Leading Edge October 2015 by Royal London Asset Management

LEADING EDGE RLAM’S REGULAR REVIEW OF INVESTMENT MARKETS • OCTOBER 2015

Investment Clock Head of Multi Asset, Trevor Greetham introduces the Investment Clock model and offers an insight into what time it’s telling at the moment.

Balancing act

With the threat of an interest rate rise looming, Craig Inches and Paola Binns ask ‘could now be the time to consider short duration bonds’?

Quality compounders and recovery stocks

Martin Cholwill examines opportunities from across the UK equity income market.

Global bond opportunities

Fund manager Rachid Semaoune highlights some sectors he’ll be focusing on within RLAM’s soonto-be-launched credit fund.

Recovery or overheat?

Trevor Greetham and Ian Kernohan, RLAM’s Senior Economist, examine where we currently are on the investment cycle.

For professional investors only, not suitable for retail clients

2 | TITLE OF MAG | APRIL 2015

Rob Williams

Head of Distribution

Welcome Welcome to the latest edition of Leading Edge, our regular update on investment markets.

The third quarter was one of the most volatile on record for some asset classes, dominated as it was by expectations of a rate rise in the US and the collapse in investor confidence triggered by mounting concerns that China simply cannot grow at breakneck speed forever. With the US Federal Reserve ultimately staying its hand, this continues to be a difficult time for investors as they attempt to negotiate see-sawing markets in thrall to central bank intervention and rhetoric.

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 6678 Fax: 020 7506 6796 Web: www.rlam.co.uk For professional investors and advisors only. This document may not be distributed to any unauthorised persons and is not suitable for retail clients. This document is for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Nor does it provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. 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. Where this document references the trade marks ‘FTSE®’, ‘FT-SE’ and ‘Footsie’, these are owned by the London Stock Exchange Group companies and are used by FTSE under licence. The FTSE All Share index is calculated by FTSE. FTSE does not sponsor, endorse or promote the product referred to in this document and is not in any way connected to it and does not accept any liability in relation to its issue, operation and trading. All copyright and database rights in the index values and constituent list vest in FTSE. The views expressed are the authors’ own and do not constitute investment advice.

This latest e-zine is designed to keep you and your clients informed about how we are navigating global markets, keeping you up-to-speed with our positioning and the opportunities (and danger areas) our teams continue to unearth. I’m delighted to say that this edition features comments from our new Head of Multi Asset, Trevor Greetham, who joined us in April. Trevor’s unique investment process – the Investment Clock – is featured inside, along with his thoughts on the global outlook. As a business that believes in the power of flexibility to deliver strong investment performance, we are no strangers to working with external parties and we are also pleased to bring you the thoughts of fund expert Jason Broomer of Square Mile Consulting. While we are, and always will be, predominantly an active investment house, we recognise that passives can play an important role within balanced portfolios. Jason’s expertise in this field is considerable, and we hope you will find his suggestions on how to choose passive funds informative and insightful. As ever, we remain committed to thinking differently to the wider market. We’d love to hear your thoughts on the e-zine, so if you have any comments or feedback, please share them by emailing: leadingedge@rlam.co.uk Enjoy the issue.

Rob Williams Head of Distribution

OCTOBER 2015 | LEADING EDGE | 3

Contents

€

Also this issue 7 The passive opportunity Jason Broomer of Square

Mile Research considers how passive funds can complement an investors’ portfolio, outlining his process for evaluating tracker funds.

16 RLAM roundup

Some key facts and news from us.

€

£ £

€

Quality compounders, and recovery stocks

Global bond opportunities

08 Investment Clock Head of Multi Asset, Trevor Greetham introduces the Investment Clock model and offers an insight into what time it’s telling at the moment.

Martin Cholwill examines opportunities from across the UK equity income market.

Fund manager Rachid Semaoune highlights some sectors he’ll be focusing on within RLAM’s soon-to-belaunched credit fund.

Recovery or Overheat?

Buy and maintain

Balancing act

We look at the potential benefits of a defensive buy and maintain strategy, with thoughts from Fund manager Shalin Shah and RLAM’s valued client, Volvo.

With the threat of an interest rate rise looming, Craig Inches and Paola Binns ask ‘could now be the time to consider short duration bonds’?

