Bowie’s two favourite bonds currently – Nationwide and Coventry contingent convertible bonds or Cocos – are also the riskiest investments he has ever owned in the portfolio.
Though the Coco sector is known for being highly volatile, Bowie believes these coupons and the other sterling names he owns will fare well in the rising rate environment and be able to withstand any Brexit-related economic fallout.
Currently, three quarters of Bowie’s £457m corporate bond portfolio is invested in UK assets, spanning global blue-chip companies like insurers Prudential and Aviva, supermarket Sainsbury’s and agribusiness Tate Lyle. This design is “because of Brexit rather than in spite of Brexit”, he explained. The reason being because the UK’s split from the European Union has made the sterling credit curve the cheapest on a spread basis.
In the current rising rate environment, Bowie is gravitating toward bonds that not only have low duration but more importantly have an attractive break-even yield, which is found by dividing the yield of a coupon over its duration.
This is the reason why Nationwide and Coventry stand out as “our two very favourites”, he said. With a yield of 4.69% and a duration of 1.64 years, the Nationwide Coco has a break-even yield of 2.86%.
“That means you can buy the Nationwide bond today and if the yield goes higher by 286bps, that is the point at which you would start losing money. So, it gives you a lot of protection against rising rates, nearly 3% in fact.”
Given that Bowie assumes the Federal Reserve will hike rates at least two to three times, if not more, the Nationwide coupon provides more than enough protection.
However, due to the volatility of the Coco sector, he limits the fund’s exposure to just 5%.
Also, he stresses that not all Cocos are created equal. Part of the appeal of Nationwide and Coventry is that they are very high-quality building societies with extremely high capital ratios. Coventry is “one of the strongest capitalised banks on the planet”, said Bowie, boasting a capital ratio of 31%.
“And because they’re a building society, they only do residential mortgage lending so I don’t get worried by things like Volcker trader risk. They’re not an investment bank so I can sleep at night owning these bonds because although it’s a volatile sector and these bonds have the potential to lose you everything, I only buy the highest quality banks in that sector.”
That said, he likes the investment grade legacy tier 1 bond from Barclays, which has a break-even yield of 153bps. Also on his list of top protection bonds are BBB coupons from Legal & General and America Movil, which have break-even yields of 151bps and 101bps, respectively.
On the flip side, Bowie does not own certain bonds from FTSE 100 names like Rabobank, GlaxoSmithKline and bond proxy British American Tobacco because of their poor break-even yields. The BAT BBB bond with a duration of 7.3 years has a break-even yield of just 29bps, which means the potential to lose money in the current rate environment is high.
The AAA coupon from Wellcome Trust has even less wiggle room with a break-even yield of just 8bps.
