Interactive Investor

How and why I invest in the gilt market

David Coombs, head of multi-asset at Rathbone, discusses where he is finding the biggest opportunities.

7th December 2023 17:04

Sam Benstead from interactive investor

David Coombs, who is head of multi-asset at Rathbone, sits down with ii's Sam Benstead to discuss where he is finding the biggest opportunities.

One area that has caught his eye is the bond market. He says that rising yields mean that the income is now attractive and, in addition, in 2024 bonds could resume their role as behaving as defensive investments.  

He tells Sam why he likes gilts and which types of gilts he is buying. 

Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is David Coombs, head of multi-asset investing at Rathbone Funds. David, thank you very much for coming into the studio.

David Coombs, head of multi-asset investing at Rathbone Funds: Thanks for having me.

Sam Benstead: So, multi-asset investing, you can invest anywhere effectively. Where are you finding opportunities in the stock market?

David Coombs: Well, it's very different to what it was even three years ago. I launched these funds in 2009 and for the first 10 years, to be honest, it was mostly equities, cash and a few alternatives, and I was struggling to even kind of claim to be multi-asset. And, of course, that's because of zero interest rates. So, now I'm finding value in long-dated government bonds, which is not something I've been used to talking about for quite a long time.

In the US, we've got some positive real yields, that's yields above inflation. In the UK government bond market, we don't have that yet, but nevertheless, my core view is that interest rates will trend down over the next year or so in the UK. And if I can lock in, say, 5% returns in 30-year government bonds, then that looks really attractive to me.

It's not as exciting as discovering the next big internet player, I get that. But actually, for me, the potential upside from here, and even more importantly, if we go into a recession in the UK, which I think is probably more likely than elsewhere in the world, then those government bonds will perform very well because what we might see is not just interest rates trending down, but sort of gapping down or coming down really quick because, in my view, the Bank of England has raised rates far too far already, and they may have to adjust quite quickly, but we'll wait and see.

But, there is a significant risk right now of recession, and building up some diversification against that through government bonds just feels the smartest move right now.

Sam Benstead: We've seen a lot of investors on our platform also buy bonds, but they're generally buying shorter-dated gilts.

David Coombs: Yes.

Sam Benstead: And you said you're buying longer bonds?

David Coombs: Yes.

Sam Benstead: So, talk to me about the appeal of long bonds over short bonds, particular when the yields are quite similar at the moment.

David Coombs: So, I get 5% interest on my cash in the fund, so there's no point in me buying short-dated gilts or government bonds because I'm already getting that cash anyway because I'm going to institutional cash rates. So, if I wasn't getting that, then I would also be buying short-dated government just as they are, because clearly it makes a lot of sense.

I was at a meeting yesterday with Charles Schwab, a big wealth manager in the US, and they're [seeing] the same trend in the States with US investors buying short-dated US Treasury bills. So, this is quite a global phenomenon, not just in the UK, interestingly. But for me, I'm trying to look ahead and my funds are a five to 10-year time horizon. If interest rates are down at, say, I don't know, 3%, say, by mid-2025 or even lower, which they could be, but I've locked in at 5% for longer, that's got to be a very attractive investment that people want to buy from me.

So, what I'm trying to do is just lock those short-term rates in for longer. Now, long-dated government bonds are very volatile investments. And I'm not recommending the average person goes out and buys them because they are hugely volatile, and they've been very volatile this year. Within a well-diversified portfolio, it makes sense. I'm not here to give advice, obviously, but I think for my own account, if you like, at home, clearly if I'm getting a very low interest rate from the bank, then why not buy government bonds at 4.5%, 5%, 5.25%? It kind of makes sense.

Sam Benstead: The correlations between stocks and bonds broke down a bit last year. They both fell at the same time, whereas you'd expect bonds to rise and stocks to fall, so you create this diversification in the classic 60/40 portfolio. Is that diversification benefit back now for bonds?

David Coombs: Well, we don't know. Of course, when people talk about those correlations, it's classic textbook. It's something I learned 40 years ago, and what I've also learned since then, is that a lot of the time it doesn't work. And that's the point. What tends to happen is everyone looks at these very long-term relationships, say, oh, bonds and equities are uncorrelated, therefore we can rely on that. Well, the reality is you can't. And that's why a lot of passive multi-asset funds struggled in 2022, because they had lots of bonds because they were seen as low correlation and they weren't to your point. And both fell a long way.

