The manager of the £163m Sarasin Sterling Bond fund is adding subordinated financial debt to the portfolio because he believes the assets are undervalued in light of Basel III.
John Godley, the head of fixed income and manager of the fund, says the new regulatory framework will require financial institutions to issue a new type of Tier 1 capital, leading them to redeem existing issues.
“Under Basel III, Tier 1 capital will have to be loss-absorbing, and most existing debt capital issues are not. This means financial institutions will have to issue new forms of qualifying Tier 1 capital, encouraging them to redeem the old stuff at the first call date,” he says.
“Much of this Tier 1 debt is trading as if it will not be called, which we think is wrong.”
Godley has added Tier 1 issues by Old Mutual, Legal & General and Standard Life and is looking for further opportunities.
Meanwhile, Godley used market weakness in Q2 to buy higher-yielding exposure. He bought a John Lewis 15-year bond in sterling and a Nationwide Building Society 10-year subordinated bond in euros.
“We kept our heads in Q2 and instead of reducing our high-yielding credit exposure, we added to it. These bonds have performed exceptionally well during this quarter, with spreads tightening,” he says.
The bond manager has also increased the duration of the gilt portion of his fund as the yield curve has steepened.
“We have been playing the longer end of the gilt yield curve for most of this year. So far, yields in the two- to 10-year space have fallen further, making the curve even steeper and increasing the reward for taking duration risk,” he says.
Godley has also added to his emerging market currency holdings, introducing a Philippine peso bond issued by the European Investment Bank. The fund also holds bonds in Indonesian rupiah, Korean won and Brazilian real.
“I like the Philippines because of its macroeconomic strength. Even though it has a higher budget deficit than some other countries in the region, it is by no means a problem when you compare it to Western economies. We expect a 10% currency appreciation this year,” he says.
