OMAM’s Johnson says coupons are more valued than ever for fixed income investors

Christine Johnson, manager on the Old Mutual Corporate Bond fund, says coupons are the key to continued compound interest.

What might the Libor scandal mean for the UK banking sector?

Unfortunately, it’s yet another blow for a sector which is already in a fairly powerless state; it seems to be one scandal after another or one capital problem after another. It’s been focused on Barclays because of the fines imposed both here and in the US; however, as more information is coming out we’re seeing that this was an industry-wide practice, and also that it’s something which potentially the regulator and even the Bank of England are being implicated in.

In terms of the fines the amounts are manageable. In terms of potential civil law suits, it’s very difficult to quantify how much that will be, but one thing we can do is look at other industries which have been subject to some kind of class action. If you wish to extract damages on that scale it’s important that that industry remains functioning and able to pay. It might be a multi-year drain on earnings, but it shouldn’t a capital event.

Which sectors do you prefer at the moment?

Rather than industrial sectors, what we’re preferring at the moment is geographies. It’s becoming increasingly polarised between the haves and have-nots in Europe, and it’s also becoming polarised in terms of the US relative to Europe. In respect of Europe, we prefer non-financial, operational companies based in economies which we still find it possible to analyse. In the non-core economies, it’s extremely difficult to look at corporates in isolation from the sovereign, so we prefer not to hold either corporate or financial paper in the periphery.

We like the UK. Growth isn’t great, but it’s okay. It’s considerably further down the path in terms of putting itself back together after 2008. We also like the US, where we see the first tentative signs that all the stimulus, all the money that’s been spent in the last few years is starting to have an effect on the real economy. Also, despite the slowdown, China is still running at a growth rate of 7%-8% this year, so we still want to have exposure to companies who are doing business in those parts of the world where growth is still comparatively strong.

Are you being paid sufficiently for the risk that you’re taking?

The question of whether you are being paid for your risk is the most fundamental question that you ask yourself every single day as a credit investor. The most basic way of thinking about that is to think about default rates. Moody’s recently came out with their latest default study and they are predicting that default rates rise slightly next year, somewhere into the 3%+ level.

The long-term average for defaults is 3%, so we’re not moving into very dramatic territory. If you compare that with 2008, default rates hit 13%. That puts the current level of risk into perspective. Now compare that with what you’re getting paid, which is the spread over government bonds. The spread over government bonds, if you take the spectrum from high yield through to investment grade, the spread now is nearly two thirds of what it was in 2008.

We have comfortably less than a quarter of the default rate, or risk, but more than two thirds of the compensation. So in the most fundamental sense, yes we believe we are indeed being fairly compensated.

You’ve been taking the portfolio to a more defensively position. Is this a tactical or a strategic decision?

It’s probably more tactical. The global backdrop is deteriorating, while Europe lurches from crisis to crisis until problems are forced out into the limelight. It seems that we’re approaching another of those moments. There’s been a few arguably slightly cynical attempts to stop this happening with the rather botched bank bailout for Spain, with some attempts to try and put alid on the situation in Greece, but it’s noticeable that perhaps the market’s patience is running thin and the half-life the relief rallies is getting shorter and shorter.

Spain is becoming a major concern. It’s quite possible that in the next three months it may lose its investment grade status with at least with one rating agency. These are not corporate issues, these are much wider systemic issues. We’re still happy to hold that core of corporate bonds that pays for our risk, that contributes to the income of the fund, but we want to balance that a bit more with some government bonds, which just helps to damp down the volatility of the fund.

The risk on/risk off environment that continues to dominate, do you see an end to it?

It’s difficult to imagine it ending in the next couple of years. I know that seems such a long time, but if you are trying to force structural change, which is what people are trying to do, and rightly if the eurozone is to survive, you have to have this succession of crises which force action to be taken.

This is happening against a backdrop of high government indebtedness, which reduces the flexibility to create strong growth through an aggressive spending programme. Instead we bobble along, things flare up and then some kind of solution is found, growth stays neutral-ish, not particularly strong, but not terribly weak either. In this environment, particularly now we’re in an environment of falling inflation rates, means that every single coupon is worth a little bit more. From the perspective of compound interest, we don’t need strong growth; we just need to avoid harsh recession. We can manage the to and fro of the risk on/risk off by trading in and out of government bonds, as long as default rates remain low and we get paid our coupon.

 

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