London & Capital shifts bond holdings to prepare for growth

Despite having seen latest forecasts for global growth slightly downgraded to 3.3 per cent by the International Monetary Fund, Sanjay Joshi, head of fixed income at boutique wealth manager London & Capital, believes the worst is over, for the time being at least.

Discussing macroeconomics, balance sheets and geopolitics, there is a cautious optimism to both his predictions and allocations. Around 60 per cent of L&C’s $3.9bn assets under management are in fixed income.

“We are not saying things are totally rosy in the garden,” says Mr Joshi over herbal tea in his Mortimer Street offices in London’s West End. “Clearly last year, there was maximum risk of the economy going into recession, but now stability is returning.”

He puts this down to a partial resolution of the US trade conflict with China, some political progress in the UK around Brexit and a loosening of monetary policy by the Fed, European Central Bank and other central banks in Brazil, India, China and Japan.

Time for change

This new-found stability can prove a challenge to fixed income managers, necessitating a change of investment strategy, believes Mr Joshi. “If you move to faster growth coupled with looser fiscal policy, does this mean the era of quantitative, accommodative monetary policy will finally be behind us?”

Bond managers must think more carefully about how much of their clients’ portfolios they allocate to “high quality assets” and paper associated with higher yield and risk, sometimes originating from emerging markets.

Both durations – up to six years in the first half of 2019 – and asset “quality” are being reduced dramatically as Mr Joshi’s team oversee a sharp re-orientation of high net worth client portfolios.

The strategic overweight to government bonds was reduced in Q4 last year, as was the cash-like exposure to single A and double A corporates. However, there remains a barbell-type approach with a core holding in IG credits set against an overweight in more risk orientated assets (such as financials, corporate hybrids and EM debt). In their place, an almost equity-style sector selection approach has re-populated portfolios with a host of triple B positions lurking at “the lower end of the spectrum”, issued by banks, utilities and other regulated industries.

“We are less exposed to pure interest rate sensitivity, but happy to take more credit risk,” he suggests, giving some insight into the type of conversations L&C’s relationship managers have with wealthy families.

“Clients come to us to talk about fixed income investments, to discuss government and sovereign bonds, but we tell them this is a class for all seasons,” he says with the firm’s advisers brandishing their latest “risk matrix” during the client consultation.

“The risk matrix shows them how we can reduce risk when there are fears of an economic recession and increase risk during times of economic certainty.”

Take a chance

Basically, this means most customers have realised the economic environment has changed the nature of bonds in their portfolio. The anchor investment designed to stabilise holdings after the financial crisis has now been replaced by a riskier segment of paper, positioned to profit from potential, renewed global growth.

Rather than buying into negatively yielding government bonds, which some institutions must hold to maturity, private clients have more flexibility to exploit opportunities on the corporate side to both maximise income and generate capital growth, suggests Mr Joshi.

“This discussion with clients will increase in importance,” he says, predicting “damaging spikes” in government bond yields during 2020. “Our competitors are saying ‘don’t buy fixed income’. But their focus is only on government bonds and they ignore everything else. But we say look at the transformed balance sheets for financials, a regulated industry that is now completely different from 10 years ago,” when the fallout from the global financial crisis had left many family fortunes sliding.

Today, companies including GE, General Motors, Ford, Vodaphone and VW are all deleveraging significantly, opening up opportunities for investment in their corporate bonds

This diversification of portfolios is a challenge to most fixed income experts. Mr Joshi understands this better than most, having previously worked in investment banking, hedge funds and with pension schemes. “The fixed income world is dominated by institutional investors, who have an appetite for government and corporate bonds,” he says. “But institutional language also gets picked up by private banks.”

This means they sometimes ignore the “innovative things” some firms are doing in transforming their balance sheets. “There is more to life than government bonds,” insists Mr Joshi. While private banks such as Credit Suisse and UBS have a desire “to move away from sovereign bonds, this movement is typically into loans and high yield, not focusing on sectors and corporates trying to transform themselves”.

Moreover, institutional investors such as pension funds are transfixed by a macro-economic bond perspective, rather than a sector focus on areas such as financials.

“You have a macro view, but you need more bottom-up thinking,” says Mr Joshi. “You need to understand balance sheets. Equity investors have always been more focused on this.”

Financial re-engineering

In financials, he overweights subordinate debt relative to senior debt, studying evolving regulations and focusing on transformation of balance sheets, including higher Common Equity Tier 1 ratios, which measure a bank’s solvency through capital strength.

As well as a strong showing of US names, L&C is keen on SocGen, BNP Paribas and Credit Agricole in France, BBVA and Santander in Spain, Barclays, HSBC and Lloyds in the UK and Germany’s Deutsche Bank, “where transformation and restructuring are finally having an impact on the bottom line”.

These banks, he says, are beginning to focus on commercial banking, including  wealth management and deposit taking, while scaling back investment banking and riskier ventures in emerging markets.

“European banks have seen what US banks have done. Investment banking remains important, but there is more focus on predictability and certainty of earnings,” says Mr Joshi. “Five years ago, if you bought bank bonds in Spain, France or Italy, you were taking a sovereign bet on European bonds and they were heavily involved in Eastern Europe and other emerging markets. That has changed dramatically over the last decade.”

These names have all performed remarkably well in “significant stress tests” designed by central banks to test their strength in the face of potential market shocks.

In addition to financials, Mr Joshi draws investors’ attention to the dramatic increase of Triple B debt over the last three years, from less than 10 per cent to one third of outstanding debt. This throws up opportunities as companies have begun to initiate significant deleveraging.

“Our message is that macro-economics matters, but sector and issuer comparison is very important in ensuring our clients are happy with returns from fixed income, that their capital is preserved and that they can take advantage of growth opportunities.”