manager of aberdeen's £1.2bn fixed interest fund buys oversold investment graDE bonds to combat rising yields
Paul Reed manages by far the largest fund in the UK Other Bond sector, with his Aberdeen Fixed Interest fund weighing in at just over £1.2bn as of last month.
Like many managers in the sector Reed has seen yields rise in the non-investment grade market, which forms the focus of the Fixed Interest fund, as capital values have edged down. Reed, who has been a fund manager for more than 30 years, is optimistic as he believes the worst is over in terms of defaults and there are plenty of opportunities in badly oversold investment grade bonds.
Without a true benchmark, how do you judge the success of the fund?
In the long term we hope to do better than gilts for people. That has not been easy in the last year or two. In the long run we usually achieve this and at the same time provide the investor with a decent income.
The average profile of an investor in the fund is someone who has saved for a long time and is looking to take income while leaving the capital to their children.
Does the gilt and investment grade market look overpriced?
The top end of the investment grade market looks as vulnerable as gilts do. You could paint a picture a year on in which growth levels look much better and there is much more Government issue. You have only got to get a few wobbles in inflation for gilts to look horribly exposed at the longer end and all those things pricing off them will look the same.
The Government borrowing requirement looks to be higher next year. They could tax us more, but it looks like the wrong time to be pushing taxation too hard. They should be borrowing at these cheap rates.
That would knock though to the very high grade AAA, AA or very well-liked A, even triple BBB pluses.
Just how jittery are the high yield and corporate bond markets just now?
I have not seen this kind of nervousness since 1973/74. That was a tricky time.
Can you give an example of the way the market treats out-of-favour stocks?
Take a stock like Bombardia, which at one point was yielding 6.5%, and is now yielding 14%. There is no change in its rating with Moody's, but the market decided that a profit warning for the equity was enough to be scared about the bond. That is the kind of market we are in. An equity profit warning goes straight through to the corporate bond. It has never been quite as bad as that.
Where are you tending to put money now?
This year I have tended to push the money into better quality stocks because of the uncertainty around. We have had few bonds being redeemed out of some of the lower rated credits. William Hill and Coral, both single B companies, have been redeemed at a premium. I have not been buying single B's with the money. I am buying BBB which are out of favour.
That is my preferred area, the lower end of the investment grade.
These are stocks that are scaring the investment grade boys, but for us they can provide some of our better types of companies.
Can we use historical parallels to forecast when the market will become less jittery?
I'm a bit of an optimist. I think this is about as tough as it is going to get.
It is as bad in terms of sentiment as 1973/74 but it is hard to draw exact parallels.
In 1973/74 there were many more secure issues which only very rarely did not get paid in full when the company went under because they were generally priced under par.
The yields were nearly 17% in gilts. There was rampant inflation and there wasn't much of a new issue market for years after 1972. As the bear market in equities developed in 1973, 1974 issues dried up altogether and did not recover until 1981/82.
The corporate bond market will always recover when the economic situation becomes more positive and investors begin to seek better value.
What is your prognosis for those stocks the market has punished?
I think in a year's time a lot of these companies the market likes won't do very much in terms of prices, but many of those companies that have sunk badly will recover. How many will become dead is another question.
How bad is the default rate in the high yield market? Are we past the peak?
The European high yield market has been developing since 1997. This year 40% of the market has defaulted. We are certainly at the peak. Next year's default rate will not be anywhere near that. It mainly effects euro-denominated issues. Up to £10bn has moved into non-investment grade from investment grade, and there is more happening.
Have the credit rating agencies fallen from everyone's good graces after seeing so many bonds downgraded after the market has already punished the stock?
They are starting to be panicky and have got behind the curve on a few companies and have been criticised. There has been some very odd reasoning behind some downgrades. They have given the reason for a downgrade as the equity price falling. That is not good enough. That just creates anomalies, which is good news for us.
What is the size of your team?
There are a lot of fixed interest professionals in this company. There are 28 overall. Phil Roantree runs the Sterling bond fund, which is all investment grade corporate bonds.
He has a team working with him. Then there are the higher yield professionals. Mark Saunders is really my deputy and has worked with me a long time. Mark is head of the credit side, with four analysts assisting him.
How has the headline yield changed over the past two years?
What we expect to pay over the next 12 months has edged up and the price of the units has edged down. However, the fund has not been casualty free and total distributions have declined a little. That said, so have deposit rates.
Do IFAs often ask about the size of the fund?
Yes, but I tell them that the difficulty was years ago when the fund doubled from £100m to £200m. Doubling a fund is a lot different from adding £100m to a much bigger fund. Now it is nowhere near the problem it was.
Balance between bottom up and top down views?
In the main its bottom up on companies but you have to start with the macro picture. A lot of these bonds aren't really that sensitive to movements in the gilt market unlike investment grade corporate bonds in general. They are individual credits that move about on their own company news, but you need views on such things as inflation and growth in the UK and US economies.
How long do you tend to hold a credit?
Indefinitely. We try to buy cheap and hold. You try to buy cheaply when you can, and if there is a good surge I might sell.
The yield generally has to be much lower than when I bought it to make me sell, unless I simply have more interesting ideas for which I have to make room, or take a negative view of the credit.
Have the troubles in the debt markets attracted predators to the market?
What has been happening lately is that there are investors coming into some high yield bonds to take them down and force them to reconstruct, Americans in the main. They are keen to get into the equity. They are buying these bonds in the hope they will end up with the lion's share of the equity somewhere near the bottom of the market. The existing equity gets wiped out.
How much of the fund is now in equities?
The equities I have got in fixed interest have come from convertibles converting rather than high yield stocks reconstructed. I would be surprised if the fund ends up with more than 5% in equities, but I don't want to cut stocks out which can recover.
Are convertibles an asset class only used by the more experienced managers?
They are a dying breed. All I see are redemptions. It has been a great defensive asset class in this last year or two, because they have been in old economy stocks. I love the fact that you get an equity option as well as a bond yield. If the equity takes off you can get a big lift. I lost a lot in the bull market. The prices got so high I just had to sell them such as John Laing and Iceland. You must only buy them on a bond basis when they are under par. If the equity doubles and carries the bond price up, then you are at risk that the equity will fall back, and a sale must be considered.
FUND MANAGER: Paul Reed
Paul Reed joined Aberdeen in 1991. He has grown the Fixed Interest fund from £5m to around £1.1bn.
Reed joined Aberdeen in 1991 from the Merchant Navy Officers Pension Fund where he worked from 1982.
He began his career in 1958 with Friends Provident becoming a fund manager in 1970.
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