Philip Matthews, manager of the TB Wise Multi-Asset Income fund, has positioned the portfolio’s fixed income holdings into defensive assets such as asset-backed securities (ABS) and senior loans, to hedge against rising inflation.
Faced with the problem of trying to generate an attractive level of income that can, at the same time, provide an element of inflation protection should interest rates move higher, Matthews said he has chosen to diversify the portfolio in a more defensive direction.
“With yields on government bonds remaining low and real yields negative, investors still appear to be relying on inflation proving to be transitory to justify current yields,” he said.
Rather than investing into corporate credit, Matthews believes the yields on offer within ABS and senior loans are higher than corporate bonds of a similar risk.
Greater inflation protection
“This should provide an extra level of cushion if the cyclical headwind of higher inflation and tighter monetary policy prove greater than expected,” he said. “In addition, both asset-backed securities and senior loans are better protected against inflation.
“The coupons payable to investors are floating rate in nature, meaning the yield on the bond moves up as interest rates rise, providing some indirect protection against rising inflation.”
As way of example, the fund recently increased its exposure in the TwentyFour Income fund, an investment trust, managed by a team that specialises in investing across the spectrum of higher-yielding ABS such as mortgages, credit card debt, senior secured corporate loans and auto loans.
“The quality of the credit work from the team at TwentyFour gives us confidence the portfolio is well protected on the downside should default rates rise, whilst the fact that ABS use floating rather than fixed rates offers a hedge against rising rates if the reflationary environment proves more than transitory,” he said.
Fixed income more balanced
Matthews added the fund’s other fixed income holdings, such as GCP Infrastructure and Starwood European Real Estate, also have an element of floating rate exposure.
“Furthermore, GCP Infrastructure should see improving credit fundamentals as many of the underlying borrowers benefit from rising power prices, one of the causes of the recent spike in inflation,” he said.
“Similarly, a return to normal activity should improve the earnings outlook for the borrowers at Starwood, in particular the hospitality sector (hotels) which represent circa 40% of the loan book,” he added. “The loans are strongly asset-backed with a modest loan to value of 62%, providing significant downside protection.”
In both cases, as inflationary fears perhaps are reaching a crescendo, the fund has topped up its holdings in both trusts as Matthews said the risk-reward outlook for investors in fixed income starts to look a little more balanced.
“On the one hand, if current inflation feeds through into higher wage settlements, this will force central bankers to be more aggressive in raising rates,” he argued.
“Equally, inflation expectations are now no longer surprising on the upside and any shock to global growth forecasts from events, such as Ukraine or a new variant of covid, would most likely see bond yields to reverse some of their recent strength.”