Dan Buchanan: Welcome to the latest in our Aberdeen Standard Investments closed-end fund podcast series, where we catch up with our closed-end portfolio managers and gain some perspective on these complex market conditions. Today we are focusing on the high yield fixed income space with the manager of the Aberdeen Income Credit Strategies Fund, ticker symbol ACP, Ben Pakenham. Welcome, Ben.
Ben Pakenham: Hi, Dan.
Dan Buchanan: Ben thanks for joining us from London. Let's begin with your view on the high yield bond and bank loan markets, and particularly, can you speak to the current economic cycle related to credit markets?
Ben Pakenham: Yeah, absolutely. The view here is that the current environment is basically a supportive one for high yield and leveraged loan market, especially, and this is important that sort of high yielding sections of those markets. The economic growth outlook is impressive, getting revised higher all the time. Nominal growth could get up to 10-11% in the US, it’s obviously a huge number. That's kind of assuming about two and a half percent rates of inflation. Though we think other parts of the world, particularly Europe liking to grow less fast, the rate of change which investors focus more on in absolutes is still very large.
As a result within revenue growth and margin expansion will lead to pretty substantial deleveraging over the next couple of years. This effect will be most notable on those sectors were the worst affected by COVID-19 and subsequent shutdowns and restrictions that we all know too much about. Retail, leisure, transportation, energy, real estate, industrials, these are the areas of the market that we think are likely to be the relative winners, as they have been under the recent months taking -- posting the vaccine announcements which started in early November.
Yeah, the good news as well is that these are kind of the highest yielding areas of the market as they were the most hard hit by the pandemic. Earnings collapse, they had incremental liquidity requirements over and above the more defensive parts of the market. This cause that balance sheets become really stretched, which in turn led to low bond prices obviously, ratings decline.
ACP, as a natural buyer of high yielding securities, gravitated towards those opportunities and has benefited spectacularly in the last six months or so, as we use the crisis to rotate away from more defensive sectors, which are kind of mean healthcare, TMT that kind of thing, and allocate more towards the sectors that I just mentioned.
We think that this dynamic will continue. We think it will continue to lead to compression, meaning that we think lower rated or higher yielding assets will unbalanced continue to outperform higher quality on the lower yielding sections of the high yield market. For those companies that managed to avoid defaulting in the last year, we think they probably made it out of the woods so high probability that they have at this point, certainly for the coming years.
Incidentally, default expectations are rapidly declining. The global default rate is expected to be somewhere in mid to high 3% by the end of the year, which is to compare -- to compare that’s like mid 60s now, and I think peaked at around 7% last year.
Finally, and also, I think, very importantly, as the as the trajectory of economic activity kind of continues, its upward momentum, the market begins to price in higher interest rate expectations. This is obviously very topical at the moment. We've seen implied interest rates move substantially higher this year, especially in the US where the 10 year treasury, for example, has gone from, think about north 0.9% beginning of the year to just north of 1.7% right at this moment in time, we just have another big move this morning, and yesterday of the FOMC meeting, so that's a huge move right in the space of two and a half months of massive moves.
We expect this kind of theme to continue, not to the same extent that it has but we expect the kind of yields to continue rising, government bond yields continue rising. It's important to kind of understand those parts of the market that are most sensitive to interest rates or government bond yields are the highest quality parts of the market because they have less kind of yield or spread to protect them from that underlying government bond move. That's another feature that we really like about sort of single B's and triple C's, which account for the bulk of the fun today. That's a [Inaudible 00:16:08] answered your question Dan, but yeah covered a reasonable amount of ground hopefully.
Dan Buchanan: No, that's very interesting Ben. I mean, you mentioned interest rates, and you mentioned a very low default rate. I'm just curious on how do you assess risk when you're constructing and/or managing a portfolio like ACP, which is very much in the high yield space?
Ben Pakenham: Yeah, again, because of the dividend payout that the fund requires in the kind of yield generation. We are not just in high yield, we're kind of in the generally in the higher yielding end of high yield. The average rating on the fund is kind of single B, maybe B minus on a worst rated basis, which is a good couple of notches lower than the high yield average, so I think that's important to know. Obviously, we yield a substantial amount more than the global index, you know, maybe double the global index, so we are taking more risk.
The biggest risk for this fund is obviously credit risk. We're constantly assessing the highest yielding and therefore most stressed parts of the market, which means by definition, we're exposing ourselves to default risk. I mean, there's no beating around the bush with that. We have to do that to as I said, continue to pay out the dividend without taking too much impairment on the capital side.
In order to generate those yields, the implied default rate on the underlying instruments is pretty significant. Our job, obviously, is to do the credit work, assess the risks, and ultimately buy the bonds that we think over compensating us for those risks. It's important to remember that you may still think a company is quite risky, but just not as risky as the rest of the market thinks it is.
Fortunately, we have a team of great sector analysts across the globe who do a brilliant job of kind of screening the most appropriate candidates for the fund. Then we as the fund managers look to get the best of those candidates into the fund, and there's a huge amount of work clearly in between those two things.
We also use leverage to boost the yield of the funds. This means that we don't need to invest in quite such risky underlying companies as the portfolio yield would imply. The leverage is there to basically get that -- that boosted yield in without having to generate quite such a high yield as the payout might imply. Leverage, of course, does come with its own risks. By investing in higher beta bonds, which generally the highest yielding bonds are, we also expose ourselves to draw downs in market sell offs. We saw that in late 2018, we saw it fairly acutely in March last year.
