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Rhys Davies, Fund Manager
Bond markets have been anything but boring over the last couple of years – what happened?
They’ve been exciting – and painful - for investors. We all know what happened in 2022. Inflation, which is the nemesis of bonds, was a lot higher than most people expected. Interest rates were hiked in reaction. Many people criticise the central banks for being late to the game, but when they did start, they were certainly very aggressive.
In the UK the base interest rate has gone from 0.1% to 5.25%. The bond market had to adapt to that. In Europe, for example, yields had become very low. The high yield bond market was only offering a yield to maturity1 of 3.4% at the end of 2021. So there were many bonds with coupons2 that were uncompetitive versus interest rates.
There were a lot of sub-investment grade bonds, those with a rating below investment grade BBB- and below, with coupons of 3% or 4%. These bonds should offer a higher yield than government bonds, to reflect the extra risk of investing in a corporate bond compared to a government bond. But with government bond yields rising to 5% and beyond, it meant that prices of high yield bonds had to fall to ensure that the yield on high yield bonds remained higher.
By the end of 2022, the yield to maturity in the European high yield market had risen to around 8% and the average price of bonds in the index had declined from 101 to less than 863. That meant a lot of pain for bondholders last year - it was the biggest calendar year price move since 2008 - as we moved from a world of low yields to high yields. That shouldn't be played down, but in terms of finding income in the bond market, I believe it has left us in a very good position now.
Do you think the interest rate hiking cycle is near an end?
The short answer is yes, I think we’re near the end. A couple of months ago, market pricing suggested that investors were expecting several more hikes, particularly in the UK. But expectations have since reduced. In part, that’s due to falling inflation. The market is now being priced on the expectation that the central banks are finished, or nearly finished, with their interest rate increases.
We’ve all just experienced a very aggressive hiking cycle. In some ways, the economy has held up better than predicted. For example, the labour market – as measured by unemployment levels and wage growth – is still looking positive. That’s the case in the US as well as the UK. My main issue is that a lot of this positive data is backward-looking. If you look at some of the leading indicators, there is more reason to be pessimistic about growth. Levels of activity are deteriorating and even some labour market data is now getting weaker.
We also have to bear in mind that there is a lag between the imposition of interest rate hikes and their full effects on the economy being felt. Given the size and pace of interest rate increases, there is potential for economic conditions to weaken further from here, which would tend to create the conditions not just for the hiking cycle to end, but for interest rates to be cut.
Where would a weaker economy leave the high yield bond market and your portfolio?
It’s an important question. The prospect of reaching a peak in interest rates is very good news for bonds. When interest rate expectations fall, the coupons available from bonds that have already been issued at fixed rates become more valuable. So just as bond prices fell when interest rate expectations rose last year, so they could rise if interest rate expectations fall this year and next. We call the sensitivity of bond prices to interest rates "duration". I've been adding to the duration of the portfolio over the last year, for example buying longer maturity bonds.
But we have to think about growth as well as interest rates. The high yield bond market, which is where the BIPS portfolio invests, is more sensitive to the growth environment than other parts of the bond market. This is because high yield bond issuers are typically more indebted companies. It also means that they are more exposed to a rise in the interest payments on their debt, which is now happening across the board.
For the moment, heading into the fourth quarter of 2023, corporate earnings are okay. The high yield sector is not particularly highly indebted and many companies issued bonds when interest rates were low and they were able to borrow on good terms. But these conditions could change.
Lower economic growth tends to depress earnings and so reduce companies’ ability to service debt. At the same time, when it comes to refinancing their debt, they are likely to have to pay significantly higher interest rates. We have seen some examples of that already. These two risks – lower earnings and higher refinancing costs - are definitely clouds on the horizon.
But, as I said earlier, yields are a lot higher now than they were and we want to take advantage of that. The key for us is to manage the portfolio actively. It is always about aligning risk and reward. For that reason, I’ve been raising the credit quality of the portfolio in recent months. About a quarter is now in investment grade corporate bonds, where credit risk is lower. We have also reduced our exposure in CCC rated bonds, the highest risk area.
While some companies may struggle in the coming quarters, we want to be picking up the good levels of yields that the bonds of better-quality companies are now offering. Our investment decisions are driven by research into both individual securities and their issuers. We use our excellent credit research resources to identify companies that are more or less equipped to handle the risks we see in the market.
What is the yield on your portfolio today?
There are a few ways of thinking about the yield. The simplest and most visible is the dividend yield. That’s what the shareholders receive. The dividend is decided by the board of the trust. The BIPS board’s annual dividend target right now is 11.5p per share. At the current share price (164p at the time of writing4), that is equivalent to a 7% yield. (The level of the dividend is not guaranteed).
