Market Commentary – June 2019

US markets expect Fed rate cut

Shares and bonds in the US rose sharply as the Fed kept rates unchanged and hinted at rate cuts to come in 2019, as President Trump’s tariffs look set to add further to the slowdown in economic growth in the US and globally. Whilst Chairman Powell has tended towards a patient approach to monetary policy, the on-again, off-again nature of the Sino-US trade talks may well necessitate a more nimble approach, and there is already some dissent among the Fed members, some of whom favour an immediate cut in rates.

ECB promises further policy easing if necessary

The strength of the Euro, coupled with continuing disappointing economic data across the EU, led to speculation that the ECB might feel pressured to cut rates in the Eurozone, turning the base rate negative. In addition, a speech by Mario Draghi, outgoing President of the ECB, stated that the central bank will stand ready to ease its policy stance further in order to stimulate the EU economy. This was popularly interpreted as a hint at renewed quantitative easing in the region.

Johnson looks set to be the next PM

As the process for electing a new leader for the Conservative Party rumbled on, Boris Johnson emerged as the clear favourite to become the next Prime Minister, ahead of Jeremy Hunt. Johnson is popularly viewed as the only person who can actually unite the Party and deliver Brexit. He has also been mentioned as the only person who would stand a chance of pushing Theresa May’s deal, in some form, through Parliament. The leadership election will be concluded, and the new leader announced on Tuesday 23rd July.

Emerging markets buoyed by G20 talks

Emerging markets had a good June, rising more than 5%, slightly behind developed markets. Emerging markets were boosted towards the end of the month by confirmation that negotiations between China and the US would continue. Unsurprisingly, given the news, countries at the centre of trade tensions, notably China and Korea, led the rally, while countries with lower sensitivity, notably India, were relative laggards.

Equity markets around the world rose strongly in June, led by Europe, where a further round of quantitative easing began to look likely. All major markets rose, and many emerging markets also saw strong gains over the month. The US market performed well, as expectations of a rate cut in July began to take hold, and there was talk of further cuts later this year. The markets were also calmed by suggestions from the G20 meeting that the trade negotiations between the US and China are now back on track, and President Trump also reversed his earlier ban on technology sales to Huawei.

Despite assurances from the ECB that interest rates would be held down well into 2020, inflation expectations across the continent continued to weaken, leading to increased speculation that a return to QE might be the only option left to the central bank. With this background, markets across the continent did well during June, with the major markets turning in high single-digit returns, and emerging European markets also mostly positive, with Romania, once again, being the notable exception, down 16.3%. UK stocks also rose as Boris Johnson, seen as the man who can deliver Brexit, seemed to move closer to becoming Prime Minister.

The Euro rallied against other major currencies during June, prompting speculation that the strength of the currency might prompt a rate cut from the ECB, as a stronger Euro will further undermine efforts to boost inflation in the economy. Sterling failed to pull back any significant ground against the Dollar, though it did finish the month at 1.2696, above its worst levels, having fallen to just above 1.25 intra-day. Speculation about a series of rate cuts from the Federal Reserve contributed to the Dollar’s weakness against other major currencies during the month.

Global fixed income saw another strong month in June, as expectations around the world turned to rate cuts from central banks amid weak inflation data. Negative yields on European sovereign bonds fell to lower levels as the ECB seemed to hint at a further round of quantitative easing in the EU, and the strength of the currency led to speculation about a rate cut, taking the base rate into negative territory.

*A Generic bond is a theoretical bond that always has the specified tenor, unlike a Benchmark bond, which is a physical bond, with a decreasing tenor.

Unrated Bonds – Busting the myths

Unrated bonds are a much-maligned area of the bond market. This is due to general misapprehension as to why bonds are unrated, and a reluctance to invest in what is perceived to be a very risky area. Hence unrated bonds are usually under-researched and present numerous opportunities for managers who are experienced in assessing credit quality.

The largest bond market participants are insurance companies, in which the Investment function is often overseen by staff who are not necessarily investment specialists. When a manager wants to invest in an unrated bond, he/she will have to persuade the Investment Committee that this is a good idea, and this is where the proposal often gets kicked into the long grass, as non-investment colleagues will often assume that if a bond could be rated, it would be.