Trevor Greetham and Ian Kernohan , RLAM’s Senior Economist, examine where we currently are on the investment cycle.

4 | LEADING EDGE | OCTOBER 2015

Quality compounders and recovery stocks: Martin Cholwill examines the UK equity income market. The third quarter of the year saw a number of industrial companies warning of challenging market conditions, the negative impact of lower commodity prices on oil and mining stocks and those that service them, and a slowing Chinese economy. While there were some attractive prospects from strong labour markets and, consequently, the UK and US consumer, this backdrop proved challenging for equity markets. In the UK, the FTSE All-Share index delivered a total return of -5.7%*. Martin Cholwill, manager of the Royal London UK Equity Income Fund considers the opportunities for income-seeking investors across various sectors and business types.

OCTOBER 2015 | LEADING EDGE | 5

“It has been a difficult quarter for equity markets worldwide. The Federal Reserve’s (Fed) decision not to raise interest rates in September acknowledged a strong US labour market, but cited recent global economic and financial developments as a reason for not raising rates at the moment. This decision has created uncertainty in the mind of investors on the future path of US interest rates; if the Fed does not raise interest rates now, when will they do it? In the UK, I believe there is scope for politics to be very fluid and to remain an important investment theme over the next few years, with the conservatives targeting the political middle ground, as we saw when Tony Blair was Prime Minister.

Flight to quality My basic premise is that we are in a low growth world (hence prevalent Quantitative Easing) with headwinds from high levels of government indebtedness worldwide. Consequently, sustainable growth in companies remains a scarce commodity across the stockmarket and I am focussed on quality growth compounders rather than ‘recovery’ situations which may be based on hope rather than evidence. During the first half of the year, the IA UK Equity Income sector favoured recovery stocks, however, with fears over China and the emerging markets slowing and consensus expectations for global GDP growth falling, investors have refocused on quality, benefitting investment

performance. I stick with my basic premise, albeit accepting that by focussing on quality, one may miss out on some of the gains associated with frothy markets, but portfolios dominated by companies with strong balance sheets and sustainable growth tend to be more resilient in tougher times and provide better longer-term returns, both in absolute terms and on a risk-adjusted basis.

Identifying compounders One such quality compounder that I currently favour is Spectris. The industrial firm has a rock solid balance sheet, and its valuation is not particularly demanding. Within the mining sector, the Rio Tinto share price had held up much better than other mining stocks and I think we will see signs of a recovery in global industrial production before we see a recovery in commodity prices. Overall, many oil and mining stocks performed poorly over the quarter. A number of funds within the sector, including the RL UK Equity Income Fund are very underweight this part of the market and their performance will have benefitted from this factor. We have seen clear evidence that lower commodity pricing is negatively impacting the mining and oil stocks. However, I would not get too negative on economic prospects. What we have not seen yet is the full benefit of lower commodity prices feeding through into better economic growth rates. It is much easier to imagine the global economy being tipped into recession by a sharp rise in the

oil price, not a sharp fall. Ultimately, there is a transfer of wealth from oil producing countries to developed economies from a lower oil price. Potential casualties Given inflation remains well under control, I believe there is plenty of scope for further policy stimulus in developed economies, should the authorities believe it is required. Whilst there is plenty of pain in the resources space, UK consumer confidence continues to be strong, supported by better wage growth and low inflation, due to the lower oil price and interest rates remain at record low levels. Stock selection remains critical and I think we are likely to see more corporate casualties within the oil and mining space. Despite the Fed’s recent inactivity on interest rates, markets are aware that, at some stage, interest rates in both the US and UK are likely to start slowly creeping up, as a result of economic recovery becoming better established. Overall, I believe we will see a continuation of the interventionist economic environment that has characterised most developed economies since the credit crunch. I believe stockmarkets can continue to do well over the medium term against a background of anaemic economic growth and exceptionally low bond yields.”

RL UK Equity Income Fund 5 year performance 120

Percentage change

100 80

Royal London UK Equity Income IA UK Equity Income

60 40 20 0 -20 ' Sept 2010

' Sept 2011

' Sept 2012

' Sept 2013

' Sept 2014

' Sept 2015

Source: FE, total return, bid to bid, net income reinvested as at 30.09.2015. Based on A Acc Share Class. Past performance is not a guide to future performance.

