Jake Moeller, Lipper’s head of Research for the UK & Ireland reviews highlights of a meeting with Ben Pakenham, senior investment manager at Aberdeen Asset Management.
Many asset allocators are struggling to interpret the bond market at the moment. Fear of a bubble and a structural shift to an increasing-interest-rate environment present investors considerable food for thought. For Aberdeen’s Ben Pakenham (pictured), however, the view is refreshingly straightforward: high-yield bonds are the most removed from the bond bubble risk. “If you believe QE is effective in creating inflation growth and normalizing the economy,” states Mr. Pakenham, “yields will have to rise, and European high-yield bonds for income investors provide the best haven for this risk.”
Mr. Pakenham joined Aberdeen in 2011 from Henderson; he manages the €700-million Aberdeen European High Yield Fund with his colleagues Steve Logan (Head of European High Yield) and Mark Sanders (Senior Investment Manager). This fund has been a recent success story for Aberdeen (which has faced a number of recent outflow headwinds in its emerging markets business), and it has both a strong performance track record in a competitive sector and a gross yield to maturity (as of June 30, 2015) of 5.5%.
Diversification benefits of high-yield bonds are a recurring theme in Mr. Pakenham’s thesis. He recognizes there is some equities-type risk with the asset class, but he thinks the “pull to par” of a bond will result in a lower volatility profile. Certainly, there is a broader diversification benefit evident over the last ten years. There has been a 50% correlation with investment-grade bonds and a negative correlation with government bonds, and although these correlations have begun to increase in the risk-on/-off period of the last 12 months, Mr. Pakenham has been able to avoid sensitivity to government bonds by maintaining a comparatively lower duration in the fund (2.9 years against the market of 3.8 years).
Of particular importance to Mr. Pakenham are the structural differences between the U.S. and the European high-yield markets. He cites the progress of QE (Europe has just started its program as the U.S. winds up its) and the collapse of the oil price. With 15%-20% of the U.S. high-yield market forming funding for shale and gas companies, this has been significant. Europe has had virtually no exposure there. With the European high-yield market consisting of two-thirds of its assets rated in BB and approximately 40% of the market with a market capitalization of €30 billion or more, Europe is robust. It also has a higher average rating than the U.S. (less than 50% of the U.S. market is BB, and it contains three times as much CCC-rated debt).
Such figures are significant. During the recent Eurozone turmoil, larger investment-grade companies such as Tesco have “fallen” into the high-yield space but remain decent-quality stories and provide a cheap entry point. And despite the higher sensitivity to government bonds investors expect from a higher-quality market, shorter European durations are going some way to negating this. There are also implications for defaults. With the U.S. further along the route to higher interest rates, higher default rates are more likely there sooner. “We are basically being compensated in Europe as well today for default risk as we were nearly three years ago,” says Mr. Pakenham. “The long-term average spread in our market is 500 bp, which we are close to, but the long-term average default rate of 4.5% is miles away from where we are at 2.7%.” Mr. Pakenham is also impressed with the conservatism evident in Europe in this credit cycle: lower yields haven’t pushed up leverage, and debt is being used to pay down existing debt; maturities are being pushed out in turn, placing less pressure on default rates.
The fund is largely unconstrained. The 25% weighting of financials in the ML benchmark has been largely ignored. Similarly, Mr. Pakenham is not keen on sectors that are hard to model such as shipping, basic industrials, and automotives. His preferred sectors include healthcare (“where you know cash flows and earnings profiles”) and selected services. Geographically, there are some regions Aberdeen will eschew. Italy, for example, often sees a ten-year timeframe for a company to complete bankruptcy, which is unpalatable, but Greece has featured recently–despite its problems–via the Intralot company, which has significant revenues outside the country. Although Mr. Pakenham likes the U.K., the seeming overweighting there is again an anomaly of the index composition, though he notes that bondholder terms have remained stronger than the U.S.
The fund is underweighted in government bond risk and has a strong overweighting to B securities, many of which are less than one year maturity (25% of the entire fund is less than one year maturity). This provides a rolling liquidity source to the fund and reduces volatility. This has given the fund “positive convexity,” where low beta (because of the short maturity profile) results in outperformance during a market sell-off. And this may not be a bad thing. A recent JPM study suggests that, should spreads go from 4% to 7%, a portfolio with a duration of three years paying a coupon of 6% would lose you 10% of capital. Holding a ten-year-duration government bond portfolio in the same situation would cost you 30% of your capital while paying you very little income.
“The biggest risk is in supposed risk free bonds” warns Mr. Pakenham.