstream

Maximising the risk/reward trade-off beyond investment grade

Focus on corporate governance

Head of Sustainable Investments, Mike Fox examines how millennials are driving the growing interest in sustainable funds.

Head of Global High yield, Azhar Hussain outlines how high yield can be used to maintain income while managing risk effectively.

After nine years of positive returns from corporate bonds, is credit still a winner? Head of Credit Eric Holt and Senior Fund Manager Paola Binns look to answer this question.

P.20 Where’s the value in cash? Craig Inches and Tony Cole ponder this question

When the corporate governance warning lights are flashing, the board and investors must not ignore them, says Ashley Hamilton-Claxton, RLAM’s Head of Responsible Investing.

4 | LEADING EDGE | JUNE 2018

Credit Investing In 2018 After nine years of positive returns from corporate bonds, is credit still a winner? Finding an answer means looking at credit from a historic perspective, but also current valuation levels to identify the opportunities and risks for investors. After the slow growth / low rates and inflation environment of the last decade, it’s important to address the likely hurdles ahead and mitigate the effects of potential interest-rate rises.

Fixed income investors have had a good run over the last five years, as global markets have been awash with the liquidity poured in by central banks. Over most of this period, the Bank of England’s base rate has remained at 0.5% (with the notable exception of the post-referendum period, when the rate was slashed to 0.25%). As well as supporting growth, accommodative monetary policies have pushed down gilt yields. Falling yields have been the main driver of the stellar gains generated by fixed income. Staying ahead of inflation is a key consideration for most investors. The table below shows that cash has failed in the race to do so. But thanks to falling interest rates, gilts have delivered returns above inflation, as have investment grade and high yield bonds.

Eric Holt, Head of Credit

Paola Binns, Senior Fund Manager

The icing on the cake Typically, corporate bonds trade at yields over and above those on gilts. This premium is termed the credit spread and compensates investors for the extra risk they incur when they invest in corporate bonds, rather than government-backed securities. These risks involve liquidity and the risk that the corporate bond’s issuer may have its credit rating downgraded. There is also the risk that the issuer will default altogether, but this is generally less of a concern in well-diversified portfolios of investment grade bonds.

Managing the downside One way in which this is done is by eschewing bonds with unfavourable risk-return tradeoffs. For example, we avoided bonds issued by Steinhoff last year. Steinhoff is a South African company that owns many global brands. In July 2017, the company issued a BBB bond. We didn’t get involved in the transaction, as we didn’t feel the yield involved offered enough compensation for the risk of Steinhoff being based in South Africa. In December 2017, the company announced that it would restate the last three years’ financial statements, and the CEO resigned. The price of the July 2017 bond nearly halved in response. Credit rating agencies reacted by downgrading the bond’s BBB rating to CCC.

Five year bond market returns Five year returns to end 2017 Gilts

24.4%

Investment Grade

31.6%

High yield

34.1%

Inflation (RPI)

12.7%

Cash

2.2%

AAA

Bond price 100 90

BBB

Source: Bloomberg and RLAM from 1 January 2012 to 31 December 2017, net of fees and gross of tax. Returns represented by the following indices: High Yield is the BofAML £ Non-Gilt index, Investment Grade is the BofAML GHY index, Gilts are BofAML UK Gilt Index, Cash is 7 Day LIBID.

Launched 80 July 2017 Euro 1.875% 70 2025 60 50

CCC D

December 2017

Jul 17

Dec 17

Source: RLAM as at 29 March 2018

Of course, situations like the one Steinhoff experienced can’t always be avoided. But the associated risk can be mitigated by a well-diversified portfolio, and this is what we do at RLAM.

JUNE 2018 | LEADING EDGE | 5

How else does RLAM add value? As well as seeking to avoid certain investments that do not offer investors enough compensation, RLAM’s portfolios target excess return by seeking value in credit markets. One of the ways in which we successfully did this is by our participation in an issue by Eskmuir Group, a UK-based commercial property company. In late 2017, the company wanted to raise long-term finance, to increase the opportunity to invest in property, and earn incremental return from doing so, over and above the cost of debt. As the issue was not rated, it was excluded from several benchmarks and lacked attention from most investors. Despite this, we had a favourable view of the issue. Firstly, this was because the issue was secured, meaning that bondholders had a first claim on the company’s assets to mitigate downside risk. The issue was also over-collateralised – the company is obliged to maintain the value of assets bondholders have a claim on to at least 1 2⁄3 times the value of the debt outstanding. Furthermore, the income the company generated from the properties was enough to cover the interest payments. Most importantly, the bond offered investors a good balance of risk and return, as the yield offered a very attractive premium over gilt yields.

Looking forward Among RLAM’s extensive range of credit funds are the RL Short Duration Credit and the Sterling Credit Funds. Both are very similar in terms of the underlying portfolios – these comprise sterling investment grade corporate bonds. Both portfolios are well-diversified, and seek to balance risk and return to deliver performance. Moreover, in both cases, there is an incremental yield – the value generated by our security selection – to support performance. The key element that differentiates the funds is duration. The RL Short Duration Credit Fund has a duration of three years while the RL Sterling Credit Fund has a duration of eight years. This means that the former is far less sensitive to changes in gilt yields, and by extension, interest rates, which may make it a better investment if central banks continue to slowly tighten their previously accommodative stances. RL Short Duration Credit Fund 3yr benchmark duration

0.90%

RL Sterling Credit Fund 8yr benchmark duration

1.15% 0.75%

RLAM RLAM Credit benchmar

0.85%

Credit benchmar

Gi l t Total yield: 2.75%

1.10%

1.25%

Gi l t Total yield: 3.25%

Source: RLAM as at 29 March 2018

To sum up, corporate bonds have been winning the race against inflation in the last five years. Although the end of the “lower for longer” era may pose some challenges, we believe these bonds can still continue to outperform. At RLAM, we will continue to seek to generate excess returns over the medium term, thanks to our strategy of effectively managing the downside, seeking out value in credit markets and building well-diversified portfolios.

Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio holdings are subject to change, for information only and are not investment recommendations. The views expressed are the authors’ own and do not constitute investment advice.

6 | LEADING EDGE | JUNE 2018

ESG & Credit: sustainable outperformance Whilst Environmental, Social and Governance (ESG) analysis is long-established in equity markets, focus is starting to turn to how to integrate ESG considerations into credit portfolios. Given how vital long-term sustainability is for lenders, we believe that clients can benefit greatly from the insight ESG analysis provides, but this can only be unlocked if asset managers take an appropriate approach. Focusing on material ESG factors A vital first step is to focus on the ESG factors that really matter, rather than all the surrounding noise. Looking at genuine environmental externalities, social costs, social impacts, governance and remuneration helps us to form an understanding of the business or asset. In order to build this understanding, we must focus on the most material ESG indicators: material to the business, operations, environment or society. We leverage the Sustainability Accounting Standards Board and our own sector analysis, to define the specific issues that we see as material in each instance. Something that is material to the construction industry might be completely immaterial to consumer goods, and systemic risk faced by a financial firm is very different to the existential risk faced by a utilities company. We investigate and seek to understand the company’s leadership and governance, their business model, the end-to-end lifecycle of their products and services – from the sourcing of their raw materials to whether they have a responsible end-of-life disposal strategy in place. This analysis might lead us to uncover a risk, an opportunity, a weakness

or a competitive advantage. When we have this extra information, we will have a better understanding of whether we need to demand greater or lower returns for the risk that we are taking.

Sustainability is a vital part of credit investing Whilst ESG analysis is a firmly established part of equity investing, some question its relevance for “safer” credit investments. We, however, believe ESG analysis is crucial for lenders, given credit’s asymmetry of return: whilst equity investors’ returns mirror corporate performance, this is not the case for bonds. As a lender, our best outcome is that a company pays the interest and principal on its bonds, as with a fixed coupon we don’t get to share in the upside of a company’s improving fortunes. We are, however, susceptible to any risks that might cause a borrower to deteriorate, which can result in bond holders suffering losses. So as a lender if we are not sharing in the upside, why wouldn’t we want to understand the material ESG factors that can better inform the downside?

A quick fix… With ESG factors clearly important for credit investors, how can we effectively integrate ESG analysis into our credit framework? For those fund managers looking for a quick fix, the path of least resistance is to borrow from equity colleagues, replicating those more established ESG processes for their credit portfolios. Using this approach, with its reliance on “off the shelf ” screening tools, allows asset managers to quickly rebadge their funds as “ESG credit” portfolios, but at what cost to clients? We believe that taking this route can be highly detrimental to clients, as it ignores some key nuances of credit. One important factor is that as a lender, you are a key stakeholder for a business, but are ultimately not the owner. As such, your influence and control can be very limited. You cannot outsource this responsibility to the equity markets, because as we see time and time again, interest between equity and credit can diverge hugely - often to bondholders’ detriment. Added to this, a large proportion of borrowers do not have listed equity, and as a result are not covered by off-the-shelf data systems, meaning you could miss out on opportunities from a large part of your investable universe. An equity focused

JUNE 2018 | LEADING EDGE | 7

Matt Franklin, Credit Analyst

Gail Counihan, Responsible Investment Analyst

approach also ignores the ability to lend to the same company in many different ways, such as lending to different parts of a large group or secured over specific assets. Off-theshelf tools will give ESG scores for the parent company rather than the specific area of the business you might actually be lending to, which can have very different ESG profiles.

…or a bespoke approach We believe that in order to meaningfully integrate ESG risks into credit analysis, an approach which reflects the nuances of the asset class is essential. When taking account of the long-term social and environmental profile of the asset that we are financing, we tailor our review for each specific bond and the way we have lent, helping us to produce more meaningful analysis. Our longestablished focus on lending with security and covenants provides a strong foundation, helping to improve our control position and influence with borrowers. This is enhanced by our in-house ESG experts, performing targeted analysis which complements our focus on under-researched areas of the market.

A key part of our integrated ESG and credit framework is engaging with the companies we lend to. Whilst many dismiss engagement from a lender’s perspective, seeing it as incompatible with the asset class, we believe it can be hugely beneficial to clients if done appropriately. The key to our success is targeting our engagement with borrowers, focusing on where our ability to influence is highest. Whilst engagement with a global behemoth like Walmart is unlikely to yield meaningful results, focusing on companies without equity capital (such as housing associations) and those with a greater reliance on debt markets (regulated utilities) can lead to far more worthwhile discussions.

ESG analysis supporting better credit decisions So how does our integrated framework work in practice? When we analyse a bond, we are looking from today to maturity for the risk that a borrowers’ balance sheet deteriorates. This will include traditional credit risks such as operational gearing or economic sensitivity, but when we effectively integrate ESG factors into our credit analysis, we are then able to identify additional risks that a company faces.