*Source: FE as at 30.09.2015. 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. Investment in smaller companies may be riskier and less liquid than larger companies, which could mean that their share prices and therefore fund performance is more volatile. Where this document references the trade marks “FTSE®”, “FT-SE” and “Footsie”, these are owned by the London Stock Exchange Group companies and are used by FTSE under licence. The FTSE All Share index is calculated by FTSE. FTSE does not sponsor, endorse or promote the product referred to in this document and is not in any way connected to it and does not accept any liability in relation to its issue, operation and trading. All copyright and database rights in the index values and constituent list vest in FTSE.

6 | LEADING EDGE | OCTOBER 2015

Global bond opportunities

€ €

$ Rachid Semaoune

£ £

€

Fund manager

lobal fixed income markets have come under pressure this year as investors start to contemplate the end of loose monetary policy and record low interest rates. While the global economy is far from being out of the woods, with some economies starting to strengthen and others weakening, rate rises in core areas such as the US are looming. Against this backdrop, how to position fixed income exposure is becoming a key conundrum for many investors. However, there remain plenty of opportunities globally to make returns even if interest rates do start to rise gradually. Below, Rachid Semaoune, manager of the Royal London European Corporate Bond Fund and co-manager of the soon-to-belaunched Royal London Global Opportunities Bond Fund (subject to regulatory approval), highlights some of the themes he is focusing on - and areas he is avoiding - in the current environment. Energy companies “There are growing concerns that a number of energy companies will not be around to see prices recover, such is the stress they are under following the sharp decline in the oil price. The problem for investors is, unless your manager is benchmark agnostic, you will almost inevitably have a significant exposure to the energy sector, because energy names make up 13% of the US high yield market*.

The sector is also paying some of the highest yields out there following the sell-off in oil prices. Instead of holding all the names, our new Fund can cherry-pick the survivors, namely companies that have managed their balance sheet conservatively and have put in place appropriate hedges against falling oil prices. Financials Our new Fund will be very active in subordinated financials. In particular, AT1 securities have been recently issued by banks to shore up their balance sheet and meet the new Basel III capital ratios. In times of financial stress, coupon payments can be suspended or the principal can be written-off or converted into equity. AT1 securities of high quality banks, such as BNP, HSBC, Lloyds and Nationwide, offer an attractive yield similar to junk-rated bonds but with lower default risk. High yield As well as financials, high yield markets in general will be a core focus for the Fund because the yields on offer are attractive, even when you consider the outlook for interest rates. While there has been much doom and gloom around the impact of rate rises, a 0.5% increase in interest rates can easily be absorbed by the high yield market.

Since we expect any rate rises to be marginal, and well flagged by cautious central bankers, we do not foresee either a rapid increase in defaults or a rush out of the sector. Indeed, in this environment of lower yields for longer, investors will still be searching for the highest rates of income they can get.” Global opportunities The Fund is aimed at expanding RLAM’s credit expertise, offering investors access to a more internationally orientated product. It will retain the fixed income team’s credit philosophy: seeking to exploit market inefficiencies. The Fund will have an unconstrained approach, giving exposure to a greater range of investment opportunities. This flexibility could be beneficial in today’s uncertain market environment.

* Source: Bank of America Merril Lynch US High Yield Index as at 28.09.2015. 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. Fund launch subject to regulatory approval. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down. Sub-investment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk.

OCTOBER 2015 | LEADING EDGE | 7

€

Global bond The passive opportunities $

opportunity €

For a growing number of investors, the passive approach offers a number of clear benefits. Portfolio diversification, exposure to specific assets – such as gold and oil – and low costs are chief among them.

Jason Broomer Head of Investment, Square Mile Investment Consulting and Research

But with more than £10bn of UK retail investors’ money sitting in passive funds with higher annual charges than most active products, making the right choices is crucial*. Jason Broomer, Head of Investment at Square Mile Investment Consulting & Research, highlights how investors can navigate their way through the oftenconfusing world of passives to build the solutions into their portfolios efficiently.

