RSA investments' Andrew tunks and fatima luis use stockpicking strategy to seek out good value stocks in a weak market
September was the worst month on record for the European high yield bond sector with the Merrill Lynch index plummeting 13%. That dramatic drop has, however, thrown up a great many opportunities for active managers in what is necessarily a stockpicker's market.
Royal & SunAlliance Investments offers a range of four corporate bond offerings, three of which form a risk contimum investing primarily in sterling and Euro denominated debt.
The High Income Bond fund, managed by James Foster, invests in investment grade corporate bonds. The Extra Income Bond, also managed by Foster, invests in a mixture of investment grade and high yield debt. The Maximum Income Bond, investing purely in high yield debt, is managed by Fatima Luis.
Luis, who joined RSA Investments' worldwide bond desk in 1998, taking over the Maximum Income Bond Fund in November 2000, and Andrew Tunks, managing director, worldwide bonds & treasury, talk about RSA's corporate bond investment process and the opportunities in the high yield sector.
The current process begins with a top-down macroeconomic view. How is that formulated?
Tunks: We forecast the economic variables the main ones being GDP, inflation, and shortterm interest rates for the main economic blocks, that is the US, the Eurobloc, Japan and the UK.
We get input from bonds and equity representatives. The bonds team lives, eats and breathes economics. The equities team will have a view on the economics, but more importantly will meet corporate directors and will gain a view in terms of pricing power, inventories, investment programmes, and forecasts for the future from those meetings.
Feeding that more informal information in, we can get a strong view about how corporate America or UK is performing and what they think about the future. That helps set the overall view. These inputs go to our house economist who develops a view and that will be presented to our economic strategy group. of which I am chair.
The quarterly meeting that follows focuses on the overall direction of spread in relation to the Government gilt market. This looks at what is going to perform best. It also looks at credit ratings. Swap spreads provide an arbiter for value within the credit market. It won't tell you whether the BBB will outperform or whether AAA will outperform or whether high yield will outperform.
What is the process for deciding on sectoral views to be implemented in the funds?
Tunks: The sectors are looked at in the monthly cycle. On this sectoral level, the credit team interacts with the equity analysts. There is a clear and constructive dialogue going on between the two.
We look at sectors to decide which we believe will outperform and which will underperform, just as you would do in an equity portfolio. Out of this will come our preferred sectors. The outcome of that will be implemented on the funds unless anything changes, at which point it will be reassessed. The events of 11 September are an example of this.
The top-down approach is then challenged bottom-up. We may like the company but hate the sector. That is not a sin. That's fine. But we have to be clear on our view. For each credit we will analyse the balance sheet and business risk. We will take a view on the management and whether they are a natural downgrade or upgrade.
How is the team split in terms of responsibilities?
Luis: We cover the market through analysts that specialise in different sectors. For example, I cover telecommunications and media because they play a very big role in the high yield sector. That way we cover the whole market and we do it throughout the whole strata of credit rating. Individuals don't concentrate on just investment grade for example or high yield. Effectively it is an accident that a company is a BBB or an AAA company. That is important as stocks can be upgraded or downgraded, points at which it is not sensible for the responsibility for the company to change.
How close do you stick to your benchmark?
Luis: We don't follow a benchmark because so much of it is awful.
It is a stockpicker's market. September has been the worst month ever for high yield with the Merrill Lynch Index losing 13%. The biggest ever fall before that was in September 1990 which was about 4% in the US high yield market.
Even before September, I was taking a more defensive view. We had increased food names like United Biscuits and the US lens maker Sola.
We took some profits on some automotive names that had become very expensive. We had also moved our cash position higher. We are currently at around 8% in the Maximum Income Bond fund.
Is the balance of top-down and bottom-up different in Maximum Income compared to High Income and Extra Income?
Luis: For high yield, it is really a stockpicker's market. Our sector views are important but the performance comes from the views on the individual credits.
How would you assess the opportunities available in the European high yield sector currently?
Luis: A large part of the market is trading above 1,000 basis points, which means it is in distressed territory. That is 10% above government debt. We are not going to have a default rate that equates to that risk premium. What the market is saying is that we are going to have between 30% and 40% default rate. Currently, the default rate is running at around 10%, but it will peak in the second quarter of next year at around 11%, but nowhere near the levels the market has priced in. That gives us an opportunity if we can be in the right stocks.
Tunks: We have a period of corporate uncertainty but we can foresee a time in the future when that uncertainty will dissipate. From Fatima's point of view there is balance here. We can see that defaults will take another notch upwards. Risk premium will therefore increase in the short term.
How strong is the flow of new issues into the high yield market?
Luis: It is completely dead. There haven't been any since the beginning of August. It is anybody's guess when that will build again.
How well spread is the high yield market now?
Luis: It used to be dominated by the telecommunications in-dustry, but market reversals have changed that. It is relatively well spread now, but chemicals, autos and auto parts as well as general industrials and cable and media are all well represented.
What scrutiny is given to the paper itself, the actual terms of the deal?
Tunks: Cognance is very important. Issues will specifically have wording in their trusts deeds that will protect investors against various events. Some paper has no wording in this relation, some will have weak and some will have strong. There can be examples whereby the investor is protected by various tests.
For example, if the company's debt goes above a certain level or if the company is taken over, the debt is redeemed. It may be that despite a bearish view on the company we will spot wording that will protect us within an individual issue. This can produce a very large windfall profit. This work is done by the analysts.
The best paper in these terms tend to be the best as they were written to encourage investors into the market. Now in the high yield market default rates have turned up and the quality of issuance has turned up also. It began to be apparent six months ago. There are clear cycles there.
What is the economic outlook for the US?
Tunks: We expect the US economy to go into a mild recession. The fairly aggressive monetary policy, combined with the loosening fiscal policy that is already going on in the US, is expected that some growth will appear mid-way through next quarter with clearer signs occurring in quarter one 2002.
One thing that will be prevalent in the upswing, and this is particularly relevant in the US, is that the authorities will not want to stand in the way of the upswing. Historically, Alan Greenspan has had a reputation for a little push on the brake and a little push on the accelerator. This time the economy will be allowed to find its head and move. In the latter part of 2002 the Fed will start to increase interest rates again. We think the Fed funds rate will remain at 2.5% for the best part of a year.
For a full range of in depth interviews with the UK's top fund managers go to www.ifaonline.co.uk
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