In fact, this is the exact opposite of the truth. There are many valid reasons why bonds might not be rated, the most basic of these is that it does not need to be. Obtaining a bond rating is an expensive business, costing several millions of Pounds for larger issues, and if the company is not in the position of having to present its credit rating in order to, say, tender for a contract, then it will often not bother.

Many high-quality private companies choose not to seek a credit rating, as once a rating has been acquired, the company could then feel pressured to take short-term decisions to preserve that rating, which may conflict with the long-term interests of that business.

A credit analyst looking at any bond is only seeking to answer two questions – can the company afford to pay the coupons and will they be able to repay the capital. Hence, if an issuer is clearly very safe, the company will know that there is a ready pool of buyers for its bond, and so may not go to the trouble of getting it rated. Some examples of this might be:

  • Investment trusts, where the bond is only a small percentage of the value of the fund, so that the bondholder will be repaid unless the market falls by a very large amount
  • Housing associations, which generally have strong backing from local authorities.
  • NEC bonds – initially secured on the property of the NEC, but now fully backed by the City of Birmingham

Credit ratings can be nebulous and unreliable indicators of quality and financial health – Heinz was a highly rated, food manufacturer, whose bonds were investment grade (Baa2) until it was bought by Berkshire Hathaway in 2013, at which point it was ascribed a rating of B2 by Moody’s – nothing had changed at Heinz. Consider also, the possibility that a credit rating agency, in receipt of several million Pounds in fees from a client company, may be reluctant to give that company’s bond a disappointing rating. William Harrington, a former Senior President at Moody’s has publicly stated that the company uses a long-standing culture of “intimidation and harassment” to persuade its analysts to ensure ratings match those wanted by the company’s clients. Since the financial crisis ten years ago, the ratings agencies have been the subject of harsh criticism for the high ratings they accorded to bonds that subsequently turned out to be worthless.

Unrated bonds are often secured on specific assets, unlike their rated counterparts, and therefore are less risky (ie would have a higher credit rating) than comparable rated bonds. In short, unrated bonds are simply another source of Alpha – one that is often overlooked.

In terms of analysing the volatility of unrated bonds, this can be tricky. There is no unrated bond index, which means that it is hard to look at historic performance, since many of the unrated bonds that were in the market even ten years ago have now matured. Anecdotally, and speaking very generally, unrated bonds are slightly more volatile than BBB indices, but considerably less volatile than BB indices. However, insurance and real estate bonds tend to be even less volatile than the BBB index.

Illiquidity is a very topical issue, and it is true that there can be less trade in unrated bonds. This is because the pool of unrated bonds tends to be tightly held by those investors who understand them. This, in turn, means that buying unrated bonds in the secondary market can be very difficult, but selling them can much easier, as there is usually a ready pool of buyers looking to add to their holdings.

Funds that invest in unrated bonds, such as Close Select Fixed Income, generally have strong risk controls in place, and, particularly, close monitoring and regular testing of portfolio liquidity, going beyond the FCA’s standard requirements for liquidity assessments, use of liquidity buckets (categories of bond, broken down by the expected time required to sell them) and stress and scenario testing. In addition, where we invest in such funds, we also monitor the unrated bonds independently for liquidity.

Disclaimer: FOR PROFESSIONAL USE ONLY.

This report was produced by Independent Strategic Research Ltd (“ISR”). The information contained in this report is for informational purposes only and should not be construed as a solicitation or offer, or recommendation to acquire or dispose of any investment. While ISR uses reasonable efforts to obtain information from sources which it believes to be reliable, ISR makes no representation that the information or opinions contained in this report are accurate, reliable or complete. The information and opinions contained in this report are provided by ISR for professional clients only and are subject to change without notice. You must in any event conduct your own due diligence and investigations rather than relying on any of the information in the report. All figures shown are bid to bid, with income reinvested. As model returns are calculated using the oldest possible share class, based on a monthly rebalancing frequency and all income being reinvested, real portfolio performance may vary from model performance. Portfolio performance histories incorporate longest share class histories but are either removed or substituted to ensure the integrity of the performance profile is met. The value of investments and the income from them can go down as well as up and past performance is not a guide to the future performance. ISR and Independent Strategic Research are trading names of Independent Strategic Research Ltd, registered in England and Wales No. 09061794. Registered office: 34 Southwark Bridge Road, London, SE1 9EU, UK.

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