One of the issues we have with being levered is the need to stay within a certain ratio, debt to assets. That's a requirement on this facility itself. Therefore, as the net asset value of the fund declines, there's a need to repay debt. This can lead to kind of crystallizing losses on bonds that we may not want to sell. We did suffer a little bit from that last year. But ultimately, we'd rather run the funds with more leverage and less risky underlying positions.
Dan Buchanan: Right, thank you. Based on your comments about risk and interest rates and default rates, have you reshaped the portfolio at all in light of this environment?
Ben Pakenham: Yeah, I mean, I think I sort of touched on that briefly in the introduction. But it's pretty simple, really, I mean, we use the sell off last year to rotate the fund into lower rated bonds. We funded that by selling double B’s. We've seen quite substantial increase in the number of triple C’s and non-rated bonds in the fund. We also rotated into more cyclical sectors, and we funded that by selling defensive sector positions, which we think offer little value at this point.
From a sort of geographic perspective, we've also been rotating away from Europe a bit and buying more US and Yen positions, while we think the relative value is slightly improved in those markets, although we still do have a big position in Europe.
Dan Buchanan: Ben, curious to know what the mood is among companies and management that you've been speaking with as of late?
Ben Pakenham: Yeah, broadly positive, I'd say almost unanimously positive. I mean, there's a huge amount of pent up demand, a lot has been written about that. Maybe it won't all be spent, but I think people are keen to get out there again and enjoy life and get on with their lives. That will come with a meaningful amount of spending and savings rates are just incredibly high by historic standards, so that's going to be very interesting and clearly a huge drivers of the expected economic kind of growth that we're predicting, and most people are.
On top of that, there's really easy access to cheap capital that's so important, particularly for levered companies like the ones that we're looking at, the ability to access debt financing, and the ability to get low interest rates on that debt is just really important at sort of reducing the default risk or improving the sort of solvency ratios of those companies has been one of the really huge factors in why default rates have been so low in the last kind of decade plus loss factor is capital and that capital is very cheap, which means affordability is good to these companies.
Then, really importantly, again, supportive sponsors, so equity investors, both public and private have been really keen to provide capital often in the form of equity capital. They're just -- owners don't want to give up assets, and they've seen to be good assets, that have come under immense pressure on what they think is, and there's likely to be a temporary basis. If you need to put in more equity to protect their investment, then that's the right thing to do, and we've seen that. We've seen a lot of very bondholder friendly activity.
Yeah, and kind of going back to beginning of the question, I think that the feeling of real optimism about the future as the vaccines get rolled out, restrictions get eased, and hopefully before too long ago we go back to much more normal environment.
Dan Buchanan: We're all looking forward to that Ben. Let me switch gears for a moment. The Aberdeen Income Credit Strategies Fund ACP is a closed-end fund. From your perspective, how does the closed-end fund structure the vehicle itself help you to effectively manage a portfolio of high yield bonds?
Ben Pakenham: Yeah, so this -- I mean, they’re two different animals, open-ended and closed-ended. Most of the funds are managed, most of the assets are managed, or an open-ended vehicles. Clearly, what we saw in the dark days of March last year was just huge outflows from risk assets in general, and of course, high yield was caught up in that. You're having to hit pretty low prices on bonds to fund those outflows, and it was an intense period for investors.
The beauty of being in a closed-fund is you're not subject to that dynamic, you're not seeing outflows from the funds, you're not forced to fund outflows and crystallized losses. However, I did just mention the leverage on the fund, and the fact that that does can create a similar dynamic, because you're still subject to covenants. Those covenants are a function of the asset value of the fund. The asset value falls within -- in order to sort of stay within those covenants, you do need to pay down some of the debt facility, and we did have to do that last year.
Ultimately, it was not as bad as financing 35, 40, 50% outflow which did happen in some high yield market and some high yield funds, not ours, but in the market. It's not nearly as bad as that, but it doesn't, -- the leverage doesn’t completely protect you from being forced sellers, and I think weak markets.
Overtly, though, as I've touched on, we think we've got the right balance between the leverage and the underlying investment. Ultimately, you've got a choice, right, you can either have -- if you're paying out 10%, you can either have a portfolio full of bonds that yield 10%, or you can have, which, that would be a pretty risky portfolio where you can have a portfolio that yields than that so less risky underlying investments but with the leverage, we think that the latter is the safer way to play.
Dan Buchanan: Right. Finally, Ben, what would you say to clients today that give them comfort that they should invest in high yield bonds?
Ben Pakenham: Yeah, I mean, I think that the same -- I’d sort of go back to what I said, about the mood of companies, I mean it's very similar. We think it's a good time to invest in higher yielding high yield market. The economic environment is such that we think there's going to be substantial deleveraging. We think earnings are going to improve, we think the monetary and fiscal tailwinds of markets that we enjoy will continue and remain to be there for markets. Although there's a bit of concern in the short term about inflation expectations and government bond yields, we actually see that as being broadly healthy.
Government bond yields are increasing because economic activity is increasing and much rather have it that way around than stuck in a low yield environment forever. If you're worried about that, then stay away from the lowest yielding parts of the market which are going to be most exposed to the higher government bond yields. This fund is far away from that to get pretty much. You've got a lot of buffer there to kind of cushion any increases in government bond yield. Yeah, it's looking pretty good for the companies that we’re invested in and I think it's an attractive proposition [Inaudible 00:26:41]
Dan Buchanan: Well thank you Ben, for your insights today, and thank you to our listeners for tuning in. You can find out more about the fund at www.aberdeenacp.com. I am Dan Buchanan with Aberdeen Standard Investments. Do look out for future episodes.
