Investors in senior secured bonds have an alternative way to generate income from some of the world’s brand and industry leaders.
Senior high-yield debt requires a different way of thinking to equity investing, explains Zak Summerscale of Babson Capital. Senior secured bonds are the first to be repaid in the event of financial difficulty for the issuer and, therefore, offer investors a relatively secure source of investment income. “My goal is to get back the money I invest and earn a very attractive interest rate along the way,” says Summerscale. “It’s a different mentality to equities.” The manager of the St. James’s Place International Corporate Bond fund discusses the shape of, and opportunities in, the senior secured market.
Q. Can you briefly explain senior secured debt?
A. Secured debt means that collateral, such as property, plant or equipment, has been pledged as security against default. Investors in senior secured debt are legally entitled to be repaid ahead of other investors in the company, which results in lower risk and better liquidity than other debt instruments.
Q. What is your attitude to risk and growth?
A. In our world, it’s definitely ‘risk and growth’ rather than ‘growth and risk’. Risk is really what we’re looking at: the fundamental risk of losing money. The advantage of bonds is they have a finite maturity. So if we’re right, over the term of the bond, we’ll get our money back irrespective of volatility along the way.
Q. Do you view volatility as a positive?
A. In the same way as equity investors, volatility can be a huge opportunity for us. I think the markets can be incredibly irrational in the short term and it annoys me when people look at volatility and just think that it implies risk - it doesn’t. It reflects what the market perceives to be the value of companies, not their actual fundamental value.
Q. How is the fund positioned?
A. When the fund was launched in April 2010, the vast majority of the market was North American-driven and Europe had only just started issuing secured debt. Today the majority of the assets in the portfolio are in Europe and we believe the bigger opportunities are in Europe, although that’s not because we think European economic growth is going to be particularly positive.
Q. Are interest rate raises a threat to your portfolio?
A. The duration of the portfolio is less than three years and the yield is currently in the region of 6.5%. The portfolio is well-diversified geographically between the US and Europe [including the UK], so we have some protection from interest rate rises from any one central bank. Obviously, if all central banks increase rates simultaneously, there’s a risk for the portfolio but if only the Fed raises, then euro and sterling bonds are not affected to nearly the same extent or vice versa.
Q. What’s underpinned the success of the portfolio in 2014?
A. In 2014, success has all been about the selection of bonds. The first half of the year was probably the worst that I can remember since the global financial crisis in terms of poor-quality bonds coming to market. It was a good sign that people were rushing for yield at any cost, but the last three months has taken a lot of that excess out of the market. It’s also part of the reason the duration of our portfolio has actually gone down because we weren’t buying the new longer-dated assets; we thought they were extremely poor quality. We’ve only had two defaults since we started, which equates to 0.1% of the portfolio compared with the market default rate over the period of 2%.
Q. Can you give an example of a bond you’ve avoided and why?
A. Phones 4u is probably the biggest name in the senior secured bond space, but we weren't invested in it. The bond went down 70% in one day, which really shouldn’t happen to this asset class. It is a good example of a bond that should never have been issued. Essentially, it was equity risk dressed up as a bond, without any of the upside from equity; it was a company which had no fundamental value other than its three contracts. It lost one of those contracts in April and the price hardly moved. It lost the second contract with Vodafone in September and the bonds fell 70%. And it lost its Everything Everywhere [EE] contract in October. Put simply, you shouldn’t own a bond where one contract can cause you to lose 70% of your value overnight. The knock-on effect was that anything retail was suddenly panned and we picked up a lot of attractive positions. Strong issues from good brand names, such as Vue Cinemas and Pizza Express, were suddenly down five percentage points because Phones 4u had defaulted. That’s another very good example of irrationality in the market.
Q. Are there any investment opportunities following the European Central Bank’s recent test of the financial health of the region’s banks?
A. Yes, I think the recent asset quality review, the ‘stress test’ the ECB performed to review the health of the European banking system, will result in even more pressure on banks to refinance some of their historic loans that pre-date the collapse of Lehman Brothers and the financial crisis. And that, in turn, I think will create attractive supply of issuance for the senior secured bond market.
The opinions expressed are those of Zak Summerscale and are 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 St. James's Place Wealth Management.