These can be risks such as governance issues and environmental legislation, which can also have a huge impact on a borrower, and our bonds as a result. Our overall investment question does not change, but we now have additional information to make a more complete decision. By effectively integrating credit and ESG analysis, we are able to improve our credit analysis, helping us to make better portfolio decisions. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the authors’ own and do not constitute investment advice.

8 | LEADING EDGE | JUNE 2018

ESG in global equities: meeting clients’ needs Investors increasingly want their investments to not only deliver returns, but to do so while adhering to positive environmental, social and governance (ESG) practices. However, ESG assessments often frame companies in a binary manner, whereas the complete picture is far more nuanced, and a company’s overall ESG performance is materially shaped by the areas on which an analyst chooses to focus. Let’s consider two current stocks, which perfectly illustrate this idea: Think analogue, not digital Is Amazon an angel or a villain? Viewed one way, the company can be seen to have a poor ESG scorecard: environmentally, it offers limited carbon intensity disclosure and generates significant packaging waste; socially, it deploys controversial labour practices. Its CEO also maintains a position as the chairman of its board of directors. However, it could equally be argued that the company scores highly on ESG criteria: its business model supports lower carbon intensity relative to peers; it’s perceived by many of its customers as generating high social value; and the CEO owns only 20% of the firm* (creating solid interest alignment with shareholders), with the company also offering good pay disclosures. Tobacco is another example. Traditionally, companies producing tobacco products would immediately fall into most ESG exclusion lists, due to the social harm they cause. But this restriction can prevent investors from actively investing in companies promoting a move away from smoking, as is the case with Philip Morris International. The company’s manifesto is to “pioneer a smoke-free future”; already, 13% of its revenues come from smokeless tobacco products*, and towards such products the company allocates threequarters of its research and development investment. A binary ESG framework doesn’t capture the significant change in the industry.

Deep integration into the investment process

Additive to the ability to value stocks

Such examples show that ESG evaluation presents a complex set of challenges, and that such evaluations must be both stockspecific and range across a continuum. For this reason, we don’t see much value in outsourcing this analysis to an independent third party. As external providers, their evaluation on relevance, materiality and change would invariably be divorced from our own investment decision-making process, and therefore offer us limited investment insight. Instead, we integrate ESG analysis directly into our investment process.

Recently, under new management, Japanese stationery and furniture manufacturer Kokuyo has become increasingly focused on creating environmentally friendly products, such as a staple-free stapler and solvent-free glues. The benefits to the environment and to society are evident, but how would that transfer to shareholder wealth? Our analysis showed that this not only drives sales and supports gross margin improvements in an increasingly environmentally minded market, but that the strategy is also generating noticeable cost savings. The revised cashflows therefore change the valuation, from quite attractive on a raw basis to considerably more attractive on an adjusted basis**.

The investment process employed within our global equities team always looks to identify companies with two key attributes: we first identify companies that offer strong shareholder wealth creation, and then narrow down our universe to those that are also attractively valued. ESG analysis is embedded into both of these steps, so it’s wholly consistent with the overall investment strategy. When identifying wealth-creating companies, ESG is part of the assessment, with governance a particularly important focus, as we look for alignment of a company’s governance structure and shareholders’ interests. ESG is further integrated into valuation. For each investment candidate, we model future cashflows by identifying bullish scenarios, a base case and a bearish case. We view promising stocks as ones for which there’s more upside potential than downside risk. It’s into our cashflow scenarios that we explicitly model ESG risks, so they directly impact our valuation work. Over time, we’ve found this generates consistent benefit to our investors, as was the case with the following examples.

By contrast, UK Provident Financial, a door-step lender to consumers with poor credit history, has had a long track record of profitability. Considering it in 2016, we augmented our analysis with regulatory risk, having witnessed the effects of tighter regulation in Japan on similar companies. The revised analysis changed the payoff structure entirely, and we decided not to buy the stock. Nine months later, shortly after regulatory changes were introduced, the company’s share price fell by 66% in a single day***.

JUNE 2018 | LEADING EDGE | 9

Peter Rutter, Head of Equities

Principles, not rules Our ESG framework enables us to better capture the complexity and materiality of a company’s profile on a stock-by-stock basis. RLAM’s global equities team has integrated ESG right into the heart of its investment process using principles rather than hard, fixed rules. This approach adds to our ability to screen for wealth-creating stocks, and then identify attractively valued investment opportunities. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. *Source: RLAM as at 30.03.2018. ** Source: RLAM, CS Holt as of 15 Nov 2017. *** Source: RLAM, CS Holt as of 20 April 2018. Portfolio holdings are subject to change, for information only and are not investment recommendations. The views expressed are the author’s own and do not constitute investment advice.

10 | LEADING EDGE | JUNE 2018

Avoiding hidden dangers in decumulation: a multi asset approach to meeting income needs while mitigating downside risk £350,000

£120,000

£300,000

£100,000

£250,000

£238,635

£80,000

£200,000

£60,000

£150,000

£40,000

£100,000

£20,000

Equities have now been on the ascent for nearly a decade, while bond yields have moved downhill. However, the need for income could lead investors into decisions that may have a negative impact in the longer term.

Don’t fall for the myths 5

£0

Let’s start by debunking some of the myths about income investing.

Examplefrom 1 (15% Drawdown at the end) Example 1 (15% Drawdown at the end) de-risk when they are drawing income One such myth is that investors should their portfolios. But a low-risk strategy as this 2may result in at the star (15% Drawdown Example 2 (15% Drawdown at themay start)prove to be quite risky, ironically,Example a portfolio that fails to generate the returns needed to replenish drawdowns. Having some risk is desirable, as it makes it more likely that the portfolio will be able to generate a sustainable income stream over the long term.