I think that's the advantage we have as an active manager because we had nothing in bonds, because we recognise that that correlation breaks down significantly, particularly in a rising interest rate environment, which is what we've seen. And let's not forget, in the US, in particular, it is the fastest rate of increase of interest rates ever and the steepest, biggest increase as well. So, the quickest and steepest. We've never seen that before. So, all the models that people look at to try and analyse what's going to happen broke because we've never seen it. And these kind of one in 100-year events seem to happen every year, do you know what I mean? Just different ones.

I think from here going forwards, as I mentioned just now, if we do go into recession, you see companies’ earnings fall because consumers have less money to spend. So, we might see, particularly with those kinds of companies that we call cyclical, so ones linked to the economic cycle, that if we go into recession, their earnings fall, their revenue sales fall, their profits fall, and their share prices then fall.

If then interest rates fall, you would expect bond prices to rise and then you get that negative correlation with bonds rising and equities falling. And that's kind of where I think we're going. Hence, going back to my first question: why is that one of the best asset classes to buy right now?

I'm buying diversification and being paid 5% while I wait for it to work. Go back five years, you were earning about 0.5% from 30-year bonds. It wasn't a great diversification tool, as we found out. Also, you weren't being paid to wait. Now you are, so it's a completely different set of circumstances.

Sam Benstead: You like bonds. You also like equities. I think about 60% of your growth portfolio is invested in the stock market.

David Coombs: Yes.

Sam Benstead: Where are you finding opportunities in the stock market?

David Coombs: It's not easy, I'll be frank. We're long-term investors. We invest in businesses, not short-term share price movements. So, the difference of a multi-asset manager buying equities is that we try to buy long-term businesses with very strong balance sheets. What does that mean? It means and it sounds like common sense, but high returns on capitals, typically double digit. We're looking for companies with low levels of debt. That might seem obvious.

Now, given that obviously borrowing costs are rising, companies that can invest from cash rather than borrowing obviously have a massive advantage when interest rates are rising. Think back to 2009 to 2020 when everyone had access to capital is pretty much the same rate. Well, you're seeing a huge dispersion now. So, we want [to] own equities that don't have huge amounts of debt. We want to own companies where there's some visibility of growth, hopefully less cyclicality that we talked to earlier. So, more resilient going through an economic cycle. What we really think about is where are the customers?

Because ultimately businesses are reliant on customers. And I know that kind of gets lost sometimes when we talk about investing, but ultimately to us, that's what's really important. And then you look at in which economies do we think there's more resilience, where the consumer has more spending power? And in our view, that's the US. And I know the pushback. You may not do it, but I'll do it for you. Yes, the US market is expensive. Well, we can talk about that. But, ultimately, I would argue that it isn't.

More importantly, the US consumer is in a much better place than the European consumer or the Chinese consumer. Second, you've got the US government providing stimulus via Joe Biden's administration, whether it's through the Inflation Reduction Act or tax breaks on investing in renewables, for example. Contrast that to the UK where we're raising taxes and we've got a much less-diversified economy. So, we would rather invest in companies that are exposed to the US economy and parts of Asia, and that tends to lead us to companies that are listed in the States. When I think about resilient businesses, these aren't exciting. These are Coca-Cola HBC AG (LSE:CCH), Alphabet Inc Class A (NASDAQ:GOOGL), Amazon.com Inc (NASDAQ:AMZN), Microsoft Corp (NASDAQ:MSFT). I mean, the big behemoths is where I want to hide, really, in equities [in] the next couple of years. I just think they're more defensive.

Sam Benstead: These giant American technology shares, the Magnificent Seven, some have called them. You mentioned a few of them. Could you give me one of these companies that you like and one that you dislike?

David Coombs: Well, we own five of them, thank goodness. I guess I like Microsoft because it feels to me more like a utility. We own Adobe Inc (NASDAQ:ADBE) as well, which is not one of the Magnificent Seven, but we like businesses that have become, almost, you can't do without them. You know, when people think about technology, you think about exciting things. But Microsoft, most businesses would not be able to operate without paying their Microsoft subscriptions. It's one of the last things they cut.

