HAPPY NEW YEAR
As we say goodbye to 2022, which turned out to be the most challenging year global markets have encountered for well over a decade we believe that the outlook for corporate credit market seems brighter in 2023. Fundamentals for credit markets are likely to improve this year even though the threat of continuing high interest rates, inflation and perhaps a recession still loom. Default rates in the investment grade public arena are likely to remain low and whilst last year’s market turmoil led to negative returns in most sectors, the widespread sell-off and continued volatility has created some attractive investment opportunities. The last quarter of 2022 thankfully saw the total return performance of all our portfolios turn around appreciably.
Last year most worldwide markets were hit by the continuing global Covid crisis and the Russian war with Ukraine in February, pushing inflation to ever rising levels. Virtually all asset classes suffered with many seeing significant negative performances by the year end. American equity markets were particularly hard hit. For example, the U.S. technology heavy NASDAQ share index has fallen over 34% over the year, but it should be noted that the UK’s Footsie index ended the year at a small premium. Treasury bonds also suffered with yields rising steeply this year. The U.S. 10-year government bond yield shot up from just a 1.5% yield at the start of the year, to a high of 4.24% in October to finish the year at 3.88%. Of note though was the inverted yield curve, which first started to be seen in July, and has now created the steepest Treasury bond yield inversion seen for decades. We could see a strong rebound in Treasury bond yields during 2023. We think the the yield curve will steepen later in the year after initially remaining inverted which means they could post good returns by year end.
Market expectations for the new year are mixed with many investors anticipating inflation starting to ease, as we saw in some countries last month. The effects of Covid are reducing in Western economies, although they seem to be deteriorating in China. Most commentators seem to believe we will unlikely see an end to the Russian war this year.
There is however, a lot of bad news already priced into the fixed income market with some substantial yields available and, in many instances, some large price discounts, allowing for strong capital appreciation over time. We believe that the increase in yields similarly means that bonds are more appealing on a relative basis versus equities.
Looking at companies raising new dollar debt last year, investment grade borrowers found a ready market for their debt, albeit at ever increasing yield levels. By the end of the year issuance numbers were only a little down on the year before. The high yield market itself didn’t fare as well as we saw the slowest annual supply since 2008. Last year the new issue investment grade corporate credit market was fully open, with borrowers able to borrow and investors able to invest.
Despite the Fed’s forceful approach to last year’s tightening financial conditions and increasing inflation, the U.S. economy has remained strong. The recently seen reduction in inflation will hopefully continue, helped the American consumer absorbing the cost-of-living crunch better than thought, and the low unemployment rate. The Ukrainian war disaster is likely to remain a drag on economies with higher energy costs, particularly in Europe.
We now look forward to a better performing corporate fixed income market in 2023. Already, the last quarter of 2022 saw a significant performance upturn for all of our managed credit portfolios beating their benchmarks. Our careful research and robust fund management processes will be once again the key to performance this year. As always, stock selection will be vitally important and the careful mix of sectors creating diversified portfolios will lead to good performance. This year we maintain our positive stance on the U.S. dollar denominated bonds, which served us well in 2022.
Subordinated bank bonds
We continue to believe that the subordinated debt of significantly important global financial entities offer the best risk return this year. This is despite the recent concern with the latest lack of repayments on their call dates. The strength of financial institutions means that, although not repaying their debt on call dates, they continue to pay an increased, floating, yield. A banks switch from fixed coupons to floating rate bonds isn’t all bad for investors. The price of bonds that aren’t called initially tend to slump in value but then likely to recover as many maintain a continuing six-monthly call option which creates a situation that a bond could be called at par at any time. In the meantime investors continue to benefit from an increased income stream.
Amgen makes major acquisition of Horizon Therapeutics
December saw Amgen Inc. agreed to buy Horizon Therapeutics at a valuation of about $27.8bn in what would be Amgen’s biggest-ever acquisition. The US biotechnology giant offered around $116.5 for each Horizon share. The offer price is at a around 20% premium to Horizon’s closing price of $97.29 the day before.
The rating agencies were very quick to downgrade Amgen. Fitch and Moody’s immediately assigned ratings to negative watch, while affirming their ratings at BBB+ and Baa1 respectively. S&P though downgraded the company from A- to BBB+, leaving it on negative outlook. All firms cited Amgen’s increased debt load from buying Horizon for their actions. S&P said Amgen's leverage will now rise to about 4x before declining to about 3.1x to 3.3x two years after deal closes, with ongoing risk that the leverage could remain elevated if Amgen pursues more acquisitions. S&P also said will consider further downgrades if leverage remains greater than 3.3x two years after the deal closes.
NatWest bond repayment
An interesting situation arose when NatWest Group repaid a bond they first launched 30 years ago, a couple of weeks ago. They announced that their £200m 11.5% junior perpetual bond, that was first issued in 1993, will be repaid on the 19th January on the basis of the ‘spens clause’* set out in its trust deed. In fact, only just under £31m remains outstanding as the bank has progressively bought back their issue over the years. The Spens calculation resulted in the bond’s price, which was trading around 160.00 before the announcement, to rise to over 240.00. This situation was prompted by a change in UK banking law - since the start of 2022 this bond no longer counted as regulatory capital therefore it was considered expensive funding.
*The term ‘spens clause’ is used to refer to the specific situation where the borrower can make a repayment calculated using the prevailing gilt yield at the date of early repayment. A spens clause is a protection for investors by requiring the borrower to compensate them at higher price whilst allowing the borrower to repay the bond when needed.
UBS CoCo repayment
At the beginning of last month UBS announced that they were calling their 5% bond on it’s first call date at the end of January this year. The price of the bond leapt higher with this announcement as the market was clearly not expecting the early repayment. Banks usually call their CoCo debt, also known as Additional Tier 1s or AT1s, at the first opportunity and replace it with a new bond, but as interest rates have risen sharply this year, so repaying debt has become a lot more expensive, so more companies chosen not to call their junior subordinated debt. The price of the UBS bond rose overnight from around 96.00 to 100.00.
Trevor Cooper FCISI
Chief Executive Officer
Chief Investment Officer
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