How sustainable is income?

100% Annuity best

90% Probability income is sustainable

£50,000 With the equity bull market in its 10th year, investors looking to draw income from their 0 portfolio may be tempted to move away from stocks and seek yield in more exotic parts of the fixed income universe – which could expose them to unexpected credit risks when the business cycle turns downwards. Trevor Greetham believes that a multi asset portfolio can be used to generate a sustainable income while making use of tactical asset allocation to manage downside risk.

Trevor Greetham, Head of Multi Asset

Defensive fund better here

80% 70%

Growth fund better in the longer run

60% 50% 40% 30%

Defensive Portfolio, 4.5% income

20%

Growth Portfolio, 4.5% income

10% 0%

Years into retirement Source: RLAM for illustrative purposes only. Calculations in line with ‘mid-range’ growth rates as required by the Financial Conduct Authority for pension illustrations. Multi asset returns are based on monthly performance data for the underlying asset classes included in the portfolio fund as represented by their respective benchmarks – see fund factsheets for full details. Multi asset plus returns are calculated using simulated historical positions based on in-house tactical asset allocation models but do not include the impact on return expected from stock selection within each asset class.

JUNE 2018 | LEADING EDGE | 11

Another myth is that it is better to earn natural income via high yields, so that withdrawals come from the income generated and the capital is left intact. But thanks to central banks’ money-printing strategies since the financial crisis, low rather than high yields are now the norm. If you were looking for asset classes today that offer yields similar to those seen 20 years ago, this would mean areas such as aircraft leasing or peer-to-peer lending which can involve high default risk. A portfolio comprising these assets may turn out to be illiquid, volatile and poorly diversified. This can give rise to unpredictable income streams, and lead to large losses in early years, which as can be seen in the chart below, can have a particularly damaging effect on a portfolio. Path dependency Buy and Hold

Decumulation: Drawing 6% income

£350,000

£120,000

£300,000

£100,000

£250,000

£238,635

£200,000

£80,000 £60,000

£150,000

£40,000

£100,000

£20,000

£50,000

£47,701 £27,921

£0

Example 1 (15% Drawdown at the end)

Example 2 (15% Drawdown at the start)

Source: RLAM, for illustrative purposes only. Calculations shown make no assumption about yields and are based on total return

100% Annuity best

Probability income is sustainable

90%

Defensive fund better here

80% 70%

Growth fund better in the longer run

60% 50% 40% 30%

Defensive Portfolio, 4.5% income

20%

Growth Portfolio, 4.5% income

10% 0%

Years into retirement

How can well-diversified multi asset funds meet income requirements? We believe that using a multi asset strategy that uses unit encashment – which involves withdrawing capital and income – can be more prudent when drawing income from a portfolio, rather than chasing yield by investing in untested asset classes or going to the other extreme and eschewing risk altogether. This allows investors to target diversified total returns through exposure to a broad range of asset classes. The breadth of RLAM’s multi asset range means we are well-positioned to cater to different investors and their desired risk-return outcomes. Simulated past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.

12 | LEADING EDGE | JUNE 2018

Sustainable investing: moving into the mainstream Millennials are driving the growing interest in sustainable investing. But even if they do not care deeply about sustainability, investors are increasingly attracted to the strong returns these funds can provide.

Demographic shift Rewind 15 to 20 years, and if you asked people what importance they placed on environmental, social and governance (ESG) analysis in investment decision-making, the answer was invariably “none”. Where investment products were ESG-friendly, it was perceived as being detrimental to investment performance. Also, beyond a very narrow marketplace, the view was that products of this nature were not saleable. Sitting here in 2018, people’s views have changed quite considerably. In 2015, millennials became the biggest demographic in the US economy, and they will be the single biggest demographic for the next couple of decades. Demographic shifts can have a very powerful impact on the corporate world; they have impaired certain business models and created new ones. We think it is entirely logical that the asset management industry will also feel the effect of demographic changes. Every generation has its own values and beliefs, and for a younger generation that is increasingly that the products they purchase should be sustainable. For most of the last couple of decades, companies have talked about their baby-boomer strategies and how they are chasing the grey pound. But this is changing – with companies increasingly focused on their millennial strategy. Over the next 30 to 35 years, millennials will be the accumulators of assets and, as an industry, it is important we respond to that with a shift in product requirements. Sustainable funds are well placed to benefit from that shift. They have the basic utility of an investment product and the return it provides, and they have the social context as well, which is likely to make them very appealing to millennials in the years to come.

How environmental, social and governance analysis can add value The fundamental building block of delivering strong investment returns is a strong financial identity. That means a good management team, a value-creating business model and long-term growth. There are many fund managers with successful track records who do not go beyond that. However, we think a strong ESG identity gives you two things: a social context to the fund, and a deeper investment insight. There are a whole raft of examples of how deep ESG insight created a financial competitive advantage. Our view is that the combination of a strong financial and ESG identity will deliver the potential for stronger returns. The debate on the impact of ESG analysis on investment performance is not a new one, and most have the view that it has a negative impact. Our experience is very different – yes, it has an impact, and it is a positive one. Sustainable investing is moving into the mainstream, and we see that objectively through the flow of money into our range of five multi asset sustainable funds. But it is also a great way to invest, whether or not you believe in the sustainability element. Some of RLAM’s best-performing funds can be found within our sustainable range. There is the objective proof that investing in this way can be extremely profitable. Our underlying point is this: if you want long-term, structural outperformance, you have to find something that is underused under-analysed or underweighted by others. You are looking for some kind of inefficiency that you can exploit, and ours is ESG analysis.

