Kames' Stephen Snowden: no bubble in bonds

Richard Troue | Thu 15 October 2015

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Speculation over when interest rates might rise and the impact this could have on bond markets has been rife in recent years. We recently caught up with Stephen Snowden, manager of the Kames Investment Grade Bond Fund, to discuss his views.

Summary

• Stephen Snowden currently holds a more positive view than many bond fund managers, noting that in an environment of low interest rates and low inflation corporate bonds could deliver relatively attractive returns.
• The bulk of these returns are likely to come from income, with Stephen Snowden not expecting significant capital gains.
• He has positioned the fund differently to many peers and this could cause performance to deviate, positively or negatively. Collateralised bonds, which are typically secured against a company's assets and offer a higher yield than conventional bonds, account for around 20% of the portfolio.
• Over the past year the fund has grown in value by 4.1%*, compared with 2.5% for the average fund in the IA £ Corporate Bond sector. It currently yields 3.45% (variable and not guaranteed). Past performance is not a guide to the future.
• We remain happy with the fund's position on the Wealth 150, believing Stephen Snowden could deliver attractive long-term returns.

Past performance is not a guide to future returns. Source: Lipper IM* to 01/10/2015.

HL view

We hold a more cautious view than Stephen Snowden. As corporate bond yields have fallen (and prices risen) in recent years we have arrived at a point where investors are receiving less reward (in the form of income payments) for assuming the risk of interest rates rising or companies defaulting on their debts (see chart below). That said, we are in an unusual environment where interest rates are likely to be lower for longer and if economic growth remains moderate and inflation subdued, bonds could continue to perform well.

We believe Stephen Snowden is a talented bond-fund manager who has the potential to deliver good long-term returns. We currently view the fund as a higher risk option in the sector which could underperform during a tough period for bond markets. It could be considered by those who share Stephen Snowden's views, or as part of a wider portfolio in conjunction with more defensively-managed bond funds.

The chart shows the extent to which UK government bond yields and corporate bond yields have fallen in recent years. Corporate bond yields in particular have fallen significantly since the financial crisis.

Source: HL 01/10/2015

The big picture

With interest rates so low bond yields have appeared attractive, fuelling their popularity. When rates rise (or are expected to rise) the fixed income offered by bonds looks less attractive in comparison so prices fall. After such a strong run of performance and with the expectation interest rates could soon rise the fear is that many investors could sell their bonds at this point, exacerbating falling prices.

Stephen Snowdon does not subscribe to this view, suggesting investors and commentators have been consistently too negative on bonds. He admits bonds can no longer be considered 'cheap', but suggests they have been out of favour with retail investors for a long time so there should not be huge selling pressure when interest rates rise. Any sell-off is also likely to be met with purchases from institutional investors, such as pension funds, which need to keep a certain proportion of their assets invested in bonds.

A surprise interest rate rise, or rates increasing at a faster pace than expected, would be a risk and could prove this view wrong. However, Stephen Snowden does not believe economic growth will be as robust as expected and does not see inflation as a problem, meaning interest rates and yields are likely to remain lower.

Portfolio positioning

The fund currently yields 3.45% (variable and not guaranteed) and Stephen Snowdon estimates its duration (the sensitivity of the portfolio to interest rate movements) is slightly lower than the average fund in his peer group. This means the fund could fall relatively less than peers if interest rates rise, although there are no guarantees.

At present Stephen Snowdon has approximately 20% of the portfolio invested in 'collateralised' bonds, which offer higher yields than traditional bonds. These are bonds secured against certain assets (such as property – the 'collateral') and if the company cannot meet its obligations to bond holders the assets could be sold to recover some value. He has invested in bonds issued by the MOD (secured on housing), Unite (secured on student accommodation), the National Grid, Heathrow airport, the BBC, and bonds secured against property owned by Tesco and Sainsbury.

Bonds issued by banks account for a large proportion of the market, but Stephen Snowdon has been happy to have less exposure, favouring bonds issued by insurance companies. He has also had less exposure to telecoms and utilities bonds, but admits they are looking better value now so some exposure could be added in future. There is also approximately 9% invested in high-yield bonds, which are issued by companies perceived to be less creditworthy. They offer a higher yield to compensate, but are also higher risk. The fund also has the flexibility to use derivatives which if used adds risk.

Sector breakdown

Source: Kames Capital as at 31/08/2015

HL analysis

Stephen Snowden has delivered good long-term returns for investors. He performed well in the run up to the financial crisis (when he managed a similar fund for Old Mutual), but was hit hard when the crisis struck as some of his investments in higher risk bonds fell sharply in price. He has since performed well again and we have been pleased with the results to date on the Kames Investment Grade Bond Fund, which he took over in September 2011.

Over this period good bond selection has driven performance, according to our analysis. The fund has grown in value by 34.2% compared with 24.2% for the average fund in the IA £ Corporate Bond Sector, while it has also been marginally less volatile. On average the fund has tended to lag in months when the bond market has risen, but fall less in months when the market was down. There are no guarantees this will continue and past performance is not a guide to the future.

Performance under Stephen Snowden's tenure

Source: Lipper IM to 01/10/2015

Past performance is not a guide to future returns. Source: Lipper IM* to 01/10/2015.

Stephen Snowden has been less negative on the outlook for bonds than many other manager in the sector and has positioned his fund accordingly. Should his views prove correct and the environment for bonds remains benign it could go on to perform well, but there is the potential for the fund to underperform if he is wrong.

Please note the fund's charges can be taken from capital, which can increase the yield but reduce the potential for capital growth.

Find out more about this fund

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