By Jerry Wharton, CEO, Church House Investment Management
There have been significant losses for some bond investors so far this year and we have been asked how we have protected our holdings from the worst of the volatility in the Church House Tenax Absolute Return Strategies Fund.
We have always been very proactive about protecting our holdings, either through curve positioning (duration), credit quality, or explicit interest rate hedges. This has enabled us to embrace higher yields whilst avoiding the risks to capital values.
Government benchmark yields have indeed risen sharply and holders of too much duration have certainly paid the price. Bear in mind though the opportunities that this readjustment has created.
Only a few months ago, the short end of the Gilt curve was almost negative, now we have two-year Gilts offering a mighty 1.6%. Not that attractive in itself, but when you add a credit spread on top, you are now able to access a fair yield on a total return basis.
There are now a number of quality bonds, issued last year when yields were low, that are trading well below par. Remember that bonds are redeemed at par, 100p. A good example is a green bond issued by Berkeley Homes last year. The proceeds of this issue can only be used for the construction of new housing stock that qualifies for the highest rating of EPC (Energy Performance Certificate). These bonds are currently trading at 87 offering a yield to redemption in nine years’ time of over 4%. Given the current risk-free rate of return, this is a wonderful opportunity.
Another fine example is a sustainable bond from Tesco (well ahead on reducing their carbon footprint since 2015). These five-year instruments are investment grade and pay a coupon of 1.875%. We can buy them at around 93, which therefore gives us a yield of 3%.
The other weapon we have is using AAA-rated floating rate notes. These tend to be of the highest quality, mostly covered bonds secured by residential mortgage loans with loans-to-value of about 45%. The coupons of these bonds refix on a quarterly basis using a spread above SONIA (the LIBOR replacement) and therefore the capital value of these bonds actually increases as interest rates rise, providing a hedge against rising inflation.
At the end of Q1 this year, the Tenax Fund had 34% invested in Sterling corporate bonds with duration of 4.4 and an average yield to redemption of 3.75%. A further 37% was invested in AAA floating rate notes, providing a hedge against inflation, a higher return than cash, and helping to dampen volatility across the fund.
In conclusion, there is no need to sit there and take all the medicine in the way that some bond investors have. Whilst it is not possible to have completely mitigated the downside, we have contained it through judicious curve positioning and interest rate hedges. The opportunities now abound for achieving a decent yield from fixed or floating bonds.
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