Mike Fox, Head of Sustainable Investments

Investment themes to think about: Sustainability drives us to look at long-term trends and themes that will improve society and benefit investors. This can be seen in some of the themes in our portfolios today:

Electric vehicles There is a real desire by governments to reduce emissions. After tackling the power generation industry, the obvious next industry for the UK government to target is transport. Globally, there seems to be genuine political will to change transport. Combustion engines, which pollute, no longer make a lot of sense when most energy comes from the sun and you can extract that directly with a solar panel rather than inefficiently through fossil fuels. Electrifying the transportation industry is an ongoing theme. In 10 to 20 years, we think there will be significantly more electric vehicles on the road than there are today.

Artificial intelligence There is a huge overestimation of where artificial intelligence (AI) is today, and a huge underestimation of the intelligence of humans. The right way to look at AI today is using data to make better decisions. And this has been driven by the dominant theme in society today, which is the digitisation of everything. With phones in our pockets, we carry around mobile supercomputers, so there is a vast amount of data that can be mined in a more effective way. The best example I can give you is healthcare. Historically, data in the healthcare industry has not been shared, and that has been problematic for making scientific progress. There is significant potential for harnessing this data to make better diagnoses.

JUNE 2018 | LEADING EDGE | 13

Agriculture Agriculture already emits more greenhouse gases than any other industry apart from energy. The demand for food, particularly meat, is growing all the time. This is of particular relevance to developing economies because, as economies get richer, they eat more protein and add more meat to their diet. So the challenge is not just rising populations but the increased demand for protein. This is becoming an increasing concern in areas where productive arable land is decreasing because of climate change and urbanisation. So there is a real need to improve the efficiency and effectiveness of agriculture. One example where progress is being made in this field is through the use of big data and artificial intelligence, to make best use of land by sowing fields based on characteristics such as their PH and moisture levels. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio holdings are subject to change, for information only and are not investment recommendations. The views expressed are the authorâ&#x20AC;&#x2122;s own and do not constitute investment advice.

14 | LEADING EDGE | JUNE 2018

Maximising the risk/reward trade-off beyond investment grade Azhar Hussain, Head of Global High Yield

JUNE 2018 | LEADING EDGE | 15

When yields are low, investors naturally look beyond traditional investment grade bonds, attracted by higher yields but with healthy scepticism about market valuations and the increased risk of moving along the credit spectrum. The challenge lies in navigating the world beyond investment grade, to maintain income while managing these risks effectively. The last decade has seen central banks fill up the global economy with unprecedented amounts of liquidity. This has pushed down the yields on corporate and government bonds. Consequently, investors have looked further afield, towards assets which offer yields over and above those on ‘safe’ government bonds. The yield differential between high yield bonds and the equivalent maturity government bond is termed the credit spread. This compensates investors for the extra volatility, illiquidity, default risk and uncertainty that they face when they hold high yield bonds. These four elements make up the high yield jigsaw and, if effectively managed, can mitigate downside risk to potentially deliver steady long-term outperformance.

The volatility aspect Over the last decade, there has been a proliferation of short duration and floating rate funds that target duration to control volatility. Most people, when they refer to duration, generally refer to the sensitivity of a bond’s price to interest rate movements, this is known as effective duration. The longer a bond fund’s effective duration, the more the price will change when interest rates move. But for high yield bonds, it is not enough to just look at effective duration. Rather, spread duration is the key. This measures the bond’s sensitivity to credit spread movements. Bonds with low effective duration may be resilient to rising rates, but if they have high spread durations, then they are likely to be more volatile when credit spreads widen. Floating rate bonds are good examples of bonds which have short effective durations but long spread durations. Being aware of spread duration is a key element of managing the volatility piece of the high yield jigsaw.

Using a cashflow based approach to mitigate illiquidity risk Illiquidity risk was a major problem during the credit crisis – some of the best strategies suffered, as they did not have a pool of easy liquidity to draw on when investors rushed to redeem funds. Effective cashflow management is the key to mitigating illiquidity risk, and RLAM has considerable experience in this area. Our cashflow-based approach in our short duration funds is an attractive feature that allows us to meet liquidity needs and, at the same time, aim to deliver excess risk adjusted returns. During times of stress, this approach means that we can stop investments, and the fund can be wholly redeemed by internal cashflows.

Managing default risk One key element to managing default risk is by using good active credit management. In addition, utilising structural and temporal seniority can also help portfolios generate better returns with lower default rates. With structural seniority, this means that when a default does occur, bond holders are more likely to recover their investments, as they will have strong claims on the underlying assets. Embedding secured bonds within a portfolio is one way to make it more resilient to the risk of default. Temporal seniority is where a subordinated bond matures before much more senior instruments. This means that, even in cases where short-term subordinated bonds have low credit ratings, these bonds may reflect a lower probability of default than the ratings imply, provided the company has enough liquidity to meet its short-term obligations. Structural and temporal seniority are useful levers, in addition to sound credit management, to ensure that the default piece of the jigsaw leads to excess returns through lower defaults.

Avoiding uncertainty At Royal London, we’ve found that the best way of dealing with uncertainty is by ensuring the portfolio does not have exposure to elements that can introduce uncertainty. For our high yield portfolios, this means focusing on core corporate credit risk. We seek to eliminate the uncertainty involved in currency fluctuations by effective hedging.

