Rathbone Ethical Bond Fund: a bond’s worst enemy

Economics and politics can have a big impact on bond markets. We discuss with Noelle Cazalis, manager of the Rathbone Ethical Bond Fund, talk of a possible surge in inflation triggered by huge stimulus measures in reaction to the pandemic.

Kyle Caldwell, Collectives Editor at interactive investor:

Hello and welcome to our latest Fund Manager Insider video. Today I have with me Noelle Cazalis from the Rathbone Ethical Bond. Noelle, thank you for your time today.

Noelle Cazalis, manager of the Rathbone Ethical Bond Fund:

Hi, thanks for having me.

Kyle:  

As a bond manager you consider economic and political trends as part of your investment strategy. So I was wondering how much of your time is spent analysing the impact of, say, the potential outcome of the upcoming US general election and what that will have on bond markets?

Noelle: 

Sure. Yes, of course we do consider political trends. I mean, it’s very hard to say, you know, how much time, and especially I think in the bond market there are so many different moving parts.

We look at political trends, we look at economics, we look at central banks’ policy and how they affect the market. We look at supply and demand, then we look at sector dynamics, visual dynamics.

I guess there’s so many things to look at, that is what makes the job interesting, but it’s really difficult to dissociate every single thing. But I would say, over the last couple of years, politics have definitely played a big role in what we do.  

I mean, we’ve seen in the US obviously the Trump election last time around, in the UK, Brexit, which we’re still talking about quite a lot, four years after the vote, and the rise of populism in Europe.

So there’s been really much more dynamics to be aware of in terms of politics, it’s been more and more important I would say over the years. And of course, you know, who is in power in a country is going to really influence their fiscal strategy, how much depth therefore they issue into the bond market, and that’s why it’s really, really important for bond investors to look at it.

Kyle:

Sticking with the macro on, say, a 12-month view, what would you say are the biggest economic and political fears and risks for the bond market?

Noelle:  

I guess right now my biggest concern is around default rates, I think default rates have been pretty low over the last 10 years really, but with the pandemic often many businesses had to really transform themselves.

Some are seeing huge disruption, if you take the transport centre, for example, most companies have seen revenue declining by over 90%. So it’s OK for now, but how long can that go on for, you know, when your company has only 10% of its previous year revenues?

I think for now we have government putting a lot of fiscal stimulus, we have central banks doing quantitative easing, so that’s really supporting the market and supporting companies that need the cash to kind of keep going. But I think over the next 12 months we’re going to start to see default rates picking up, companies running out of cash, effectively, and not being able to service that debt.  

It’s not so much of an issue in investment grade, it’s in the higher quality companies, but I’m really worried about high yield and certain sectors there, where the companies have a lot more debts, so I think defaults are going to rise quicker there.

So yes, I’m really paying a lot of attention on things like liquidity position, how much cash they have in their balance sheet, and effectively how long can they go for in a really stressed scenario where consumers are at home and perhaps spending less than they used to.

Kyle: 

So I wanted to move on to inflation. Firstly, inflation is described as a bond’s worst enemy. For those unfamiliar with why that is, could you explain why that’s the case?

Noelle: 

Yes. So inflation is a big risk for a bond investor, and really it is because it deteriorates the return associated with bonds. So if I take an example, most bonds you pay a fixed coupon, so let’s say I get a 3% coupon every year.

Let’s say inflation now is 2%, so every year I get 3%, which is more than inflation, so the goods that I bought last year I can still buy this, and a little bit more because I get more than inflation, more than the price increase of my goods.

But inflation, if inflation rises, let’s say to 5%, I still get my 3% because the coupon is fixed, and so effectively now I can’t buy the same amount of goods, so effectively my purchasing power is lower just because of that inflation risk. So effectively that’s something that we need to look at, you know, over the long-term, and if inflation rises usually what you see is that central banks hike rates, and that means that bond price decreases, and that’s why, as investors, it is important to us.

Kyle: 

There have been a number of commentators that fear that inflation is going to rise in response to the huge stimulus measure that have been made across the world, but in US, UK, Europe, in response to COVID-19. What’s your view, is the prospect of higher inflation something that concerns you?

Noelle:

It is for sure a risk when you see that much stimulus, you know, being pumped into the different economies. I think for now my view is more that you have still a lot of deflationary forces, and in my view they remain more important right now than the risk of inflation, and there will be things like demographic trends, you know, in the economy that you mentioned, like the population is aging, that’s self-deflationary.

And then we’ve seen saving rates increase, meaning consumers are spending less, and the consumption is still fragile, whereas you see energy prices staying really low with oil price being pretty low. And I don’t really see oil price being increasing sharply over the next couple of years, with the transitioning to a lower carbon economy and things like that. 

So I think these deflationary forces are going to mean that the medium term inflation will remain contained, but perhaps it’s more of a risk I guess of higher inflation in the US, where consumption has been actually much more resilient than it is in the UK or Europe, I think now consumers are back to 97% of their pre-COVID spending level.

So it is something that we look at carefully, and especially in the US, but yes, it’s not my biggest fear or biggest risk that I’m looking at at the moment.

Kyle: 

Finally, in terms of the thematic ideas that the fund currently has, could you run through what the biggest themes are?

Noelle:  

Yes, sure. So perhaps if I start with financials, we continue to see a lot of changes in capital structure, which means that, as a bond holder, we can identify securities that would be called ‘untender’, and effectively what that means for us is that we get nice price appreciation. So we get a nice performance from an asset and that effectively is not going to continue to count as capital for banks.

So we’re seeing a lot of change or regulatory changes there and that’s been a big driver of performance in the last five years, but we expect it to remain a big driver of performance in the next couple of years.

Another theme that we look at is something called Anthropocene, which is a new geological era, where effectively the geology is dominated by human impact, and we look at a lot of different themes in that category.

So things like biodiversity destruction, population growth, and therefore as a second degree a theme, the rise of civil unrest, the fight for resources and things like that.

So we try to avoid companies that negatively affect the consequences of that and focus on the potential beneficiaries, such as renewable energy, such as social housing, you know, as population grows obviously social housing become more and more in demands.  

I mean, in London you have to wait two years I think now to get a social housing flat. That’s the kind of theme that we’re always thinking of.

And perhaps the third one I’d mention is the Green Revolution. I mean, Boris Johnson said the UK wants to be the Saudi Arabia of offshore wind, and we hear more and more comments on the Green Revolution from the EU and other economies as well.

So I think we’re going to see more and more opportunities for us as ethical investors in that space, things like renewable projects, green bonds, etc. etc.

So that’s something we’re looking at quite closely. I would say, over the last five years, we’ve already seen an increase in opportunities, but if you ask me for my view for the next five years I think this market is going to continue to grow exponentially.

Kyle:

Noelle, thank you very much for your time today.

Noelle:

Thank you.

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