How Tideway's active management adds value in £-credit markets

Tuesday 19 February 2019

We are often asked by clients about the types of bonds we choose to invest in; what attracts us to certain bonds over others? Also, why do we believe actively-managed bond funds will deliver positive, long-term returns. This is especially true in uncertain market conditions when lower cost, passive, investment options are also available.

Our Chief Investment Officer, Peter Doherty, gives his thoughts on the matter:

Passive aggressive

Passive investing delivers a generic market return at a competitive price. For money managers in an ultra-competitive, liquid market such as the S&P 500 Index and its constituents, keeping fees very low matters a lot. This has resulted in active managers finding it difficult to beat the index, net of fees, over the past decade, with passive investment strategies becoming more popular.

Furthermore, if investors believe that US equity markets will deliver, say “Inflation + 4-6 p.a. over the long term”, then it is easy to see the attraction of a passive, buy and hold low cost strategy because the market itself does the heavy lifting of delivering returns.

Right idea, wrong market

The above has got nothing to do with investing in £ fixed income credit markets. Instead, UK headline numbers for inflation, interest rates and available returns in fixed income markets do not paint a rosy picture for passive or generic index strategies.

UK Base Rates are 0.75% and UK Consumer Price Inflation is currently 1.8%, having averaged 2.28% over the past decade. Furthermore, the yield on two commonly used passive alternatives for the UK Fixed Interest sector are at similar levels: the SLXX i-Shares GBP Corporate Bonds ETF is 2.65 % and IS15 i-Shares 0-5 Year Corporate Bond ETF is 2.06%.

From the combination above, we can deduce that generic £-credit investment returns might just about match inflation before fees. Once fees are considered, the potential for a real loss on these investments will increase. Investors and their advisers, such as investment consultants, should align their implementation strategy with the actual underlying market dynamics instead of applying the “passive is best” mindset to all markets.

What does active actually mean

At Tideway, the “active” bit of “active management” does not mean trading. Active means:

“Finding the most attractive risk-reward security in a company’s balance sheet through bottom-up research”. That research includes:

  • Fundamental balance sheet analysis: Can we invest in any security of the company?
  • Reading a bond prospectus to understand the rights of the issuer in relation to capital and interest repayments.
  • Understanding the implications of any changes to regulatory capital rules for bank and insurance company capital instruments.
  • Assessing likely future total returns from a specific bond over a given time horizon.

How it works in practice - Lloyds Bank £ 13% Tier 1 Perpetual – ISIN XS0408620721

To demonstrate how we put our active management into practice and deliver returns in excess of passive investments, we have recently purchased the above Lloyd’s bank bonds paying a coupon of 13%, which can currently be found in both the Tideway GBP Credit Fund and Tideway Real Return Fund:

  • The bonds are subject to early redemption clauses, in case the bonds get disqualified from regulatory capital.
  • Under CRD IV / CRR all these bonds are subject to grandfathering for regulatory capital purposes, but according to the banks' "Pillar 3" reporting becomes ineligible for regulatory capital purposes at the end of the grandfathering period, which runs out at the end of 2021.
  • So, the "regulatory call" options are available to the banks from the beginning of 2022.
  • Considering the high coupon, if the bonds are viewed purely as funding instruments for the banks, we think the issuers have a compelling incentive to redeem the bonds. The incentive is not only driven by the coupons but also their respective make whole clauses, which reflect the cost of the instrument for the issuer from the regulatory call date onwards to their respective regulatory first call date.
  • Make whole price is calculated by discounting the remaining cash flows until the regular first call date by the benchmark Gilt + 500bps premium, meaning that Lloyds could reduce its interest expenses by that amount on a run-rate basis if it exercised the regulatory call in early 2022.

An added twist to the bond is that on top of the 13% coupon, it also it has 2 deferred coupons attached to it, totalling, 26%, which are payable on redemption.

Expected Return

Cash out = £1,698,977.90 per £1 million nominal including accrued interest*
Cash in - 22nd January 2022 (Coupon date)

  • Interest Feb 2019 to Jan 2022 = £381,022.10
  • Deferred coupons = £260,000

*current rate – Bloomberg, 13 February 2019

  • Make-whole price
7 Year Gilt Yield in 2022 Make Whole Yield Make Whole Price Proceeds per £1million
0.92%* 5.92% 139.78 £1,397,800
2.00% 7.00% 132 £1,320,000
3.00% 8.00% 126 £1,260,000

*current rate – Bloomberg, 13 February 2019

  • If 7-year gilt rates do not move between now and Jan 2022, total proceeds, ignoring coupon reinvestment are forecast at
    £1,397,800 + £381,022.10 + £260,000 = £2,038,822.10
    Estimated Total Return = £2,038,822.10/£1,698,977.90 = 20.00%
  • If 7-year gilt rates are at 3% in Jan 2022, the same calculation could give a total return of 11.89%
  • To make zero return to Jan 2022, the Make Whole Price would have to be approximately 104.90, implying a 7-year gilt Yield of about 11%!

A conservative expectation of total return over three years is the 11.89% number. It is also plausible that the total return is higher. But the most important point is that the downside is managed in relation to the interest rate sensitivity. Finally, of course, if Lloyds do not call the bond for whatever reason, the ongoing accrual rate is 13% p.a.

Conclusion

By investing in passive solutions investors risk negative or flat real returns. In contrast, there are genuine opportunities to capture material excess returns in £ credit markets through active management, using a healthy combination of research effort, experience and access to the market.

IMPORTANT INFORMATION

This document is for information and discussion purposes only and should not be construed as personal advice to invest in the Tideway UCITS Funds ICAV nor any of the securities mentioned in this document.

Forward-looking statements are based on assumptions. Since all assumptions, predictions and statements simply reflect the current view of future events, they are subject to inherent risks and uncertainties. Thus, they should not be seen as guarantees or promises regarding future performance.

Past performance is no guarantee of future returns and the value of investments and the income they produce can fall as well as rise.

Investors should make their own investment decisions based upon their own financial objectives and financial resources and, if in any doubt, should seek advice from an investment advisor.

Always read the prospectus, factsheets and KIIDs before investing in any fund.

Investing in Tideway UCITS Funds ICAV involves the risk of loss and there is no guarantee that all or any capital invested will be repaid.

Tideway Investment Partners LLP is authorised and regulated by the Financial Conduct Authority (FRN: 496214). Tideway GBP Hybrid Capital Fund and Tideway GBP Credit Fund are sub funds of Tideway UCITS Funds ICAV. This ICAV is authorised and regulated by the Central Bank of Ireland. This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution would be unlawful under the securities laws of such jurisdiction. The funds are registered for distribution in the UK and Ireland.

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Tideway Investment Group comprises the following entities: Tideway Investment Partners LLP; Tideway Wealth Management Limited and Tideway Asset Management Limited. Tideway Asset Management Limited and Tideway Wealth Management Limited are appointed representatives of Tideway Investment Partners LLP, which is authorised and regulated by the Financial Conduct Authority. FCA number: 496214.

Tideway Wealth Management Ltd
107 Leadenhall Street
London EC3A 4AF

+44 (0)20 3143 6100
info@tidewayinvestment.co.uk

© Tideway Investment Group 2019

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