“Passive funds now account for 20% of total UK assets under management, with the figure rising to 23%* when so-called smart beta solutions are included.

should be the overall exposure to the asset class, not how closely it replicates a specific index, or the exact composition of the index.

The Investment Association expects this figure to rise over the next half decade and beyond, with passive funds continuing to take market share from those asset managers whose products do not deliver sufficient alpha.

Price, of course, is a crucial factor, and we typically screen out any tracker charging above 30bps per annum, though some leeway is given to more specialist products tracking areas such as emerging markets.

Price and performance

But with much of the money invested in passive funds charging high fees, investors risk giving up far too much of their return just to track an index. Plus there are other issues to be cognisant of, including just how skewed some passives are to a few stocks or bonds which dominate indices.

There are literally thousands of trackers for investors to choose from, but with charges varying wildly, it is important for investors to know what a realistic price is for such products. In our view, 30bps is a good starting point – there needs to be a sound reason why a fund should charge more.

Core approach

Investors also need to consider the performance of trackers carefully. On this front, we look at funds primarily on their one-year daily rolling performance records, over a period of five years. This highlights the better performers, as there can be a surprising difference between the best and worst trackers which replicate the same indices.

So what approach should investors take when it comes to selecting complementary passive solutions? For our team, the key focuses are total return, whether the index being replicated is suitable for the end investor, and whether it is of sufficient size to provide the liquidity to facilitate daily trading. Despite the headlines they generate, of less importance are tracking error, and the precise basket of stocks tracked. We believe that if an investor is seeking, for instance, a product tracking US equities, the main consideration

Overall, we seek out products which have generated better relative returns for investors, are realistically priced, are large enough to offer plenty of liquidity, and are clear about what they track. We think investors should take a similar approach.”

RLAM’s tracker funds The following RLAM tracker funds have been rated as ‘recommended’ by Square Mile: RL Europe ex UK Tracker, RL FTSE 350 Tracker, RL UK All Share Tracker and RL US Tracker Funds. At RLAM our passive funds focus on those equity markets that we deem sufficiently large, liquid and mature to suit this style of investing. Our funds seek to balance trading costs and tracking error in a pragmatic manner.

Click here and find out more about our tracker funds

*Source Investment Association annual survey, 2014-15. 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. Investment in smaller companies may be riskier and less liquid than larger companies, which could mean that their share prices and therefore fund performance is more volatile.

8 | LEADING EDGE | OCTOBER 2015

Introducing the

Investment Clock Market returns follow the business cycle, waxing and waning as the world economy expands or contracts and inflation rises and falls. Looking back over history, certain assets have outperformed others depending on what stage of the cycle we find ourselves in. The Investment Clock model developed by Trevor Greetham, Head of Multi Asset, builds on this concept and forms an important part of the asset allocation strategy at RLAM. But how does it work when you get under the bonnet? Trevor explains the key drivers which help the clock to tell the time.

“The economic cycle moves through waves; from prosperity to decline as central banks inflate or deflate monetary policy as a means of stabilising activity within the economy and to keep inflation from getting too high or too low. The premise of the Investment Clock is that each of the four phases of the cycle favours a particular asset class. The Clock’s horizontal axis, left to right, reflects inflation while its vertical axis indicates economic growth.

What does well and when The Clock dictates which assets will typically do well at which period in the cycle, with equities likely to outperform in the Recovery phase, for example, and commodities and cash favoured during periods of Overheat and Stagflation, respectively. Government bonds will most likely thrive during the Reflation period, as we saw in the aftermath of the financial crisis when central banks moved to tackle the threat of a global downturn via the easing of monetary policy.

Telling the time So how do we tell what time it is? It can be easier said than done, and is dependent on an accurate reading and interpretation of economic data. RLAM’s Senior Economist, Ian Kernohan, and I work closely together to undertake a rigorous analysis of the indicators used to position the Clock. Importantly, the data we decide to include is constantly being analysed itself, with the process being tweaked over time to make sure

Trevor Greetham Head of Multi Asset

the most relevant information is used to help guide our investment decisions.

External input In addition to our own fundamental analysis of the available data, we regularly engage with RLAM’s asset class specialists, as well as policymakers and strategists from outside the company, to formulate our views. This approach means our own views are constantly being challenged, something that all good investors need. The additional input is invaluable and means that, having used multiple sources, the team have a high degree of conviction around the reading of the Clock and what stage of the investment cycle we are in.

