Defensive plays: How to thrive in a market full of surprises

2 December 2023

In this latest interview from Fund calibre, Dillon Lancaster, co-manager of the TwentyFour Dynamic Bond fund, talks us through the current push and pull factors in the bond market, focusing on the team’s strategic moves in response to the central banks’ aggressive rate hikes over the past 18 months.

The interview by the Fund Calibre team, covers why the team has been favouring government and investment grade bonds, their views on the likelihood of a recession and also on the use of European AT1s and European CLOs in the portfolio. Also discussed is the likelihood of recession in 2024 and whether defaults are set to rise.

Why you should listen to the interview: At an interesting if somewhat turbulent time in the economy for bonds, we hear in detail about the impact macroeconomics has on the changes in the asset allocation of this fund, indicating possible headwinds: how is the fund adjusting to meet these potential challenges? Dillon also takes us deep into the world of asset-backed securities – not to mention acronyms – with nods to AT1s, CLOs and BBBs.

 A few points worth highlighting:

Please note, answers are edited and condensed for clarity. We recommend listening to the full interview to get the best understanding.

 Government bonds: a safe haven“I suppose the main story that’s been dominating not only the bond market, but also the market at wide over the last 18 months, has been the rapid raising rate cycle from central banks across the world, designed to fight the very high inflation that we saw last year.

“As they’ve been raising rates, we’ve been gradually increasing our government bond exposure. And as interest rate raises carry on being passed through to the real economy, through some sort of lagged time period, we think as that growth slows down, investors will want to be in the safe havens when investing. For us, government bonds are the safest place to put your money. And so we think as growth rolls over and continues to do so, that government bonds can definitely protect you and should perform well.

“However, we think that even if growth doesn’t considerably slow down, government bonds can also perform well as inflation falls. Central banks have been increasing their rates to reduce inflation. We’ve seen some encouraging signs of this over the last few months. And if we annualise, for example, the last few months of US inflation, they’re actually not too far away from their 2% target. Now, as inflation falls to target, central banks are still in very, very restrictive territory.

“So, the Fed at the moment at 5.5% is probably about 3% higher than their neutral rate, the rate at which they’re not in restrictive or expansionary territory. And so, even without growth rolling over, you can see cuts coming through as that inflation target is met and they actually just reduce the restriction of their territory, of their rate environment at the moment. So, we think that, if growth rolls over, people will go into government bonds for protection, or if we hit inflation targets, then central banks will start cutting, and again, government bonds will perform well. And so for us, we think that government bonds, and for us in particular, we think US Treasuries are a very, very good investment at the moment.”

Countering recessionary headwinds

“In the last few months, there’s definitely been a growing narrative that we could avoid a recession. And the reasons for that are the inflation signs have been getting better across developed nations. Meanwhile, growth has actually remained better than what people were expecting for this year. I think uncertainty is definitely still elevated and it’s still early to put all your eggs in one basket there.

“The rate rising cycle that we’ve seen has pretty much been the most aggressive since the early 1980s. And if we just look at the lagged impact of putting a hike through to the real economy, as a rule of thumb, that’s eight to 12 months. Well, in the last 12 months, the Federal Reserve alone have put through 200 basis points of hikes. So, with the economy already showing signs of slowing down and perhaps that’s still coming through to impact the real economy, then I think it’s too early to say that we’ve avoided a recession.

“So far, growth has held in strong, but I think weakening has begun and definitely more impacts from central banks to come through, which means that we’re not out of the woods yet.”

Will default rates tick upwards?

“Well, default rates at the moment are about 2%. I think we may see them possibly go to between 3.5%- 4% over the next kind of 12 to 18 months. And the reason for that is, as we come up to maturities and with the higher yield environment, that seems logical. The reason we don’t see it spiking to 2008 levels is that corporates, like the consumer really, are still in a healthy place. Corporates, their interest coverage levels are very strong; corporate leverages is also very healthy at the moment. And this time around, the healthy banking sector means that corporates have lots of different avenues when they’re talking about refinancing debt. So, we don’t expect defaults to spike, but because of the conditions that you mentioned, I think they can definitely drift higher from here.

“I think that plays into what we’re doing in the fund, increasing credit quality where we do have high yield exposure, making sure that you’re in BB or very strong B names. 95% of defaults come from the CCC sector, and so for us, there’s no reason to be in there when you can be paid very healthily elsewhere. So, it’s about reducing that exposure and going up in quality. And when you are in a name that has to refinance in 2025 or in the nearer term, it’s about having high conviction that they have the means and abilities to do that through free cash flow, et cetera.”

 Happy to take on subordinated risk

“We’ve got around 25% in US Treasuries at the moment in between 10 years and 30 year duration; the longer duration you have, the more protection that gives you as yields go lower, the more price movement you get, and so therefore the more protection.

“It’s a real high conviction that these yields are very, very good medium-term yields to be locking into. If we look at where the 10 year was trading a few weeks ago, at almost 5%, that’s not far off where the US high yield index was trading only three years ago. So we think, at the moment, these kind of yields are giving you very good medium-term entry points and should protect you and should perform well on any growth rollover or in terms of also if inflation gets close to target or back to the 2% target.

“In terms of our credit portion – the 75% of credit – that has been increasing credit quality, so the high yield that we were holding a couple of years ago, we’ve been rotating that out and into investment grade corporates. However, we do have a couple of top picks as well, which are still offering a lot of yield and we think offer very good risk/reward-adjusted metrics at the moment. And those are European AT1s, so that is subordinated bank debt. We think that banks are in a very healthy position at the moment. They have been kind of revolutionised since 2008 and been made by the European regulator and the UK regulator to be much healthier. For us, we like banks at the moment, we like the national champion banks and we like them so much that we’re happy to take subordinated risk. And that is where the AT1 bucket comes in.

“At the moment, you are being paid about 12% in some names of national champions, so take Barclays for example: you’re getting paid 12% in sterling to hold their AT1 risk, which Barclays (which is in possibly, historically, the strongest position it’s been in, rated BBB) even at an AT1 level, is a very strong proposition at the moment.

“We prefer European banks for these AT1s. Whereas the US banks are not all regulated and there’s much lighter regulation over there. In Europe, every single bank is under regulation which means you get much tighter risk controls. And so we think that, on a risk/reward adjustment, we prefer to be in European banks (including UK) because the regulator has done a very good job to make banks safer post-2008, and as a bond holder that definitely benefits you.”

 Conclusion: This interview is a fact-filled listen to a manager whose fund differs from most strategic bond funds due to a consistent weighting in asset-backed securities. This team specialises in ABS which usually helps them invest “where others fear to tread,” so it’s interesting to find out why – and how – they’re slightly retrenching in order to protect client capital.

Professional Paraplanner