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Opportunity Amid The Outflows

16 August 2018 by Chris Bowie

Typically in August, credit liquidity becomes a bit like my lawn this summer: patchy. Over the past few weeks there have been a few stories of large fund groups seeing significant outflows from the asset class, and even of liquidations, which begs the question: what are they selling?

They are selling what they can easily raise capital from, namely government bonds and short dated investment grade (IG) credit. Typically these short dated IG bonds exhibit higher levels of liquidity than other parts of the credit curve right through the economic cycle, and funds seeing outflows right now look to be hitting the bid from their short dated exposures because of that ability to raise capital easily in tougher times.  These assets have the additional benefit that a portfolio manager can sell them very close to his or her accounting mark, such that the outflow pressure does not swing the NAV unduly.  From that perspective, liquidating these assets makes sense.

However, we think some of these short dated IG bonds are the wrong assets to sell, precisely because we believe they are some of the best anchor assets to have in a portfolio given current conditions. With debate moving towards the ‘end of the cycle’ in the US, long end rates risk, political instability in DM and EM markets and the prospect of further rate hikes in the US, these short dated, good returning assets may be the best chance of achieving those returns with low volatility over the next 12 months.

The funds that have been selling these bonds have cheapened them to the point where there is now fantastic value in parts of the market, with some bonds that mature in less than a year offering a 3% yield.

Two good examples are the Barclays 14% Tier 1s and Nationwide’s 6.875% AT1s, bonds which are often very tightly held.  In the case of the Barclays bond, this is a legacy Tier 1 bond issued in 2008 at the height of the crisis, hence the high coupon of 14%.  That coupon should give bondholders confidence the bond will be called at its first call date of June 19, 2019, less than a year from now.  If Barclays doesn’t call the bond, it switches to three-month LIBOR plus a premium of 13.4%.  Thirteen point four percent!  That huge floating rate coupon is what gives bondholders protection against call risk, and yet today the bond yields nearly 3%, for just 10 months of risk.

Similarly, and further down the capital structure, though in a lower risk bank with far higher capital levels, the Nationwide 6.875% AT1 (CoCo) also looks attractive and is callable the day after the Barclays bond.  Although the reversionary rate is less than half the earlier example, it still switches to 5yr Swaps plus 4.88%, a generous level of call protection from today’s yield levels.  Investors concerned about the general risks of CoCos can console themselves in this case with the knowledge that Nationwide has Core Tier 1 capital of 30.5%, in excess of double the level of most other banks, and it mostly does residential mortgage lending.  That is a huge buffer of protection against a capital loss or write down on this bond for bondholders.  And the bond is yielding more than 3%, and is likely to mature before next years’ summer holiday.

In both cases, we see these bonds as low risk investments, due to the high levels of capital held by the issuing banks, high reversionary rates, short dated nature and lack of exposure to Turkey.  Their GBP yields of around 3% are more than 4.75% in US dollar terms, and 1.70% in Euros (adjusted for the 1Y Forward FX hedge) – fantastic value in a global context.

When other investors are forced sellers of credit for reasons that have nothing to do with the fundamentals of those individual bonds, and provided you keep the risks low and the maturities short, taking the other side of that trade can be a very attractive proposition.

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