Flexibility This framework provides a scientific basis for the team’s decision making process, but the Clock represents the start not the end of the investment process. We and our colleagues in the broader investment team devote a lot of time and effort to working through what could be different this time around. The Clock is important but we leave room for experience and good judgement to play their part. This is especially important as, while history often repeats itself in broad terms, there are unique aspects to every economic cycle.

Getting tactical Asset allocation positioning goes further than setting weightings for the broad asset class exposures. We also take great pains

OCTOBER 2015 | LEADING EDGE | 9

Investment Clock: the cycle drawn as a circle

scientific basis for the team’s decision making process

Industrial Metals

RECOVERY

Like all active strategies, tactical asset allocation isn’t easy and we cannot expect to get every investment decision right. But with a disciplined research-led process we aim to stack the odds in our favour so as to add consistent value for our customers over the long term. 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.

UMER DIS ONS CR &C ET IO

▼

LES

, H E A LT

R HCA

Energy

InflationLinked Bonds

TA P

REFLATION

▼

STAGFLATION

Precious Metals

INFLATION FALLS

Growth and inflation cycles are key

Asset classes and the economic cycle Rate hikes

“Overheat” COMMODITIES BONDS “Reflation”

“Stagflation” CASH

STOCKS “Recovery”

Rate cuts

GROWTH INFLATION

What does best and when Source: RLAM as at 30.09.2015

Long run analysis supports the intuition Growth

Inflation

Bonds

Stocks

Commodities

Cash

Reflation

9.5%

-3.3%

-27.4%

3.1%

Recovery

t t

4.9%

20.9%

-10.0%

1.3%

Overheating

0.8%

6.8%

17.4%

0.4%

Stagflation

t t

Globally, we are underweight the euro and yen, money printer currencies, and underweight the commodity-sensitive Australian and Canadian dollars.

High Yield Bonds

t t

In a similar vein, while we dislike the largest UK equities currently, we are overweight sterling because the UK is also moving towards a point where it can begin the long and slow process of normalising interest rates.

CASH

▼

Meanwhile, within fixed income markets we favour corporates, but we are underweighting government bonds given poor value and the prospect of eventual interest rate rises in the US. This thinking also influences views on currencies which are built into our positions, with a current bias towards the US dollar.

COMMODITIES

BONDS

CE N

GROWTH MOVES ABOVE TREND

Government Bonds

STOCKS

FIN A

Softs

Y AR N

IALS & ENE TER RG MA Y

Corporate Bonds

to set what we see as an optimal allocation within each asset class, identifying a variety of opportunities and areas to avoid. For example, while we favour equities in general, we are overweight Japan and Europe, regions that capture the essence of the Recovery phase with loose monetary policy and good growth prospects. Conversely, we are avoiding emerging markets as growth rates in China continue to disappoint.

OVERHEAT

LOGY & INDUSTR NO IAL CH S TE GROWTH MOVES BELOW TREND

”

INFLATION RISES

▼

This framework “ provides a

-0.7%

-13.6%

38.9%

-0.4%

Average return

3.2%

6.4%

2.6%

1.0%

Stay on the diagonal if you can! Source: RLAM as at 30.09.2015

10 | LEADING EDGE | OCTOBER 2015

Recovery or Overheat: Where are we in the investment cycle?

With growth continuing in the US, a slowdown in China pushing commodities down and inflation non-existent for many developed economies, equities look the best assets to back despite the recent sell off. But how long will this current phase of the investment cycle last and are there other opportunities for investors to generate attractive returns?

Click here for more information on the Investment Clock

In this discussion, RLAMâ&#x20AC;&#x2122;s head of Multi Asset, Trevor Greetham, and Senior Economist Ian Kernohan, discuss where we are on the teamâ&#x20AC;&#x2122;s Investment Clock, and where investors should be concentrating their attention to maximise returns as we approach 2016.

