by Jake Moeller.
Jake Moeller reviews highlights of a meeting with Torcail Stewart, fund manager, Baillie Gifford, on March 24, 2016.
The £30-billion Investment Association (IA) £ Strategic Bond sector is the fastest growing bond sector in the U.K. and contains nearly 70 funds (50% of which have been launched since the global financial crisis). Net flows reached a recent annual peak in 2014 of nearly £8 billion, and despite a more recent slowing of demand the sector remains particularly popular with those investors for whom regular yield is paramount.
Baillie Gifford Corporate Bond Fund is one of the relative elders of the sector, launching in 1999. Previously known as an equity house, Baillie Gifford has built up its bond expertise under the stewardship of Stephen Roger only since the turn of the century. At just over £500 million in aggregate value the fund has perhaps been quietly flying under the radar of many investors. Fund manager Torcail Stewart sees this as an important part of the fund’s value proposition: “We don’t have a large, unwieldy fixed income book across our business,” states Mr. Stewart. “This allows us to take decent-sized positions that reflect our conviction in a particular line of stock or issuer.”
Distortions in the Corporate Bond Market
The ongoing global low-interest-rate environment has led to huge inflows into bond funds. And, with commensurately lower rates of issuance, Baillie Gifford highlights some important concentration risks that are not potentially clear to investors. “The median size of a bond in the corporate bond market is around £350 million,” states Mr. Stewart. “A £10-billion fund, taking an active 2% position in a bond, would require a purchase of £200 million–this isn’t always feasible.” Indeed, for a £25-billion “Leviathan fund” Baillie Gifford has calculated it might contain up to 500 bonds to be fully invested.
The predominance of insurance companies in the corporate bond market presents another opportunity for Baillie Gifford. Being driven by matching liabilities and Solvency II ratings “buckets,” any credit downgrades result in forced selling. Fund managers who recognize change faster than ratings agencies are able to benefit. Baillie Gifford’s high level of active share in its portfolio is underpinned by these two factors –distortions and nimbleness.
Furthermore, Baillie Gifford has a strong track record of protecting existing investors and managing fund capacity prudently. Mr. Stewart believes his fund could continue to maintain meaningful active share up to around £1.5 billion.
Philosophy and Process
Baillie Gifford Corporate Bond Fund is a relatively straightforward fund within the somewhat eclectic IA £ Strategic Bond sector. It seeks to generate returns primarily from best ideas stockpicking, mainly in the BBB-/BB-rated space.
It has a long-term neutral asset allocation benchmark of 70% sterling investment grade and 30% European high yield and can invest globally (although all bonds are hedged back to sterling). Securities are generally selected with a three- to five-year time horizon in place, and consequently the portfolio is characterized by low turnover of around 20%-30% per annum.
Stock selection is underpinned by a “compensation” screen that examines yields relative to long-term default rates. There is thorough financial statement analysis undertaken on all current and potential bonds, but there is a considerable qualitative component in the Baillie Gifford methodology. It seeks “positive milestones,” i.e., long-term sustainability, quality businesses with international exposure, management turnaround stories, and perhaps most significantly, declining leverage. It then assesses how these might impact or improve debt serviceability.
Table 1. Baillie Gifford Corporate Bond Fund – Five year performance within quartiles of IA £ Strat Bond sector (to March 31, 2016 in GBP)
This gives the fund something of an equities feel to it. Considerable importance is placed on company visits and understanding business operations. Mr. Stewart encourages feedback from the Baillie Gifford team of equities analysts to challenge or confirm his investment theses (Mr. Stewart himself is a former equities analyst), and currently there is a 30% overlap of companies in Mr. Stewart’s portfolio with Baillie Gifford equities holdings.
Table 2. Five year risk/return of Baillie Gifford Corporate Bond Fund within IA £Strat Bond sector
The use of derivatives in this portfolio is minimal and used for portfolio construction efficiency, not for example to implement tactical changes in credit beta. The fund will generally match the duration of its index and only has a small margin of variability here. Top-down factors are also considered but mainly to provide context to the corporate operating environment.
This is a highly diversified portfolio across sectors and is currently defensively positioned, with over 40% of the portfolio invested in BBB-rated securities (the sector average is 25%). The largest sector exposure of the fund is to financials, with insurance being the preferred subsector. Mr. Stewart likes Admiral Insurance, RSA, Brit Insurance, and Pension Insurance Corporation (PIC).
PIC is unrated (currently 10% of the portfolio is in unrated securities), but Mr. Stewart feels comfortable with this. “They have an excellent annuity book and may soon get rated,” he says. “Like all unrated securities we apply a conservative internal rating (BB for PIC), and consider only those that are going to be more liquid. It is well worth its 6.5% coupon.”
Table 3. One-year price performance of Pension Insurance Corporation 3 Jul 2024 (to April 6, 2016)
The portfolio currently has around 20% in U.S.-denominated securities, with Mr. Stewart liking Subsea7, Bed Bath & Beyond and Millicom.
Mr. Stewart sees some headwinds to the corporate bond market and is defensively positioned not only with the high BBB-rated exposure but also with around 10% of the fund in short-dated supranationals.
He stresses, however, that the environment is very suited to stockpicking funds such as his. “The Western consumer is still over-levered,” he says. “The growing risk of Chinese deflation will persist for a long time. Rapid credit expansion doesn’t usually end well, but there are some interesting opportunities again in EM bonds. Good companies have sold off with bad–just as they have with oil and gas.”
Despite its overall cautious stance, the fund has 34% in high yield which is an overweight to its neutral asset allocation. This gives the fund some “firepower” should spreads have cause to widen as it can invest up to 50% high yield.
The fund has a compelling performance record, and it has been firmly entrenched in the first and second quartiles of the sector over the last five years (see Table 1. above). It also collected Lipper Fund Awards in 2014 for both the three- and five-year categories (as did its sister fund Baillie Gifford High Yield Bond). The fund currently has a running yield of 5.5%
From a risk/return perspective the fund sits in the northeast quadrant over five years, with slightly higher volatility than its peers (see Table 2. above), but it still maintains an enviable set of Lipper Leader scores, especially in the Preservation category (see Table 4. below).
Table 4. Lipper Leaders scores for Baillie Gifford Corporate Bond Fund (to March 2016)
Baillie Gifford is a unique fund house. It has a trust ownership structure that guarantees its independence and provides for low staff turnover. It has compact but highly collegiate teams, and for a firm that doesn’t have the longer-term pedigree of some of the big-name established bond houses, it is punching far above its weight in this sector.
This material is provided for as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice. The author does not own shares in this investment.