Global markets slumped in the first half of 2022. With shares and bonds falling more or less in tandem there have been few safe havens, even for investors looking for modest but stable returns.
By the end of June, the Investment Association UK Gilts sector, representing the average return of funds investing in UK government debt, had fallen 15.0% year to date. Corporate bonds fared a little better in the first half of the year with the Sterling Corporate Bond sector average 12.5% lower, with income reinvested. There have been few areas of sanctuary for investors outside of cash, which still provides little return, and some niche areas such as commodity stocks, infrastructure and some property where the prospect of income more resilient to the threat of inflation attracted investor interest.
It has therefore been a highly challenging environment for investors, including those seeking to generate a high and sustainable income while preserving capital – the objective of Chris Ainscough and Morgan Bocchietti, managers of the Charles Stanley Monthly High Income Fund. They aim to build a varied income portfolio with at least 60% in government and corporate bonds (currently 63%), supplemented by opportunities in equities and alternative areas such as preference shares or infrastructure.
A perfect storm
The root cause of the recent market troubles has been a sudden surge in inflation, the highest level since the 1970s. This has alarmed consumers and forced central banks into belated, drastic action. The consequent anticipated steep rise in interest rates to combat inflation has upended the investment environment.
Previously, investors expected continued subdued inflation and interest rates following a short period of ‘transitory’ price rises. That meant they were willing to pay more for the cash flows from financial assets. Capital values were buoyant, and yields compressed. Now, with inflation unleashed due to a perfect storm of money creation from the Covid era, supply chain disruption and commodity price inflation exacerbated by the Russian invasion of Ukraine, investors have quickly reappraised investments through the lens of a period of higher and longer-lasting price rises. In short, they demand higher yields – and thus lower prices – for assets.
The good news is this difficult period will, at some point, come to an end. In fact, one of the risks going forward is authorities go too far, raise rates excessively and cause a damaging economic downturn. In this scenario, the income from bonds and other reliable income-producing investments would start to look more appealing as inflation becomes yesterday’s enemy and the interest rate cycle peaks. As such, the managers believe long-term investors should use the market downdraft as an opportunity to accumulate for the recovery on the other side of the current bear market.
In particular, Chris and Morgan believe there is an opportunity emerging in high-yield debt where the ‘spread’ – or difference in yield – between lower-risk investment grade and riskier, higher-yielding debt has widened owing to the more hawkish rhetoric from central banks and worries about the global economy. The implication is that as interest rates rise, indebted or less financially stable businesses will get into trouble and could default on their debts; but they believe capital values have now fallen, and yields have risen, to a point that prices more than compensate investors for the risks.
In reaction, they have been adding bonds in the high yield part of the market, as well as selling shorter maturity (and thus lower yield) holdings and replacing them with longer-dated ones to lock into more attractive yields. This also improves the long-term capital return potential from this point, though there could be more volatility in the near term in the event of a particularly harsh economic environment, which is not our base case. The fact that asset prices already reflect the possibility of a deep recession to a significant degree is reason for optimism that the worst of the market falls has passed.
Not immune to the volatility rocking global markets, the fund has returned a negative performance year to date with the major elements, corporate bonds, UK government bonds and dividend-paying equities all falling in unison in reaction to persistent inflationary pressures and changing tone from central banks.
In theory, high dividend equities tend to have an inherent ‘value’ factor bias as well as being exposed to more defensive sectors such as utilities, which provides a cushion in falling markets. Investors often prefer these over higher-growth businesses where future profits are harder to gauge. However, in recent months most of these areas sold off regardless, albeit by a lesser amount than broader indices. Only energy-exposed holdings performed well for the fund, which was in response to higher oil and gas prices, a factor that is problematic for almost all other sectors.
More positively, some respite was found in infrastructure exposure within the portfolio, owing to the more certain nature of cash flows, the inbuilt inflation indexation of cashflows and the often highly regulated asset base.
Overall, the fund has performed reasonably well against its sector and benchmark, the Investment Association Mixed Investment in the year to date, albeit a capital loss is always disappointing. The table below shows total returns (with income reinvested) of the fund and benchmark in the year to date and over discrete years, as well as cumulative performance over various time periods.
Past performance is not a reliable guide to future returns. Figures are net of fees and shown on a total return basis, bid to bid price with net income reinvested; Source: FE Analytics, data to 30/06/2022.
During the past six months, the managers have been particularly active, seeing several opportunities to add new holdings that had fallen to an acceptable valuation level such as TP ICAP 5.25% 2024. TP ICAP connects buyers and sellers in global financial, energy and commodities markets. It is the world's leading wholesale market intermediary, with a portfolio of businesses that provide broking services, data & analytics and market intelligence. Conversely, Scottish Power UK 6.75% 2023 and Imperial Tobacco Finance 8.125% 2024 were fully exited.
The managers have also been reinvesting lower-yielding bonds into already-held names offering an attractive yield. These included Pinewood Finance 3.625% 2027, VMED O2 UK Fin 4.5% 2031, Aroundtown 4.75% Perpetual and Abrdn 5.25% Perpetual.
Another notable change to the portfolio is a halving of emerging market debt exposure via a fund run by Ninety One. This is based on caution around the short-term outlook for developing markets in light of global monetary policy tightening, as well as the improving value in high yield bonds in developed markets. Interest rate rises from the Federal Reserve have substantially strengthened the US dollar, and the sensitivity of many of the emerging market regions to shocks in energy and food leading to political and social unrest is a growing risk.
The fund does not have a formal income target but aims to generate what is considered to be a high and sustainable yield from the portfolio in current market conditions. Diversification is very important to managers. No single company represents a large percentage of the portfolio. The largest corporate positions represent around 2%. This means the value of the fund, and income from it, is not overly reliant on one area or single firm.
Given the fund’s size, it is nimble enough to take advantage of opportunities other, larger funds would find difficult to access in meaningful size. As well as positions in well-known shares and bonds, the managers are able to harness alternative sources of yield such as convertible and preference shares, local authority bonds and investment trusts.
The fund continues to be one of the highest yielding in the sector, and as of the 30th June, the yield was an annual 5.0%, paid monthly with a slightly larger ‘balancing’ payment at the fund’s year-end. The value of investments, and any income derived from them, can fall as well as rise and may be affected by exchange rate variations. Investors may get back less than invested.
We believe the fund could appeal to a wide variety of investors looking to achieve a good level of regular income as well as the potential for some growth in income and capital over time.
Find out more about Charles Stanley Monthly High Income Fund.
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