OCTOBER 2015 | LEADING EDGE | 11

his is a long, drawn-out cycle, “ Tmuch like the 1990s ”

IK: Where are we now in the investment cycle? TG: Global growth is above its long-term trend with unemployment rates falling in the US, UK, Japan and even in Europe but China and the emerging markets are slowing. The inflation picture is more complicated. Earlier this year we would have said inflation would drift up towards central bank targets but China’s devaluation and subsequent commodity price falls look set to keep the global economy in the equity-friendly Recovery quadrant of the Investment Clock, with developed economy growth continuing but inflation staying low.

IK: Which markets in particular look attractive when it comes to equities globally? Do any stand out? TG: O ur regional allocation is pointing towards Japan and Europe where central bank policy remains the loosest and growth is picking up. Both countries are likely to step-up monetary expansion in response to financial market stress and currency strength, which will be supportive for stocks. We are underweight Australia and the emerging markets, with China slowing, commodity prices weak and the US dollar strong. We are also underweight UK large caps, with oil and gas and basic resources companies accounting for nearly 20%* of the FTSE 100 index. We prefer the mid cap FTSE 250 index as it reflects positive UK fundamentals and a resurgent housing market.

IK: Has the recent sell-off in equity markets, led by China, created value in equities? TG: Yes. China’s stock market slide and a modest devaluation sparked a sharp selloff that left investor sentiment indicator as depressed as it was in the onset of the great financial crisis in 2007, after the Lehman failure in 2008 and at the worst point of the euro crisis in 2011. This suggests a strong bounce, especially if we get policy shifts in China and elsewhere to turn market sentiment around. It is hard to see how lower commodity prices and less hawkish monetary policy are a negative for the US consumer or the US stock market so we are buying the dip on Wall Street

Trevor Greetham

Ian Kernohan

Head of Multi Asset

Senior Economist

IK: While we are some way from the stagflation and reflation periods, which typically support fixed income assets, are there any opportunities in these areas? TG: We are currently underweight bonds as we think yields will go up gently from here as rate rises draw nearer. As an asset class, fixed income remains expensive, with yields so low it is hard for them to go in any other direction but upwards over the longer term. You would need to see rate cuts – rather than rises – for them to outperform again, and we are not in that scenario.

IK: What would spark an increase in inflation and place us firmly in the Overheat phase, where assets such as commodities typically outperform? TG: This is a long, drawn-out cycle, much like the 1990’s. Back then, you couldn’t get inflation going because Japan, then the world’s second largest economy, was slowing down. This time it is China going ex-growth, making it hard for anyone else to raise interest rates. To get inflation back up again you need a strong Chinese economy. We wouldn’t rule out turn a temporary pick up if they resort to aggressive stimulus. But to us, for now, this feels more like a continuation of the low unemployment, and low inflation environment which we have been in for some time. Back in the 1980s people used to talk of the ‘misery index’, the sum of unemployment and inflation. On this basis the developed economies have rarely had it so good.

*Source: FTSE as at 31.08.2015. **Source: FE based on FTSE World US Index January 1994- December 1999. Where this document references the trade marks “FTSE®”, “FTSE” and “Footsie”, these are owned by the London Stock Exchange Group companies and are used by FTSE under licence. The FTSE World USA, FTSE 100 and FTSE 250 indices are calculated by FTSE. FTSE does not sponsor, endorse or promote the product referred to in this document and is not in any way connected to it and does not accept any liability in relation to its issue, operation and trading. All copyright and database rights in the index values and constituent list vest in FTSE. 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. Fund launch subject to regulatory approval. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down.

12 | LEADING EDGE | OCTOBER 2015

Buy and maintain: Managing long-term cashflows

n some parts of government bond markets, it has been three decades since there has been a sustained rise in yields. While the Federal Reserve appears to be in no hurry to raise rates, in aggregate, the fixed income market is likely to face more challenges from here and fixed income investors will need to be more discerning to realise value. Against this backdrop, corporate credit markets have some advantages. These markets have grown somewhat haphazardly and the resulting structural anomalies can be exploited by investors to achieve a higher return, while keeping risk to a minimum. The recent emphasis on liquidity in fixed income markets – or the lack thereof – is a good example. Such is the focus on secondary market liquidity for corporate bonds, large sized issues (those with perceived greater liquidity) trade at a premium to smaller and less liquid bonds. We would argue that many investors simply don’t need this liquidity. A long-term investor with a 20-30 year time horizon does not need to pay for secondary market liquidity that they are unlikely to use. They

