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15 March 2016

Martin Horne of Babson Capital believes senior secured bonds offer plenty of value to investors.

When the technicalities of corporate bonds become front page news, it is generally for very bad reasons – and so it was in the global financial crisis of 2008–09.

In the intervening years, however, many companies have cleaned up their balance sheets and reduced their borrowing. In a number of sectors, perhaps most notably finance, borrowing cultures have changed significantly, in great part due to regulation.

Thus banks now tend to hold higher levels of ‘contingent capital’, often in the form of ‘coco bonds’ – shorthand for ‘contingent convertible bonds’. If a company faces default, these bonds automatically convert into equity, which leads to a rapid drop in their value, hitting investors. Martin Horne of Babson Capital, which manages the St. James’s Place Corporate Bond fund, believes that some of these risks are now being overlooked.

“A lot of bond owners don’t know the risk of convertible bonds – many people always assumed they would never actually be converted,” said Horne.

Horne invests in senior secured bonds, a far safer form of bonds that sit at the top of the capital ladder. Just as investors are failing to price in risk on coco bonds, so Horne believes they are failing to understand the far safer nature of senior secured bonds. “We do think there is a lot of value in senior secured bonds at the moment,” he says.

Senior secured bonds, on the other hand, sit at the top of the capital ladder, which means they are the first to get repaid, and the last to suffer in the event of a default. Inevitably, that means they tend to come with a premium over the next-best level, unsecured debt. Horne believes that premium is now exceptionally cheap.

“Unsecured bonds are trading at 7.55% above Treasuries [US government bonds], but secured debt is trading at 7.25% above,” says Horne. (The percentage yield is directly correlated to the risk level: the higher the risk, the higher the yield.)

“That means that investors buying unsecured debt are not being rewarded for the additional risk. So why take it?” says Horne.

Weather gauge

Horne sees a number of macroeconomic factors as supportive of the credit class more broadly. He points to the European Central Bank’s extension of quantitative easing (as well as accommodative monetary policy in other currency areas) and to the resilience of consumer spending. Among the headwinds for investors, he highlights low corporate profits, low inflation, and trouble in emerging markets. Many are also concerned at disappointing global growth rates but, for bond investors, low growth comes with a silver lining.

“Slow, low growth is actually favourable for bonds,” says Horne. “We want positive GDP growth. But a low-growth environment is good for what we do – high growth leads to over-confidence, after which credit quality deteriorates and default risks increase."

As of the end of January, the fund was invested in 121 debt issuers and the average maturity of the bonds was around five-and-a-half years. Bonds in the portfolio average a 6% return above Treasuries – twice as good as what was on offer before the financial crisis, Horne points out. Nevertheless, although credit conditions have improved considerably, there are areas he currently avoids.

“Credit quality is all-important in constructing the portfolio – we avoid financials at the moment,” says Horne. “The issuers we hold are well-capitalised, strong businesses like Vue, Warner Music, Brakes [the ‘foodservice provider’] and Travelex.”

Such companies are resilient, Horne argues, “even in downturns”. In the current environment, Horne believes they make for a doubly good investment, since spreads continue to price in too much risk. Moreover, few asset classes offer better security in troubled times – when a company faces debt trouble, senior secured bondholders get repaid ahead of all other investors.

“When a company faces debt trouble, senior secured gets the keys to the business,” says Horne.

 

The opinions expressed are those of Martin Horne and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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