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Zombies, opportunities and fixed income

Rebecca Cretney discusses how investors can distinguish between solid companies and the zombies, and changes we have made to our fixed income positions.

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Published 21 August
5 mins

We are now in the third quarter of 2020 and it is very clear that the coronavirus pandemic has led to a marked change in our lives in the short term. And it will undoubtedly have profound long-term ramifications on the way that we do business, the way that we communicate, and the way we consume. 

But at the height of the market turbulence created by COVID-19, opportunity was created. Companies with strong balance sheets and broad business models, able to withstand the coronavirus and its aftermath, were sold alongside ‘lame ducks’ and ‘zombie companies’ – organisations with business models that would have eventually been called into question, at some point, since they largely exist due to the prevalence of cheap credit. However, in the initial flight to cash, everything was sold – good and bad alike.

Since then, headlines have been shouting that the equity market has rebounded, with the S&P 500 back to its previous high, as if the virus and its economic aftermath had never happened. However, if you dig into the detail, it is interesting to examine just how narrow the range of companies that have rebounded is. These companies sit in only a handful of industry sectors, and can be identified based on the differing impact COVID-19 has had on their Q2 2020 corporate earnings numbers – a divergence that seems set to continue according to the forecasts. As such, I have included some graphs for flavour:

EPS estimate graphs

As you can see, there was little to no impact to the earnings of healthcare and information technology, whereas industrials, energy, financials and consumer discretionary were hit for six. The indiscriminate selling brought on by COVID-19 created both risk and opportunity. As the investment managers for your portfolios, we made some high-level changes to our strategy as we divested emerging market debt, and added marginally to our alternative investment allocations. If your portfolio holds equity, we also reduced cyclicality and increased our quality bias. Our equity managers were actively buying in March and April, in particular investing in stocks which they had previously held off buying because they were expensive.

Since April, we have made relatively few changes – not least as our portfolios are designed to be ’all-weather’. This means that we do not have to constantly adjust the composition of our portfolios to reflect a changing macroeconomic environment. And while we have talked extensively about equities – to counteract the hype and excitement reflected in the headlines – most of our portfolios hold varying levels of fixed income, as appropriate to each client’s goals and objectives.

Within the fixed income allocation, we advocate a bias to the US across the board, as yields are comparatively higher versus other developed nations, and the paper is backed by the world’s biggest economy, i.e. by the central bank with the deepest pockets.  Overall, we invest in:

  • Government debt: predominantly US government debt for the reasons I’ve just outlined
  • Investment grade debt (i.e. bonds with a credit rating of BBB and above): this is corporate debt that is also supported by the Federal Reserve (Fed), as well as by other central banks
  • High yield debt:  while there is a wide range of credit available, our investment is towards the higher end of the category’s quality spectrum, and includes some ‘fallen angels’, i.e. bonds that have been downgraded from investment grade to high yield, and which are also supported by the Fed’s bond buying program

It is this last category that is perhaps the most interesting to explore here – not least because of its diversity, but also because it provides a glimpse of the level of detail we go into during our fund selection process.

As we believe that credit default ratios are likely to increase from 2% to 10%, and that the average recovery rate of those defaulting will be 50%, we chose to mitigate this increased risk in four ways:

  1. We follow a very broad diversified approach and invest in hundreds of companies through our bond allocation, thereby spreading the risk
  2. We invest predominantly in the higher quality end of the credit spectrum, having bonds with a short time to maturity (which provides more certainty, as it is easier to ascertain whether a company will be able to meet its debt obligations over the short term than the long term)
  3. We employ specialist active managers, who have been given the responsibility to monitor the underlying holdings and ensure the companies we invest in can continue to meet their financial obligations, as opposed to passive tracking vehicles
  4. We employ the specialist managers that, among other things, have a superb track record in defaults – in avoiding them, that is!

All of these actions on the fixed income front are on top of the diversified investments into alternative closed-end trusts, property and equities, all the while using currency management to further mitigate risk. We follow a conservative approach in everything we do. You have entrusted us with your investments, and we work hard to retain that trust.  

We believe that investing doesn’t have to feel like you’re on a runaway roller coaster that is about to go off its rails at any time. We carefully assess the level of risk you are willing to take alongside your return requirements.  However, if COVID-19 or the headlines have made you want to learn more about our positioning, please call your private banker. They can explain how our strategic investment approach dovetails with the investment plan you have in place, and provide reassurance that the short-term headlines should not end with you missing out on your long-term wealth goals.

Clients of Nedbank Private Wealth can get in touch with their private banker directly to understand how goals-based investing can help, or call +44 (0)1624 645000 to speak to our client services team.

 

If you would like to find out more about how we can help clients manage their investments, please contact us on the same number as above, or complete a form using the links towards the end of the page.

Investments can go down, as well as up, to the extent that you might get back less than the total you originally invested. Exchange rates also impact the value of your investments. Past performance is no guide to future returns. Any individual investment or security mentioned may be included in clients’
portfolios. They are referred to for information only and are not intended as a recommendation, not least as they may not be suitable. You should always seek professional advice before making any investment decisions.

about the author

Rebecca Cretney

Rebecca Cretney

Rebecca joined Nedbank Private Wealth in May 2004 having moved to the Isle of Man from Barcelona to pursue a course in Business Studies with the Isle of Man Business School. Rebecca was appointed to the role of investment counsellor in March 2019 to focus exclusively on the company’s discretionary investment management services.

 

She works closely with our teams of private bankers to provide support in advising our clients with integrity, and to give additional technical investment expertise where more complex portfolio requirements exist.

 

Rebecca is a Chartered Fellow of the Chartered Institute for Securities & Investment and a Chartered Wealth Manager.

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