Adventurous Investor

October 5, 2012 6:36 pm

Thinking outside the bond box

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Contrarian calls on banks and southern Europe
David Stevenson

What will happen when the great sovereign bond bubble comes to an end? This is just the sort of question that keeps investment anoraks like me awake at night.

Most investors know deep down that the emperor has no clothes, and that lending to profligate governments for nugatory returns is not much of an investment strategy. Yet prices continue to head upwards and yields downwards.

Conventional wisdom has it that once the scales fall from our eyes, we’ll all flood into equities. But returns from those have hardly been brilliant either, and many investors can’t do without an income producing fixed-interest component to their portfolios.

What will they do once bond prices start to fall?

One option is to consider a hedge fund such as BH Credit Catalysts (ticker BHCU) that specialises in fixed income. But I find myself drawn more to those bond investors who operate a very disciplined mandate, seeking out what they think are cheap corporate bonds in the hope that when the economic recovery comes, prices will soar. These are the bond equivalent of special situations funds.

Banking on a recovery

Another thing that makes Doran’s fund interesting is its stance on banks; his second-biggest position consists of bonds issued by French bank BNP Paribas. Many managers avoid this sector like the plague, fearing that there’s much more bad news to come.

But what if there isn’t? If you think that Europe’s battered banks will one day rally, it might be worth your while looking at two unusual covered warrants from Société Générale with the tickers LC09 and LC10. They both track the EuroStoxx Banks index, which includes only the big eurozone banks. As you can imagine, this sector is volatile, shooting up and down as confidence in Europe and its banks ebbs and flows.

Traditional covered warrants offer geared upside to an underlying stock or index over a relatively short period – typically no more than a year. These SG products offer geared upside right through to December 2015. Surely they’ll have fixed the eurozone by then! You’ll need the time on your side because LC09 is only “in the money” if the index hits 150 and LC10 when it hits 200. It currently stands at 95.

These are geared instruments and not for widows and orphans. They will only ever make you money if the underlying shares increase in value, while those call index levels tell you that you’ll only make really large, geared returns if the European banking sector index rallies hard – for LC10 it’ll have to double. But if they do, you’ll double or even treble your returns.

The downside is that in the meantime, prices will be volatile and that if the index doesn’t make it above those levels, they could expire worthless. But a decent bounce isn’t inconceivable; the Eurostoxx bank index hit a high of 220 back in mid-October 2009, for instance. A repeat of that would imply a big profit on LC10 in particular.

Brown Shipley’s IFDS Sterling Bond Fund, a unit trust managed by Kevin Doran, is just such an instrument and it has caught my eye because of two particularly adventurous strategies.

The first is that Doran is a long-time fan of Pibs (permanent interest bearing securities) from building societies such as the Coventry and Nationwide.

He thinks the fears about these hybrid securities being called or abandoned are overdone, while after a period of restructuring (including several big mergers) the balance sheets of these mutuals look pretty solid. Yet the Pibs are in many cases priced for distress.

Doran’s other big investment bet is that he believes that the corporate bonds of many leading southern European utilities are also mispriced.

He’s been quietly buying big chunks of bonds in Portuguese utility EDP, as well as Spain’s Iberdrola and Italy’s Enel. He thinks bond investors are underestimating their defensive potential.

Many of these utilities have internationally diversified portfolios of assets.

Take EDP. More than half of its profits before tax and depreciation come from outside Portugal and it has big renewable assets all around the world.

If there is still financial distress to come, the equities will bear the brunt of it. So when Telefónica cut its dividend, Doran applauded because that meant the stream of coupons from its bonds became even more secure.

Obviously if the eurozone implodes, all bets are off, but in my opinion that’s not very likely.

This fund is risky by fixed-income standards, though; Doran focuses on a small number of big ideas, with a “super seven” of holdings accounting for just under 30 per cent of all assets.

By buying what he thinks are mispriced high-quality assets, Doran hopes he’ll preserve the value of his capital even if interest rates start to rise. In the meantime, you get the benefit of yield, with the fund generating just over 6 per cent.

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