“

can afford to hold bonds to maturity, thereby reducing trading costs. With bid offer spreads extending to 1%, frequent trading of a bond portfolio is wealth-destroying over time. A desire for liquidity can also blind investors to good opportunities. For example, we hold the bonds of the Grosvenor Estate in our portfolios. At £200m, the bond size is too small to enter credit indices and attract the interest of the largest funds – it is not considered to offer sufficient liquidity. However, this is a bond secured on high quality West End properties, offering considerable protection for investors, whilst providing an attractive yield. In addition, fixed income markets are often overly dependent on the opinions of rating agencies. They are used to construct benchmarks and as the starting point for portfolio construction in many cases (due, for example, to regulatory requirements on banks or insurance companies that increase capital requirements based on ratings). The rating agencies have their place, but cannot be a substitute for proprietary evaluation of bonds. In particular, rating agencies assign ratings

based largely on the likelihood of default by individual companies and this approach has a number of limitations. First, it neglects the importance of the security in the event of a default. When a typical secured bond defaults, bondholders will be left with very little. In the (unlikely) event that Grosvenor Estate defaults, secured bondholders will have recourse to a valuable property portfolio to compensate them. We believe the risk inherent in secured and unsecured bonds is very different, but the market via the ratings agencies may not be making an effective distinction between secured and unsecured bonds. Secondly, it neglects the seniority of the bond, or any covenants that are in place. Both these elements working in unison with attractive asset collateral can offer significant protection to investors. It should also be said that, for similar reasons, an approach where the benchmark is the starting point may introduce higher risk. Fixed income benchmarks take their cue from the equity market and are constructed according to the weight of outstanding

A long-term investor with a 20-30 year time horizon does not need to pay for secondary market liquidity that they are unlikely to use.

”

OCTOBER 2015 | LEADING EDGE | 13

Shalin Shah Fund manager

debt. This means that benchmarks will have the highest weight in the most indebted companies. As highly indebted companies may be at greater risk of default, this seems an anomalous starting position. We believe that the buy and maintain approach addresses a lot of these issues. RLAM’s buy and maintain portfolios comprise highly rated (Average rating in the A band) bonds, usually held to maturity, selected on the basis of the strength of their assets, covenants and seniority. The exact portfolio will depend on the needs of individual schemes, but it will look very different to the benchmark. The aim is to deliver robust long-term cashflows, allowing pension schemes to better match their liabilities but also to capture and ‘lock-in’ excess return for the long term. The portfolios will generally run with a duration of 8-10 years. The broader challenges facing fixed income markets are likely to create more opportunities for long-term investors. Looking at the structural anomalies in the corporate credit market and turning them to the advantage of investors – as is used in the buy and maintain portfolios - is an effective way to deliver robust cashflows and higher return, while keeping risk low.

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. Fund launch subject to regulatory approval. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down.

“ Adrian Wickens MemberNominated Trustee of the Volvo Group UK Pension Scheme

Our defined benefit scheme has assets of around £220m and has been closed to future accruals since 2011. When we started talking about a ‘buy and maintain’ approach, I had never heard of the strategy. We were working on reducing risk in the portfolios and a ‘buy and maintain’ seemed to offer a good potential solution, while also offering consistent cashflows. We now have 50% of the scheme in a buy and maintain solution, sitting alongside some other equity and bond holdings. We used to hold property, but no longer do so. We also have quite a big LDI portfolio, which hedges our inflation and interest rate exposure. The buy and maintain solution has helped us with the lengthy process of making our cashflow positive. The employer is still very much onside with this. We have a deficit reduction plan in place and are still trying to take upside where we can find it. We like the idea of not being hooked on indices or rating agencies. That made a lot of sense to us. Two years down the line, we are getting exactly what we asked for.