We focus on avoiding political uncertainty by investing in jurisdictions with favourable political and economic climates or where political risks can be mitigated. In these cases, it is more likely that the corporate risk spread will be higher than the government risk spread. For instance, Argentina’s bonds trade at higher yields than Chile’s. But with a high debt-to-GDP ratio, a volatile currency and an unstable political situation, the jurisdiction risk of Argentina is much higher than the corporate risk. By contrast, investments in Chile involve less political uncertainty, thanks to the country’s fairly high sovereign rating, its low debt-to-GDP ratio and a stable political situation. In Chile, it is much more likely that the corporate investment decision will determine the outcome. Meanwhile, in Argentina, the investment outcome is likely to be dependent on the way the political wind blows. Another aspect of managing uncertainty involves favouring investments in companies with transparent structures, which are easy to assess, rather than those with ‘black box’ structures. In conclusion, high yield investments are becoming increasingly more attractive as sources of return, as the yields on sovereign and investment grade bonds are close to historical lows. While there is a perception that high yield bonds are risky, this need not be the case if the risks around volatility, illiquidity, default and uncertainty are mitigated; this can pave the way for the four pieces of the high yield jigsaw to successfully interconnect to create potential excess returns over the long term. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio holdings are subject to change, for information only and are not investment recommendations. The views expressed are the author’s own and do not constitute investment advice.

16 | LEADING EDGE | JUNE 2018

Demystifying ABS Asset backed securities, or ABS, are an often misunderstood part of the bond universe – a misunderstanding that RLAM exploits to improve both security and yield for our clients’ portfolios. In this article we demystify ABS – explaining why these bonds are so attractive and how these assets can enhance returns while reducing risk in a broader portfolio context.

Security enhances recovery

Reducing down the risk…

ABS are often considered to be a complex asset class, with negative connotations post the global financial crisis. However, for RLAM, investing in asset backed securities simply means lending to a company on a secured basis. The reason we look for that security is that it should enhance recovery in a default situation, allowing us as lenders to take control of the recovery process ahead of any other providers of finance.

There are two keys risks to think about when investing in corporate bonds: credit risk and interest rate risk.

However, if we are able to lend to a company on a senior secured or covenanted basis, we can be in control of the process, enhancing our recovery. Senior secured means senior secured and this is at the heart of why we invest in ABS. With corporate volatility only seemingly increasing at the moment, having security and covenants, and the control they bring is more important than ever.

Credit risk also, encapsulates the volatility of bondholder returns. To compensate an investor for the risk they are taking by lending their money to a company, investors earn a credit spread over and above government bonds. The more volatile that credit spread is the more volatile the value of your portfolio will be. Historical evidence from iBoxx (including the period covering the financial crisis) shows that across all investment grade rating bands, the volatility of credit spreads from ABS is considerably lower than non-ABS.

All Maturities

2014-2017

Relative Performance (p.a.) Relative weight of ABS Sector

0.9%

Stock ABS

0.3%

Source: RLAM, from 1 January 2014 to 31 December 2017. Based on performance of RLAM’s all maturities credit funds.

Therefore, investing in ABS can not only enhance your recovery proceeds, provide less volatile returns, it can also reduce your interest rate risk as well.

Senior Secured Bond Post-Default

Pre-Default

Source: RLAM, for illustrative purposes only

Senior secured = Senior secured

Equity Banks Bonds

1.5% 27.8%

How Security Enhances Recovery

Assets

Typically corporate bonds involve lending to a company on a senior unsecured basis. However, other providers of finance (such as banks) will typically lend on a covenanted basis. This means if a company gets into financial difficulty and, as a result, are at risk of breaching those covenants, they will need to liaise closely with their banks. As part of those discussions, the banks will then be able to take control of the situation, get security over assets and enhance their recovery to the detriment of other lenders. As a result, a senior unsecured lender can actually become subordinated.

Credit risk means the risk that a company defaults on their financial obligation and you are unable to recover all you are owed. Historical evidence shows that the recovery rates for secured bonds far exceed those for unsecured bonds. Looking at Moody’s recovery rates for corporate bonds between 1987 and 2015, unsecured bonds saw recovery rates of 49% of their invested capital. By contrast, the secured bond holders recovered over 63% of their principal*.

Investing in corporate bonds also means you are exposed to interest rate risk. This is because of the inverse relationship between interest rates and bond prices. If interest rates rise, the value of fixed rate bonds, and therefore your portfolio, will fall. To reduce exposure to interest rate risk however, we can invest in floating rate notes or FRNs. With FRNs the coupon you receive changes with interest rates and therefore the value of a portfolio of FRNs should not fall. Adding FRN’s to portfolios can therefore reduce exposure to interest rate risk and importantly there are many examples of ABS that are also FRNs. As a consequence we have been adding these types of ABS to our clients’ portfolios to protect against future interest rate rises.

Assets

Bonds

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Richard Nelson, Senior Fund Manager

Zilla Chan, Senior Credit Analyst

… but improving the rewards Given the number of ways that we have highlighted that ABS can reduce your risk, you would think that investors would earn a lower return as a consequence. However, in practice, this is not the case, which is evidenced by the returns we have achieved for our clients by investing in ABS. For example, our all maturities RL Sterling Credit Fund, which has around a 28% ABS overweight, has beaten its benchmark by 0.76% annually over three years. The bulk of this outperformance was due to having both an overweight allocation to ABS and to strong selections within the asset class. Similarly strong results were achieved in RLAM’s long and short dated credit portfolios**.

