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Checking Fundamentals, 23/07/2021

July 23, 2021 – Written by James Baxter

The economic or macro picture is quite confusing at present with many indicators getting distorted by the post pandemic situation which continues to unfold. When this happens, it is always good to check in on the fundamentals.  How are the underlying investments looking and what is their outlook?

High Yield Bonds

As you will know we are not invested in UK gilts or US treasuries but exclusively in corporate bonds within the fixed income sector, and in particular we focus on high yield bonds with an emphasis on loans to financial companies – banks and insurance companies.  I checked in this morning with Peter Doherty at Sanlam who described one bond in particular and the outlook generally.

One of his top holdings is a loan to AVIVA with a coupon of 8.875% which gives you an indication of where rates were when the bond was issued. It trades today at a price of approximately £1.60 or 60% above its issue price so investors are now seeing a ‘running yield’ (the coupon as a percentage of the current price) of 5.5% p.a.  Peter highlighted the regulatory changes coming to UK insurers which will ultimately mean this bond, which currently counts as regulatory capital, won’t in the future and, whilst the bond is perpetual, Peter expects it to be bought back by AVIVA in early 2026 at a premium to the current price. 

These regulatory changes are a feature generally across banks and insurance companies that Peter and his team are adept at exploiting, giving investors more than a 5% premium above equivalent gilts or cash deposit rates with opportunity to make further gains from active management.  Given the peak of inflation expectations were around 3% and those are already falling again, we see this as a great return.

Peter also confirmed how risks of lending to banks had lowered from the 2008/9 financial crisis with regulators doing a much better of job and forcing banks to hold more capital. Peter quoted 2 to 7 times more capital in bank balance sheets today than pre-crisis.

Equities

I’m no equity analyst, leaving that to our professional fund managers, but I do like reading earnings releases and seeing how businesses are getting on. Q2 earnings reporting season is well underway with more big names still to report. Some will surprise on the upside, some will disappoint.  Here are the results of three big US companies I was reading this morning.  The US is the biggest market we invest in and these are some of the largest companies on the planet in these sectors.

I have highlighted the year on year growth of earnings per share, the share price as a multiple of the Q2 annualised earnings per share (EPS) and key message to shareholders:

As I say, I’m no analyst and please do not read this table as a reason to rush out and buy these shares. What I do see though is two very reasonably valued businesses, one highly valued business which has been growing significantly and three companies who all expect to make more money looking forwards.

The bank results in particular chimed with Peter Doherty’s view of strengthening balance sheets and lower than expected impairments, which he saw reading across to UK banks like Barclays and Lloyds. In short, the basis for remaining fully invested in our bond and equity funds looks pretty sound to us.

Investment Insight, 23/07/2021

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