Bond vigilante

M&G’s head of retail fixed interest Jim Leaviss discusses the future of the euro, his attitude to risk, and why economic growth is not the Holy Grail

Compared to equities, are there less opportunities in the bonds space to add extra value as a fund manager?

The fixed income space has a wide range of different asset classes within it, just like the equity market. I think you can add alpha from stock selection – credit analysis is important, as is understanding the different covenants and structures within a bond. You might have two bonds issued by the same company that have very different risk profiles, so you can add alpha through stock selection, company selection and sector selection.

Fixed income bond markets are usually broad, liquid and efficient. Can you second guess these markets consistently?

There is liquidity in most parts of the market. Obviously that deteriorates as you head to down to the more esoteric bonds and high yield. It also does not take account of the big changes that have gone on in the market, particularly after the credit crisis.

One of the reasons we made a lot of additional value for our investors in the period 2007 to 2009 was because we minimised our exposure to the banking sector. Index investors would have been forced to maintain large holdings in the banks.

This is why we disapprove of the idea of index investing fixed income. I think it simply does not work.

For a bond investor it is an index of shame and the opposite of triumph. The more you borrow, the more highly indebted you become and the bigger your weighting in a bond index. You have to take an anti-index approach and only invest in companies where you have conviction that they are going to survive, thrive and be able to repay their bond coupons. That means even if a company like General Motors is 5% of the European high yield market, if you do not like it you do not own it at all.

Can you talk a bit about the asymmetric risk in bonds? Equity investors need risk to make a decent reward, whereas for bond investors risk is deadly, is that right?

In the bond market, if I lend £100 to somebody, my upside is that the company pays me my money every year and in five years time gives me £100 back. That is pretty much it.

We spend a lot more time avoiding companies we hate. There is that asymmetry of return that we could lose it all or we could get our money back. So we are lot more careful about who we lend money to. I do not think you can add very much value by running a hugely diversified index tracking fund and being underweight this and overweight that – it is certainly not the M&G style. We believe if you get the conviction decisions right over time, that is the way to deliver outperformance for your clients. We do not follow the herd.

When markets become fearful of risk they just dump huge classes of bonds as one and head for the hills buying gilts. How do you add value then?

You have got lots of levers to pull within the fixed income world and they include duration. So you can either have a short duration fund, if you think inflation and interest rates are going up.
Longer duration funds give you more capital gains if yields fall. Then you have got credit selection on top of that.

Explain how that can work with a specific example – when Greece was causing panic how did you react to that?

Our view has always been the euro area is not sustainable in its current form. It does not have the flexibility to cope, there is not the ability to do fiscal transfers or willingness to do that to the extent that is necessary.

Do you think the euro will be where it is now with all its existing countries in 10 years time?

The euro might be here but you might well have seen defaults within that. Greece may survive and the IMF facility certainly helps Greek liquidity, but it is insolvent. Given the austerity it is going through and the debts it has, a 120% debt to GDP ratio, it is never going to be able, even on best case estimates, to get its debt down to a sustainable level. That level might be 60%.

Some people think that is quite heroic for the Greeks, given their growth outlook, so you have to say to yourself that the Greeks need to take a haircut on their debt at some stage.

Do you think over the next five years, there will be some form of haircut on Greek debt?
I think so, yes.

How could you play that rise in the perception of sovereign risk?

In a corporate bond fund you might say “I do not want to own banks with heavy exposure to Greece”. And you might say, “actually, longer-date ten-year German government bund yields look very attractive”. What is it that people are going to want to own in a world where you worry about Spain? Or even France? It is about flight to quality trade there, it is a long duration trade and it is about reducing exposure to the periphery.

How has that strategy worked for you?

It worked very well. We have had a good run of performance as a result. We did not own any Greek debt, for instance.

Are you ever tempted to rethink? Could Greek bonds be a bargain ?

