Overview
For global income investors like me, the game has changed profoundly in the past two years. High interest rates are likely to prevail compared to what we’ve been used to in fixed income markets over the last two decades, even when leading central banks do begin their cutting cycles.
Higher base rates mean higher returns for fixed income investors, but risks too. Some companies and governments will struggle with larger debt burdens and interest costs, and this will lead to more dispersion between those that can cope with a higher interest rate regime and those that can’t. This dynamic will heighten volatility especially in the lower quality credit cohorts, and lead to outsized wins and losses in more distressed parts of the market.
That can work in our favour.
The collapse of Credit Suisse (CS) last year and the reaction in the market for AT1 (convertible bonds regularly issued by banks to raise capital) bonds was a big opportunity. In the aftermath of the deal to merge CS with UBS the market had concluded that outstanding AT1s of other big banks would not be redeemed at their next call date - in contrast to standard practice - and could instead be held in perpetuity. Long-term yields on those bonds spiked because there was now no clarity around when they would be redeemed.
The question on my mind was: what if this all faded and the banks did in fact choose to refinance the outstanding AT1s on their call dates in 2024 and 2025? In that scenario we would get 100 cents in the dollar back, having bought at a significant discount. And we would probably get it within a year or two. The yield in that scenario was not 8 or 9 per cent, it was in some cases above 20 per cent.
Yes, the treatment of CS creditors in its collapse had undermined faith in AT1s. But we believed that regulators and the banks would want to revive that faith by redeeming the bonds and returning market yields to their earlier level (around 8 per cent). And we were right: over the next 12 months almost all of them did.
More juice from the fruit
I use this as an example, however, for another reason: as fund managers, we have to take advantage of the chances that arise naturally, and many of them do so in the months before bonds become due.
In the run-up to redemption or call dates, the market price of bonds tends to rise because the discount to face value evaporates if it seems clear that creditors will receive the full value of the loan back. Investment textbooks call this ‘the pull to par’. Timed well, it provides income investors who take most of their return from regular interest payments on debt with an extra capital boost.
In reality though, using this effect to make money is about spotting when the risks involved are accurately priced - and when they’re not.
Essentially the edge here is experience and research. I spend a substantial chunk of my time seeking out potentially mispriced debt in the marketplace. If I can identify companies whose debt has been discounted by the market, but we think will pay back the full face value in a year or 18 months’ time, then I can bank that extra 4 or 5 cents on the dollar.
If you’re confident the AT1 bonds will be refinanced in full, at lower yields - and they are - then the capital value of the existing bonds will rise. If you buy a company’s debt 18 months before they repay, and they do repay in full, then you get rewarded.
The sweet spot
What could go wrong in 18 months? Often, not much. But we have to be confident.
There are broader strategic choices here. We tend to focus on what we see as a sweet spot in the corporate bond market: the crossover space between the lower-quality end of investment grade and high-quality high-yielding credit. To reject the standard US terminology, much of what we deal in might technically be ‘junk’ bonds, but in reality most of it is far from that. The majority of our universe is healthy: we work with our research analysts to identify companies who will deliver solid profits for the quarters ahead. If they are doing so, why discount their debt ahead of the next refinancing?
Last year much of the market was set up for a massive credit blow-up in response to higher interest rates. Companies would not be able to afford their interest expense, a deep recession would follow, and the result was valuations that would be indicative of distressed conditions. Yet at the same time, a lot of companies were still generating pretty good earnings and were on course to refinance existing debt. The mismatch made pull to par plays an obvious hunting ground.
The impact of higher yields on companies and governments should mean more happy hunting ahead.