Now, OK, if some of their customers go into bankruptcy, every business has some cyclicality to it. But with Microsoft, in most cases, their applications, their services are embedded in their customers’ everyday lives. And it's not exciting necessarily, it's not the next big thing, but from a portfolio construction point of view and for multi-asset funds, we're looking at people's pension money, really their core savings. It just feels like an integral part of the portfolio.

Now contrast that to Tesla Inc (NASDAQ:TSLA) or Meta Platforms Inc Class A (NASDAQ:META), which I don't like, either of them. Let's pick Tesla for it’s a great example. I got a lot of pushback on Tesla. People are very passionate about it. It’s like Marmite. People really love this company. I really don’t and I don’t like Marmite either, for what it’s worth.

But why don’t we own Tesla? The first thing is governance. Discipline around capital allocation. It’s boring, but a CEO, and Meta is a bit similar, who suddenly, on a whim, will switch all the capital allocation on to the latest big thing, that's quite risky and it's hard as a shareholder to keep control of that. Second, my view on Tesla has always been, ultimately, that it makes cars. It's not really a tech company, in my view. And there's a lot of other companies that make cars and some of them make them better than Tesla do. So, the competition is coming and I think it's post super-growth, personally, and it's therefore just too risky for me to buy.

Sam Benstead: You're not a fan of the UK?

David Coombs: No.

Sam Benstead: But are there some UK companies that make the grade?

David Coombs: Yes. So, two of the UK companies we do own are Ashtead Group (LSE:AHT) and Ferguson (LSE:FERG). Ashtead, which is involved in the construction industry, big truck rentals, big crane rentals, that kind of stuff. And in Ferguson, which is the old Wolseley Company in the UK, it's kind of business-to-business selling, all kinds of plumbing, taps, pipes, again, not the most exciting business in the world. Both are listed in the UK, and Ferguson is just moving to the US.

But, between both of them, around 85% to 95% of their revenues, i.e. their customers, are in the US. So, great examples of UK-listed companies, but really US businesses. And that talks to my point. I don't care where a company is listed, I don't get into this whole kind of passionate discussion of the UK versus Europe versus the US in terms of what stock exchange am I investing in or what location. To me, the listing is irrelevant. Where a company is listed is not important. Where's the business? And US construction is doing incredibly well, partly due to the infrastructure spending that's going on in the States right now. So, it's a great example of looking beyond feeling kind of insular about supporting your own stock market, or having that home bias the UK. I don't think that makes sense anymore. But we do have some other businesses. London Stock Exchange Group (LSE:LSEG) is a great business, an international business. We do still have some really good international businesses in the UK that I'm happy to invest in.

Sam Benstead: And are they cheaper than international peers just because they're listed in the UK, or are you not finding that?

David Coombs: I don't find that as much as people say, to be honest. I mean, I hear this all the time. We do own Smith & Nephew (LSE:SN.), for example. It is much cheaper than US equivalents, Stryker Corp (NYSE:SYK) being the most obvious one that we don't hold, unfortunately, and it has performed much better than Smith & Nephew. So, I wish I had bought Stryker, but Stryker was much more expensive. It's a great example, again, of where valuation is a very poor determinant about stock selection. You know, you'll have been wrong for the last five years picking Smith & Nephew over Stryker. So, why do we own it now?

Because there’s been a significant change of management about 12 months ago at Smith & Nephew, and they're starting to turn the company around. That's quite interesting. So, Smith & Nephew right now is much cheaper than its US counterparts and is a catalyst for maybe improvement. So, you've got to look at the underlying, don't just look at the valuation, and I'm not being funny in most places.

You look at the tech sector in the UK versus the US. Well, good luck finding a tech company to start with. But you know, there is no Apple Inc (NASDAQ:AAPL) equivalent in the UK. There is no Microsoft equivalent in the UK. So, how would you compare valuations? It doesn't make any sense. So, I don't find these big discounts that everyone talks about.

If you look at something like a Tesco (LSE:TSCO) versus a Costco Wholesale Corp (NASDAQ:COST). Well, often there's very good reasons why there's a discount on a business-to-business comparison. And you've just got to wipe out the geographic piece and take that lens away, and look and compare the two businesses. Is Coca-Cola more expensive than Fevertree Drinks (LSE:FEVR)? Yes, but, there's a pretty good reason [why].

Sam Benstead: David, it's been great talking to you. Thanks for coming in.

David Coombs: Thanks for having me.

Sam Benstead: And that's all we've got time for. 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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