We hope this article clarifies the misconceptions surrounding ABS. We see a great opportunity in the asset class and through dedicated research we are able to invest in some attractive bonds with credit protective features that also enhance the returns of our clients’ portfolios. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio holdings are subject to change, for information only and are not investment recommendations. The views expressed are the authors’ own and do not constitute investment advice. *Source: Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1987-2015. ** Source: RLAM, as at 30.05.2018 based on M Acc share class 3 year annualised performance, gross of fees. The impact of fees and tax, where applicable, can be material on the performance of your investment. Tax treatment will depend on the individual circumstances of clients and may be subject to change in the future.

18 | LEADING EDGE | JUNE 2018

Ashley Hamilton Claxton, Head of Responsible Investment

Focus on corporate governance When the corporate governance warning lights are flashing, the board and investors must not ignore them, says Ashley Hamilton-Claxton, RLAM’s Head of Responsible Investing. As Hamilton-Claxton argues, companies with good corporate governance tend to perform better over the long term. When the dashboard lights up

Volkswagen

A bit like the flashing lights on your car’s dashboard, companies with good corporate governance have a built-in warning system that tells them when something is wrong. We believe companies with good corporate governance will perform better over the long term. When those lights come on, it is a signal to the board and to investors that the company needs some care and maintenance – that there is a problem that needs investigating.

Most investors know that Volkswagen was caught cheating on its emissions tests; few realised that the warning lights had been flashing at the company for some time. Volkswagen has notoriously poor governance. In 2015, at the time of the scandal, it had a very large board with 21 members, only one of whom was independent.

Perhaps the board needs refreshing with new directors, or maybe the issue is more sinister, reflecting a fundamental problem with the company’s culture. Warning signals include a high number of votes against management, a lack of independent directors on the board, a history of poor decision-making, dominant executives and a weak chairman, though there are many more. So what happens when you ignore these signals? Let us examine a couple of examples in Volkswagen and Tesla.

The company suffered hugely. In the first minutes of trading after the scandal was announced, £11 billion was wiped off the share price, which led to the company’s first annual loss in 20 years. Dozens of lawsuits have been filed. Today the company has paid £22 billion in fines, legal fees and compensation. The share price went from around €244 to around €170 today*. The CEO resigned and executives were suspended. At first the company claimed the management had been unaware of the issue, but it has since become clear that the cheating was widespread and well known.

Rather than use this as a catalyst to change, Volkswagen has continued in its old habits. The board replaced the CEO with another insider, the chairman remains in post and – amazingly – the board approved a payment of €63 million in executive compensation for performance in 2015. Currently, the board has no independent directors. There may be a glimmer of hope, as the company has announced they are appointing a new chief executive. But the controlling family are still very much in charge and governance is still a significant risk. So what have we learned? Fundamentally, the emissions scandal was a failure of leadership and governance. There were lots of early warning signals for the board and for investors to pick up on, but not everyone did. Our line of sustainable funds actually looked at investing in Volkswagen back in 2011. At the time, the company was a market leader in emissions reduction, and it would have passed our environmental test with flying colours. However, when we looked at the company’s governance, we were very uncomfortable, and decided not to invest.

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Tesla A more recent and live example of governance warning signals is another car company, Tesla. It is a highly innovative and somewhat unusual company, and the governance is no different. Elon Musk essentially has four jobs. He is the founder, chairman and CEO of Tesla, and he is also the chairman of SpaceX. He owns 20% of Tesla’s stock and the board consists largely of insiders and members of his own family. The board currently has nine directors, only three of whom are considered to be truly independent. The rest have personal or business ties with Musk. Two of those independent directors were only added recently after institutional investors complained. The company has equally unusual pay practices. In March this year, the board approved a pay package for Musk worth approximately $3.7 billion over 10 years, so that is $370 million a year for hitting extremely stretching performance targets. If it pays out, Musk would own 28% of the company’s stock, which is an eye-watering number, even by American standards. If that award pays out, and if all the other existing awards pay out, existing shareholders will suffer a dilution of about 25%. To put that into context, we would normally approve a dilution of 5%. Sometimes we might approve 10%, depending on the situation, so 25% is a large number.

There have been other issues, such as Musk, his brother and another member of the board pledging around $3.5 billion worth of shares as collateral for personal loans. If the lender ever calls in that collateral, that could be very bad for shareholders. Also note how Musk himself, though he is considered to be extremely hands-on as a manager, has failed to attend about 75% of the board meetings. And, in 2016, Tesla completed a controversial acquisition of SolarCity, a company run by his cousin. Many people considered the acquisition to be a family bailout, but it was fully supported by the board. At the time of the acquisition, Musk was the chairman of SolarCity and two Tesla directors sat on the board of SolarCity, while another director was an executive of SolarCity. This is now the subject of a lawsuit. Again, all the warning signals were there, but not all investors were paying attention.

What should happen when the warning lights come on? You can have all the warning lights in the world flashing and beeping at you, but they are completely useless if you simply choose to ignore them. Companies need skilled and experienced boards to interpret the signals from the company and from management, and to decide how urgently issues need to be dealt with. If boards ignore key governance signals, companies will suffer over the long term. Often one minor problem can cause another, bigger problem, or even a catastrophic failure. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio holdings are subject to change, for information only and are not investment recommendations. Results as disclosed in the companies’ public filing. The views expressed are the author’s own and do not constitute investment advice. * Source: Bloomberg as at 09 April 2018.

20 | LEADING EDGE | JUNE 2018

Where’s the value in cash? Cash management is a key area for many investors, but with an evolving landscape for cash funds, investors will be wondering how to protect capital when interest rates may be going up.

