Investment Strategy - High Income Bonds

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1 Client Topic Source Date : GAM : Keeping an eye on corporate subordinated debt; Beating low interest rates : The Asset : March Issue Based on investment-grade companies, high income bond investing allows investors to generate high returns by using floating rate notes without the accompanying risk that comes with investing in high-yield junk bonds. Bond investors today have to remain content with low-yield returns in the prevailing low interest rate environment. But GAM s external fund manager, Atlanticomnium, a boutique fixed-income manager based in Geneva, is not settling for this. It has found an investment strategy known as high income bond, which allows the generation of equity-like returns on investment-grade bonds. Whereas investing in high-yield bonds involves junk bonds, investing in high-income bonds does not. Atlanticomnium is a specialist credit house that is a family-run fund management business. The firm was founded by Richard Smouha in Son Anthony, equally a veteran fixed-income manager, joined the firm in Jeremy, another son, joined the firm in 2012 to launch the business in London. The success of its investment strategy is underlined by the fact that Atlanticomnium manages US$500 million in funds for GAM, a leading global investment manager. The relationship with GAM goes back a long way, since Jeremy was one of its founding members. He joined GAM in 1983 before moving on to pursue a career as a bond fund manager. Atlanticomnium currently has a total of US$700 million is assets under management. In an interview with The Asset, Jeremy explains that the firm invests in subordinated debt (also known as junior debt) of investment-grade companies. Unlike a corporate senior debt, subordinated debt is considered a higher credit risk in terms of capital structure and thus has lower payment priority should the issuer of the debt/bond defaults. (See table.) We buy the junior debt of a good-quality company because the incidence of default for any company is the same for both its senior or junior debt. So if a company doesn t default, investing in the junior debt pays a higher income for the same default rate. But we have to make sure that we invest in a company which is not going to default. The incidence of default in investment grade companies is very, very low, Jeremy explains, citing data which show that the cumulative default rate for investment-grade corporates averages just over 1% the

2 past five years. Because of the crisis, there are many investment-grade European companies with global franchises that have subordinated debt and are still earning 6% - 7%. This is what we are aiming for now, he emphasizes. The high-income bond investment strategy rests on the premise that interest rates in the bond market, which are currently at historic lows, have already bottomed out and can drop no further. We know the short-term rates are being kept low and we know that at some time in the future, interest rates are going to have to rise, although we don t know exactly when. So at the moment, we are preparing ourselves for when interest rates at the longer end of the curve will go up, Jeremy adds. Buying in down markets In terms of opportunities, the strategy works best in a market environment where there is an existing financial crisis similar to the one currently in Europe or the one in Asia during the Asian financial crisis. In 1998, the best place to invest was in Asia and we did quite a lot of investing in high-quality Asian companies. There were excellent Asian companies that we knew would not go into default but the crisis brought [the market] down and we have the same thing in Europe right now, he says. Atlanticomnium currently has 30% - 40% of its GAM strategies invested in subordinated floating-rate notes of investment-grade companies while the balance is invested in fixed floaters bonds whose yields are fixed for the first five years and become floating rate notes afterwards. We have about 20% of our portfolio invested in discounted floating-rate notes. And these discounted floating-rate notes were issued at, say, Libor plus a quarter at a time when interest rates were very high, so it was attractive. With interest rates so low now, however, no one is interested in Libor plus a quarter. So we have a situation where the discounted floating-rate bonds can make a capital gain when the interest rate goes up, he notes. This means that the price of these floating-rate notes has dropped to between 50% - 60% of par, the holder of these notes still earns double Libor at weighting, plus there is an opportunity for substantial capital gains when interest rates go up. 2

3 Favourable outlook 2012 was an excellent year for credit, according to Jeremy. There was a strong policy response by major central banks to the tail risks of a recession in the US or a break-up of the Euro-zone. As a result, there was consistently strong demand for our securities in the secondary market and the possibility for a wider range of financial borrowers to issue subordinated debt on good terms. The outlook for 2013 remains favourable. Mainstream bonds and even many so called high yield bonds now provide low absolute returns. Yet our carefully selected financials and other issues continue to provide much higher yields. Also, our deeply discounted floating rate notes, which are now much in demand, still trade at between 40% and 65% and have some way to go to reach mid-2011 price levels. The fund now yields 6.7% including these lower-yielding floating rate notes. 3

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