The Weekly Update

The Great British Pound continued its slide last week, falling ~2.4% against the dollar; as Brexit jitters worsen. Sterling has been one of the worst performing currencies against the dollar this year, down around 4% on a total return basis, while the offshore renminbi, which investors seem to shy away from at the hint of volatility is up around 2% in the same timeframe. With the referendum just 3 months away we expect the pound will continue to come under pressure; the Tory split and recent atrocity in Brussels have not helped sentiment.

Another aspect spooking investors is the UK's current account deficit, which as at 2015 sits at 4.74% of GDP (according to IMF data). In absolute terms the most recent data suggests that the UK is projected to have the world’s second largest current account deficit this year, at USD -130.56bn. Using the IMF current account forecasts, our proprietary NFA model, which assumes the UK will remain in the EU, calculates that the country’s net foreign liabilities as a percentage of GDP will exceed 50% by 2020; thus falling to a “2 star” rated country. In our view there are plenty of currencies and sterling denominated assets that offer a better store of value than sterling; at the current time.

Through our portfolio selection process, we use our proprietary Relative Value Model (RVM) to assess the relative “cheapness” of a bond, before we analyse the credit itself, to decide whether the issue offers both an attractive expected return and holds enough “credit cushion” for us to add to our portfolio. The RVM aggregates all spreads available for any credit rating of a given maturity or duration available in today’s market and then compares individual issues against the average of all similar credits of the equivalent rating and duration. Through this process our model highlights anomalies within our investment grade bond universe (which currently consists of over 9,000 bonds); which the market has in effect priced incorrectly.

To show how this works, we have created some charts (on our website) which clearly show just how much some bonds can be mis-priced. An example could be our quasi-sovereign holding in sterling issue Russian Railways (RZD) 7.487% 2031; 100% state-owned monopoly owner and operator of Russia’s rail infrastructure and services. Having rallied over 12 points since mid-January, the bond currently trades at a spread of 560 bps over Gilts, yields 7.5% and has a 2.5 credit notch cushion; remaining very attractive on a risk-adjusted basis. As you can see from the BBB chart, on average, similarly rated bonds (Baa3) with a duration of ~9 years, trade at roughly 330 basis points. This suggests that this bond would need to tighten a further 230 bps to reach “fair value”, or gain around 24 points to match its peers.

If you would like more information on the workings of the RVM and charts, please let me know.

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