Not yet, because you have got the bonds trading at 80 to 90 cents in the euro, although some of the shorter date bonds may be OK for the period where the IMF is providing support.

The thing we do not like doing at M&G is playing the ‘hand of god’ trade. It got down to that with the banks in the end – the systemic shocks cause these ‘hands of god’ to come down and do things that are not based on fundamental credit analysis.

Surely we are at the end of the road for ‘hand of god’ trades?

You cannot say that. At the end of the day, it comes down to budget deficits around the world. They are unsustainable and are probably irreversible now. The knock-on effects of fiscal stimulus and the bailout of the banking sectors led to increases in budget deficits in Western governments. But it is really only bringing forward the acceleration that was already underway due to the promises governments have made to us and to people who are retiring. The biggest burden in the US is not bailing out their banking sector, it is the Medicare liabilities further down the line. So eventually we have got to a position where governments are going to have a choice. Their choice is, do they default on their public bond markets or default to us as taxpayers and citizens? Probably the most likely early defaults will be to us. It is about saying we are going to retire at 80 instead of 60.

Is this the next great looming crisis? Should we be looking for bond markets to tell us about a demographic shift?
That is the long-term risk.

But the UK does seem to be slowly addressing this problem, or at least that is what the markets are telling us with low yields on long dated bonds?

Yes the UK is OK. We have a long debt maturity. The UK nearly went bust in the 1970s, so the Government decided to be a bit more prudent. We introduced the index-linked bond market to show we had credibility with inflation. The US has never been through that situation, it has always traded on the idea that it is the reserve currency of choice. Some 60% of the world’s currency reserves are in US dollars. As a result of that, it has been able to run big budget deficits and it feels it can always do that.

The Federal Reserve has been playing the yield curve, it has issued all its debt very short term. So half of the US bond market matures in the next three years. This is a big ask for a trillion dollar market.

That is your classical path into a debt market crisis. The US is borrowing short because it has a steep yield curve and it wants to get its borrowing costs down. That is a very risky strategy and I think eventually the ageing population is going to be extremely important and relevant for all asset classes, whether it is equities or fixed income.

Your analysis would suggest that you are not buying a lot of American debt at the moment?

No, but the US market is your ‘risk off’ market. It is the market to go to, it is a AAA. Barclays did some research that said if you looked at the US debt market on a standalone basis, the US Governments is probably a AA. Yet you could probably run a debt to GDP ratio of 200% before you would start to worry about it losing its AAA status.

Is there a danger the US thinks it is unique, but in fact it is a bit like Japan, constantly running up huge debts at low cost?

It is a very odd one, Japan. Every year people say this is the year Japan is going to get into difficulties, yet it does not really move very much and its bond yields are still the lowest in the world. Ten year bonds yield 1.1% .

It does not sound like you think that is about to happen tomorrow, next week or next year.
Well, it ought to happen, but it is a very difficult one. Japan has gone ex-growth basically, as we are going to go. Yet we all think growth is a good thing.

Japan maybe shows that growth is not the Holy Grail. It is an economy where future growth is going to be impossible without significant immigration, changing demographics or changing productivity. But probably it does not care. It is a quite cohesive, relatively happy society, with low unemployment relative to the world.

If Japan muddles along and we start to follow in its low growth wake, what about emerging market bonds? Should we buy them?

I think if you want to lend to Venezuela or Argentina, you can get very high yields but you cannot get that anywhere else. Even Brazilian yields have come down dramatically in local currency terms.

But many specialist fund managers reckon there is value in local currency debt markets? There could be pockets of value still left?

Yes, and this might be the great convergence trade. If you look at the debt to GDP ratio of emerging markets, it has been on the decline. They are effectively de-levering. Their debt burdens are going down relative to the size of their economies. They have got less debt but it is not just the ability to pay, there is also the willingness to pay. Somewhere like Ecuador has defaulted several times with a tiny debt to GDP ratio, so it is not the be all and end all.