Noelle Cazalis, manager of the Rathbone Ethical Bond Fund, explains what bonds are, why they’re important, favourite sectors and the sin stocks the fund won’t buy.
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.
Right, Noelle, to start off with, many investors either don’t understand bonds or, to be blunt, just aren’t interested in them. For those people, could you explain very simply what bonds are and why they are important?
Sure. So a bond is a debt security issued from a borrower, that could be a government or a company, and sold to an investor. Usually we get a stated rate of interest rate that we get called a coupon and a final maturity; it could be two years to maturity, it could be 30 years.
And effectively, as a bond holder, we have no ownership rights, we’re not equity holder, we don’t vote on company, but we rank above them. So if there is a problem in the company we get our money first, and so effectively it is less risky than investing in equity. And in terms of why they’re important, I guess there are a couple of things.
The first one is, it is a known income stream, we know how much money we’re going to get every year, and we know the final value of the investment as well. So it tends to be quite attractive for more conservative investors or investors that would need income, be it for retirement or to pay school fees and things like that.
So moving on to the Rathbone Ethical Bond Fund, could you explain why the fund mainly invests in investment grade bonds, what the term ‘investment grade bond’ means for those that are not familiar with the term?
Sure. The Rathbone Ethical Bond Fund is a corporate bond fund, which means we invest in corporate debt, not government debt, so that’s the main differentiation versus a government debt fund. And we focus on the highest quality corporates, which are called ‘the investment grade companies’, and investment grade could really be opposed to high yield, or ‘junks’, which would tend to be more leveraged companies, so therefore your risk is higher, rather than, I would say, in our fund there is really a high focus on quality.
So by quality we mean strong cash flows, companies that can service their debts, and therefore we’re not at risk of them not being able to pay our annual interest.
And in terms of the composition of the fund, could you run through what sectors the fund is currently favouring and whether the sort of sector weightings have changed a lot or have not changed this year, given the acceleration of the COVID-19 pandemic?
So the Ethnical Bond Fund has quite a lot of sectors that are excluded because of this ethical overlay that we have in the fund. For example, we have no exposure to oil and gas, car manufacturers, armaments, etc. But within our investment universe there are a couple of themes that we favour and sectors as a result, and the first one are banks and insurance.
Looking back since 2008 this is a sector that has really changed. If you look at ’08, it was very much the crisis was driven by problems within the banking sector.
Right now it feels that banks have been more part of the solution, and the reason for that is because regulators have really forced the banks and the insurers to hold more capital, and by doing that effectively it protects bond holders better, so these investments have become over the years less and less risky. Basically, there’s a lot of change in the sectors, regulatory change, which means that we find a lot of opportunities for outperformance and really good alpha generation there.
So we like financials, so you’d see in our fund that we have more financials than we have corporates, and really the biggest weight would be to insurers, you know, we feel under ethnical mandates as well they really screen well. In terms of other trends, I think COVID-19 has really accelerated some of the themes that we were already looking at, such as the rise of online shopping, that’s just accelerated significantly.
So we look at avoiding kind of traditional retailers and moving more into, for example, distribution centres, where the demands for these kinds of assets has been significant.
We also look at more renewables, with the energy transition that we are seeing, so we’re looking at renewable sectors, such as solar and wind.
Another theme that has been really interesting this year actually has been the rise of social bonds. For many years we talked about green bonds, but now we’ve seen social bonds really taking off. I think the market is at 75% in terms of volume this year, and this is really bonds that would be issued to fight the health and economic consequences of this crisis of the pandemic.
So we have been investing in quite a few of them, one of them being issued by the African Development Bank, where effectively they find a social project there to help African economies and populations to fight with the consequences of COVID. And the market has been really quick actually to put forward these types of instruments, showing that the capital market can really help in these difficult times.
So the fund has outperformed the average return of funds in the peer group over the long-term, and has a current yield of around 3.6%. Can you give us a flavour there of the sort of sectors that you favour in the fund, but in terms of when you are looking for the best bonds to invest what are the main attributes that you look for?
Sure. We look at sector, but then within sector you have so many different companies, so we really need to do our credit work right and make sure we pick the right ones, the ones that are going to be successful in the long run.
So I would say, first of all, we’re active investors, we’re not passive or quasi-passive, which means we only buy something if we have conviction in it, we’re not forced to buy something because it is in an index or a benchmark, so that means that our fund really has a lot of conviction behind it.
Now, for example, as I say, we don’t like traditional retailers right now, we have zero exposure, so that’s really good as an investor to be able to express our conviction like that, and in terms of what we’re looking for, there are a few attributes that are very essential for us.
The first one would be character of management, looking at management, their track records, how they plan to develop the business over the next couple of years, because if there is too much debt that’s a concern to us, for example.
Then the capacity to repay, what kind of cash flow did they general, are these cash flow resilient or can they change dramatically if we change economic cycles, for example, or are they really volatile? So we really do a lot of stress testing around cash flows and how safe our coupon is, effectively.
Then we look at collateral, so is the bond secured. Some bonds are secured against specific assets, could be property, it could be a wind turbine, so we really analyse that because that protects us as bond holders, and then we look at covenants again, this is the kind of terms and condition of a bond.
We read the prospectus, which could be a bit boring for some but I quite enjoy it, you read a 200-page legal document, to understand really where your risks lie as a bond holder and where you are protected in this investment. But I would say we usually say that we’re truffle hunters, we kind of start with our theme and then go into a few companies’ ideas, we don’t analyse every single company, obviously, some are excluded, but obviously some from a theme perspective wouldn’t really fit our long-term thinking.
You gave some details earlier on about some of the sin stocks that are excluded from the portfolio due to their ethical screen that’s applied. Could you also run through how you screen for one positive quality in terms of a bond’s ethical credentials?
Yes, sure. Perhaps if I just go back onto our ethical screening process. We have two layers, the first one is negative screening, and then, as you say, more positive screening. So the negative screening really looks at a lot of sectors, so it would exclude companies with exposure to tobacco, armament, animal testing, gambling, high-impact activities such as, you know, oil and gas and other extraction activities.
And this list is not exhaustive, I mean, there’s over 30 different criteria, but we publish it on our website and I think it’s really important for investors, and every investor might have different criteria, things that they would find ethical or less so. So all we can do is to be as transparent as possible, so it is on our website for more granularity there.
So once a company has passed that negative test, so they have no exposure to these industries or activities, we look at more positives. So it would be looking at things like employment practices of a company, provision of social services, for example, charity donation, but also mitigation of their impact as a company, and every company that we have in the Fund has no negatives and at least one positive.
Just to give a level of comfort perhaps around the governance, this decision is not made by myself as a fund manager, it’s made by a separate team that is responsible for the screening, so the decision is completely separated, which means if I really like something from an investment perspective but it’s not OK or, you know, not that great from the ethical side, I cannot add it into the fund, you know, they have the veto on every investment, effectively.
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