However, that dividend is more than covered by the income which the BIPS portfolio is generating. The excess income is kept within the trust and can be used to smooth dividends in a lower yielding environment. In addition to that, the average price of the bonds is 87, so well below the redemption price of 100 that the portfolio will receive if the bonds are held until they mature.
The yield to maturity, therefore, a measure which combines both the coupon payments and the potential capital gain, on the assumption that the bonds are repaid at par (100), is higher than the portfolio yield. It is currently about 9.5%. We also have some gearing, meaning borrowing that enables us to make additional investments, in the portfolio. Gearing is 20% of NAV and the effect of that is to increase the yield further.
That all adds up to a considerable yield. I’ve been involved in these markets for 20 years. After a long time, when interest rates were low and central banks were buying bonds as part of quantitative easing5, I’m now seeing the sort of yields that I used to see when I started. These are more like the yields that I was trained to believe high yield bonds should be paying investors.
Does the ability to gear the portfolio make the trust structure a good one for managing bonds?
I think that the investment trust structure is great. The first big advantage is that being closed-ended, BIPS has a fixed number of shares, so I'm never under pressure to sell holdings to fund redemptions. I can really focus on taking a long-term view and act boldly during times of market stress.
That’s what we did when COVID hit. In March and April 2020, the bond markets experienced what I would describe as a dysfunctional time, with a lot of indiscriminate and forced selling. Being able to manage a portfolio through that, without having to worry about redemptions, was great. We were in a position to be buying and picking up some really attractive looking opportunities.
The use of gearing is also an attraction of the closed-ended structure. It would be pretty scary to be managing an open-ended fund if it had gearing and clients could take their money out overnight. I don't think my nerves could cope with having to deal with both the gearing and redemptions at the same time. Gearing has to be managed prudently, of course and we've got a lot of experience of doing that on the desk.
The other thing I like about the investment trust structure is the ability to set a dividend target. For BIPS, it is presented very simply as a pence per share target. That means that I can put together the portfolio with 11.5p in mind. Every quarter, when I meet the board, we can have a discussion about how comfortable we are with the target.
If I feel like hitting the target would mean taking more risk than I’m happy with, I can say that. Today, there's plenty of income out there to cover the dividend and there are good opportunities to lock in attractive coupons, with the prospect of capital gains on top.
Right now, we’re in a good place.
Footnotes
1The yield to maturity is the total expected return on a bond investment, taking into account the purchase price, the coupon payments and the re-payment of principal at par, or amount of money the issuer will return to bondholders at maturity.
2A coupon is the annual interest payment a bondholder will receive from the bond issuer from the date of issuance until the date of maturity of the bond. It is expressed as a percentage of the face value of the bond.
3Sterling denominated bonds are typically issued at a price of £100.
4As at 26 September 2023.
5Quantitative easing is a monetary policy strategy used by central banks where they buy government and/or corporate bonds to try and reduce interest rates and encourage spending.
Want to find out more?
Rhys Davies is a fund manager and senior credit analyst in the Henley-based Fixed Interest Team and manages high yield credit portfolios. Click the links to find out more about the Invesco Bond Income Plus Limited:
Invesco Bond Income Plus Limited (LSE:BIPS) - Share price | AJ Bell
Invesco Bond Income Plus Limited
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
The Invesco Bond Income Plus Limited has a significant proportion of high-yielding bonds, which are of lower credit quality and may result in large fluctuations in the NAV of the product.
The Invesco Bond Income Plus Limited may invest in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events.
The use of borrowings may increase the volatility of the NAV and may reduce returns when asset values fall.
The Invesco Bond Income Plus Limited uses derivatives for efficient portfolio management which may result in increased volatility in the NAV.
Important information
Data as at 26 September 2023 unless otherwise stated.
The yield shown is expressed as a % per annum of the current NAV of the fund. It is an estimate for the next 12 months, assuming that the fund’s portfolio remains unchanged and there are no defaults or deferrals of coupon payments or capital repayments. The yield is not guaranteed. Nor does it reflect any charges. Investors may be subject to tax on distributions.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Views and opinions are based on current market conditions and are subject to change.
For more information on our products, please refer to the relevant Key Information Document (KID), Alternative Investment Fund Managers Directive document (AIFMD), and the latest Annual or Half-Yearly Financial Reports. This information is available on the website: https://www.invesco.com/uk/en/investment-trusts/invesco-bond-income-plus-limited.html.
Further details of the Company’s Investment Policy and Risk and Investment Limits can be found in the Report of the Directors contained within the Company’s Annual Financial Report.
If investors are unsure if this product is suitable for them, they should seek advice from a financial adviser.
Issued by Invesco Fund Managers Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.
Invesco Bond Income Plus Limited is regulated by the Jersey Financial Services Commission.
