Rathbone Ethical Bond manager Bryn Jones sits down with ii’s Sam Benstead to discuss fixed income investing in today’s market.
He speaks about the portfolio’s 5% income yield and how higher interest rates have improved the outlook for bonds. Jones also goes into depth about why the bond market rally at the end of 2023 has not impacted the positive outlook for the asset class.
Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Bryn Jones, manager of the Rathbone Ethical Bond Fund. Bryn, thank you very much for coming in.
Bryn Jones, manager of the Rathbone Ethical Bond Fund: Hi. How are you doing?
Sam Benstead: Very well, thank you. So, what is the appeal of investing in bonds today? And how has the investment case changed over the past year, and also five to 10-year investment period?
Bryn Jones: If we go back to 2020, you were looking at very low yields. And everyone talked about the TINA trade – there is no alternative. So, people were buying equities yielding 4% or 5%. Bonds were yielding close to 1%. And it kind of made sense for investors to invest in equities because over 10 years, you know compound 4%, you were going to get well over 50% return. Whereas the bonds are only going to give you about 10% returns. So suddenly equities you could invest in. They could actually fall in value and you'd still been better off in the equity markets over bonds.
So, investing in sort of 2020-21 suddenly became quite risky. But we've had a huge rise in yields. We saw big interest rate policy changes, in fact, the highest rise in interest rates since two years after the US independence, if you go back and look at proxies. And that meant we are now at a level where you've got starting yields that are yielding more than equities. And so suddenly investors can invest in bonds. For example, if you invest in a bond that yields you 7% over 10 years, and compound that return, it's a 100% return.
And so there's the first thing: the yields are more attractive, they yielded more than equities and for a more defensive asset class, that kind of makes sense for investors to have, but also as an insurance policy now.
When bonds were only yielding 1%, you weren't really getting paid to have an insurance policy against your risky assets. Now, you can invest in a portfolio of investment grade or government bonds, or even [those] a little bit higher yielding, and you've got an insurance policy against the other risk you're taking in your portfolio.
So, right now bond investors are finding them more attractive and normal investors, [defined] as investors who are outside the institutional space, are investing in fixed income because of those reasons.
Sam Benstead: What is your investment universe and what type of yields are you getting at the moment, and how much does the portfolio yield overall?
Bryn Jones: In the ethical bond fund, which is our flagship fund, we have a duration of about 5.5 years. And the yield is around 6%, give or take 10, 20 basis points, depending on what's happening on the day and on the underlying gilt market. So, you're getting a reasonably attractive yield with a fairly low-duration risk. And of course, in terms of the assets we're investing in, in the ethical bond fund, predominantly they're investment grade assets. So, they are the higher-quality, more defensive part of the corporate investment universe. Suddenly you're getting an asset which is yielding very attractive levels with, hopefully, levels of volatility that are lower than equities and lower than high yield.
Sam Benstead: And that 6% is the yield to maturity?
Bryn Jones: Correct.
Sam Benstead: The distribution yield is about 5%. Investors looking for income are getting around 5% at the moment if they own the fund. Is that correct?
Bryn Jones: Correct. Yes. So the fund yields around 5%, which means that there is some capital appreciation tied into the bonds. So, the bonds in general are trading below par, so below 100, which means you will get some capital appreciation as well. The other thing it is important to say about the ethical bond fund is that we take our fees from capital [and] not [from] income, whereas a lot of funds out there will take their fees from income. So, if you're in on a SIPP or an ISA, you're getting a very good 5% yield on the fund.
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Sam Benstead: There was a big bond market rally in the final two months of 2023. What's the outlook for bonds now, and has a lot of the good news around interest rates and inflation already been priced into asset prices?
Bryn Jones: You're dead right. At the end of last year, going into the end of October, the fund was up two and a bit per cent. The final two months added over 7.5% returns, so the funds had a double-digit return last year, so over a 10% return. That was driven by expectations of policy changing from the Federal Reserve and expectations that inflation was going to fall quite aggressively, which led to the huge rally in rates markets, but also pulled with it credit markets that were very confident we were going towards some kind of soft landing.
Some of that repriced at the start of this year, and we're about halfway back up from where we fell in terms of both yield and spread. Now there is, again, a little bit more value. We did think going into December and looking at technicals, you know, pricing and six rate cuts in the earliest rate cut, you know, right forward to March was a bit aggressive. And some of that's repriced now.