Craig Inches, Head of Rates and Cash Over the last few years, returns for cash asset classes have been low: on a 5-year annualised basis, investors in RLAM’s Cash Plus Fund earned 0.7%, compared with 4.7% for UK corporate credit and 6.8% for UK equities. But change is afoot, as rising rates and volatility have led investors to reassess valuations; on a 1-year basis, RLAM’s Cash Plus Fund has earned 0.5%, compared with 0.6% and 0.2% for bonds and equities, respectively*. Economic indicators suggest that interest rates are set to rise: the purchasing managers’ indices (PMI) have been in expansionary territory for some time, and headline inflation, which is on the rise, has already exceeded the Bank of England’s 2.0% target**. Additionally, corporate earnings, supported by a low-rate environment, have been improving, and we expect to see a pick-up over the summer. All this leads us to believe that we are likely to see the Bank of England (BoE) raising rates again this year with two further increases in 2019.

What does a rising rate environment spell for cash investors? Cash investments aren’t all alike; as the sophistication of cash instruments increases, so does the potential for greater yield. Our funds use a mix of assets to balance risk, liquidity and capital preservation metrics. Floating rate notes are used extensively to allow us to increase credit exposure whilst limiting exposure to rising rates and where we can, we favour covered bonds that have added protection and are exempt from bail-in. To assist with fund comparison we have likened our cash vehicles to cars to help contextualise their risk and volatility profile and how they may be best used.

Our Short-Term Money Market Fund, like a low-cost station car, is useful for short journeys, and hence contains short-dated money market instruments. It’s the type of instrument best suited for investors planning to withdraw the cash after a relatively short period, typically from under a month to around six months, or those with a very low tolerance for short-term volatility. RLAM’s Cash Plus Fund, which is more like a family car, invests largely in medium-dated money market instruments, covered and corporate floating rate notes. Its investment horizon would be best suited for investors willing to accept a small amount of shortterm volatility and expecting to withdraw cash over a period greater than six months. Finally, our Enhanced Cash Plus Fund invests in longer-dated money market instruments covered floating rate notes, fixed rate corporate bonds and mortgage-backed securities. Continuing our car theme, this is the sports car of our cash suite, in that it offers the potential of higher returns but can experience higher volatility due to increased exposure to rising rates. Recent performance has shown that this vehicle has performed well over shorter time frames, however it is best suited for investors looking to hold cash for a period of at least 12 months, allowing the higher income to offset medium-term volatility. At RLAM, a key component of risk mitigation is credit research. Research is often touted as critical in corporate bond market investing, but we believe it’s just as important in cash vehicles. We pay close attention to credit default swaps and equity movements to enhance the data made available by credit agencies, and we use both external analytics and in-depth internal research to manage credit exposure.

Tony Cole, Fund manager

We believe that the range of funds offered and the variety of the underlying instruments allows investors to engage in cash laddering, by allocating cash into different vehicles based on the time they expect to withdraw the funds and their risk appetite. This allows our investors to not only protect their money and meet their liquidity requirements for different time horizons, but also to tailor their risk exposure and maximise yield. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice. *Source: RLAM as at 29 March 2018, gross of fees and tax. Returns represented by the following indices: UK Gilts is the FTSE All-Maturities Index, UK Credit is the iBoxx £ Non Gilt All-Maturities Index, UK Equities is the FTSE AllShare Index. The impact of fees and tax, where applicable, can be material on the performance of your investment. Tax treatment will depend on the individual circumstances of clients and may be subject to change in the future. ** Source: Thomson Reuters Datastream as at 15 March 2018.

JUNE 2018 | LEADING EDGE | 21

RLAM Conference

RLAM Investment Conference: a recap of our views

We have pulled together a range of videos and webinars to bring you the thinking from our investment conference. Rob Williams explains whatâ&#x20AC;&#x2122;s on the horizon for RLAM in 2018:

Senior UK Equities Fund Manager, Henry Lowson explains how he goes about identifying compelling opportunities without being driven by market movements:

Video Chief Investment Officer, Piers Hillier outlines the main investment themes for 2018:

Video

Webinar

Peter Rutter explains how ESG factors are incorporated into his investment process:

Video Ashley Hamilton Claxton explains why interest in and focus on corporate governance has been growing: Video

Webinar

Video

Webinar

Matt Franklin and Gail Gounihan consider the benefits of integrating ESG factors into the credit research process: Video

Webinar

Eric Holt and Paola Binns discuss whether the going will get tougher for credit bonds: Video

Craig Inches explains how the landscape for cash funds is evolving:

Azhar Hussain explains how he seeks to make sense of the high yield jigsaw: Webinar

Webinar Trevor Greetham looks at how a multi asset portfolio can be used to generate a sustainable income which managing downside risk:

Head of Liability Driven Investments, Nick Woodward explains why flexibility is so important in uncertain times: Video

Webinar

Contact us For more information about the Funds or RLAMâ&#x20AC;&#x2122;s range of products and services, please contact us. Royal London Asset Management 55 Gracechurch Street London EC3V 0RL Tel: 020 7506 6500 Fax: 020 7506 6796 Email: bdsupport@rlam.co.uk www.rlam.co.uk

For professional clients only, not suitable for retail investors. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For more information concerning the risks of investing, please refer to the Prospectuses and Key Investor Information Documents (KIIDs). Issued June 2018 by Royal London Asset Management Limited, registered in England and Wales number 2244297; authorised and regulated by the Financial Conduct Authority. A subsidiary of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London, EC3V 0RL. Ref: N RLAM W 0007

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