”

14 | LEADING EDGE | OCTOBER 2015

Balancing act:

Paola Binns Senior Fund Manager

How can short duration strategies limit your risk as rates start to rise?

ixed income investors have enjoyed a very favourable environment over the last decade, with minimal inflation and accommodative central banks helping to create a backdrop of gently declining yields. Now, with those days seemingly at an end as we anticipate a move into an interest rate normalisation cycle, newsflow has created some nervousness around fixed income exposure, in particular long-dated positions. Paola Binns and Craig Inches, who manage the Royal London Short Duration Credit and Short Duration Gilt Funds respectively, believe investors can still generate an attractive return by pursuing a short duration strategy. “Clients are getting nervous about bonds, longer duration bonds in particular, and therefore in this environment it is paramount to lock-in a decent yield while building in some protection in terms of duration,” according to Binns.

Interest rates to normalise (very slowly) Binns and Inches believe central banks have been paving the way towards an environment where interest rates start to rise gently, potentially hitting 1% in the UK by the end of 2016. If this materialises, the long end of gilt and credit markets could come under stress. In this environment, the duo believe short duration strategies can mitigate much of the downside risk while still providing an attractive upside in terms of yields. “Our short duration credit fund currently has a yield of around 3.66%, versus RLAM’s Sterling Credit Fund which has a yield of 4.17%. In addition, the short duration strategies have a duration of just 2.5 years, vs an all maturity fund duration of 7.7 years,” Binns said*. “With strong yields available from short duration bonds, and with many bonds now very overvalued, we believe it makes sense to

Craig Inches Senior Fund Manager

focus more on the protection element that short duration strategies can deliver.” The liquidity myth Investors also need to be aware that, in this environment, the notion that some assets can offer far more liquidity than others may be challenged. Investors are increasingly seeing more and more incidents of ‘flash crashes’ in even the most highly-rated assets, and while investors can still sell those assets in times of market stress, the reality is they might have to accept a far lower price on their liquid holdings if they did want to sell them at certain points. Binns and Inches therefore believe over paying for liquidity now makes little sense. “Investors are once again starting to see big swings in yields, making even assets like gilts very volatile, and we expect this to continue,” Inches said.

“As such, if you are not being compensated for this via the yields on offer, it makes sense to cut your duration risk.” Inches added that some areas of the gilt market could, he believes, soon display equity-like risk when it comes to volatility. “The average duration for gilts is now longer, at around 10 years** making them far more sensitive to moves in interest rates,” he said. Investment banks step back Another factor impacting liquidity is the reduction in investment banks from the balance sheet. While they used to smooth volatility by warehousing market risk, changes in the regulatory environment since the financial crisis mean this secondary provider of liquidity is much diminished.

Binns said even the most highly-rated supranationals are coming under pressure when markets experience acute periods of stress. “Even globally-recognised bonds offer little liquidity because banks and others are not there anymore to warehouse risk. This means giving up yield to buy bonds that are perceived to be more liquid is increasingly becoming the wrong strategy,” she said. “With volatility increasing in general, the only real way to minimise your risk is to shorten your duration, and given you do not have to sacrifice too much by way of yield to do so, it increasingly looks like a sensible option for parts of investors’ portfolios.”

ith volatility increasing “W in general, the only real way to minimise your risk is to shorten your duration

”

Click here to watch our short duration bonds video

OCTOBER 2015 | LEADING EDGE | 15

*Source: RLAM as at 31.08.2015. The distribution yield reflects the amounts that maybe expected to be distributed over the next 12 months. Based on M Inc Share Class for both funds. **Source, FE as at 31.08.2015 based on FTSE All Stocks Gilts Index. Where this document references the trade marks “FTSE®”, “FT-SE” and “Footsie”, these are owned by the London Stock Exchange Group companies and are used by FTSE under licence. The FTSE All Share index is calculated by FTSE. FTSE does not sponsor, endorse or promote the product referred to in this document and is not in any way connected to it and does not accept any liability in relation to its issue, operation and trading. All copyright and database rights in the index values and constituent list vest in FTSE. 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. Fund launch subject to regulatory approval. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down.

RLAM at a glance

75 INVESTMENT PROFESSIONALS

Over 30 awards won in the past three years

Funds under management

ÂŁ83.4bn

55 funds Source: as at 30.06.2015

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This document is for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Nor does it provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. 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. Issued by Royal London Asset Management Limited, 55 Gracechurch Street, London, EC3V 0RL Registration Number 141665 which is authorised and regulated by the Financial Conduct Authority.