For example, in the UK we're only just looking over about 4.5 rate cuts for this year being priced into the market after December, where there were more than six being priced in. So, some of the good news is priced in, but we think we're getting back to fairer levels.
Sam Benstead: Investors have been calling the return of bonds for more than a year now. I remember at the start of last year, bonds was the most-popular trade. It didn't quite work out that well. And as we start this year, there is a consensus that bonds will be a good investment in 2024. So, why were markets wrong last year and why are you right to invest in bonds this year?
Bryn Jones: Well, I would argue that perhaps that's not wrong. I mean, for most of the year last year, it was wrong to take that view about fixed income. But the returns were 10% last year. So, in a microcosm of fixed income, that's not bad. And while they may have underperformed the top seven large-cap US equities, they were still very good investments at the end of the day. So, I kind of disagree with a 10% return from your insurance policy is actually quite attractive.
The danger is that this year could be quite volatile. I don't think we will have a straight path. And again, we might go through periods where we see spreads widen and yields rise, which will have a negative impact on the underlying price. But ultimately, if you're getting a 6% yield, you're getting a lot of carry protection.
So even if yields rise, you know government bond yields rise 25 basis points, and spreads widen 25 basis points. You know you haven't crystallised losses but your mark to market might be off 4 or 5%, but you're still generating a 6% return. So, your actual return for the year in nominal terms is positive.
And this is the beauty about fixed income right now; because you have so much yield, you have so much carry, and you're getting that protection. You're getting a protection of 6% every single year. And if you get some volatility, you're getting protected by that income. And that's why I've invested in my own funds for that reason.
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Sam Benstead: And what could cause bond prices to fall this year? What are you worried about?
Bryn Jones: Every time we get the economy slowing and things are getting a bit weaker and inflation is falling, that's been very good news for bond investors. You know, government bond yields fall and credit spreads tighten. Central banks are on hold and they are going to start cutting rates, which is great for economies. The real danger is though when bad news becomes bad news. When central banks are having to cut rates because the economy is doing so badly. And I guess that's the biggest fear as a corporate bond investor. We can manage yields rising a bit, we can manage a soft landing. That's all kind of easy to do as a fund manager.
You know what's really worrying for a corporate bond fund manager is a hard landing. How hard is that landing? How quick does it come? If we remember the Great Financial Crisis and the 2011 Greek debt crisis when economies grind to a halt and bank lending shrinks, and economies start to slow quite rapidly. Unemployment picks up, and businesses start to default. And it's that default cycle that really impacts corporate bond fund managers.
We can be a little bit sanguine about earnings. Equity investors, earnings events can hit equity share prices. We get an earnings event in the bond market, it marginally affects the price. It's capital events that really affect us. So, my biggest fear for this year would be a real sort of nasty, quick, hard landing. I'm not saying that that's a probability, but that's the thing that we need to be conscious of.
Sam Benstead: Investment grade bonds are normally a sleepy, safe part of the fixed income universe, but this hasn't been the case over the past couple of years as rates have changed so dramatically. So, is there going to be more volatility to come?
Bryn Jones: I think we're through the kind of impact on the price from the rates market. Will rates go up more aggressively from here? I doubt it. They might go up a little bit if we get inflation wrong. It's that credit component that we have to be conscious of. So, for example, if we do enter a kind of nasty slowdown, you want to be in your defensive, higher-quality parts of capital structures. You don't want to be in deeply subordinated or high-yield companies where they're looking to refinance, and because the economies are slowing, their earnings have collapsed and their spread, which is the extra risk that you need to compensate for taking those bonds, has widened quite aggressively because these companies will be looking to refinance at levels that just doesn't make economic sense. And then they'll enter chapter 11 or default, or restructuring and as a bond investor, that's the dangerous area.
So, I think we are through the rates part, we just need to be very conscious, as I said, of credit risk. And I guess the difference between 10 years ago and now is that you had much less gearing in companies. They tended to, whether you agreed or not with the rating agencies, have a higher credit rating. And now there perhaps is more subordination and some more triple B issuances.
Businesses have geared to try and increase their ability to generate excess return on equity. So, they will gear a business to push up their return on equity. And we've seen a bit more of that kind of financial engineering in the last 10 years. So, while investment grade historically has been very defensive, arguably some areas of it can be quite volatile.
Sam Benstead: Bryn, thanks very much for coming in.
Bryn Jones: Thank you.
Sam Benstead: And that's all we've got time for today. You can check out more Insider Interviews on our YouTube channel where you can like, comment and subscribe. See you next time.
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