Interview with Rhys Davies from INVESCO Bond Income Trust

Hi James, thank you very much for doing this. It's interesting that we don't talk about enough debt plans. I think it's a big part of the market anyway. I think for a long time people probably just threw away their funds because everything was going away. in its own way, but I think there's an opportunity now and it's quite timely that we can talk to you and find out more about what Investigation Plus is doing, as usual, do you want to start off with um conversations a little bit? about the fund and how you are going to manage it, please, sure, yes, yes, thank you very much for inviting me to the program, yes, investco Bond Income Plus or bips, which is the symbol of the stock market, is an investment focused on

income

.

Trust, so it predominantly invests in the high-yield

bond

market. So my background is as a credit analyst, which is the

bond

equivalent of an equity analyst and my focus has always been on the high yield bond market, for some time now, higher bonds. I haven't really been offering high yields, but today it's a totally different story and there are certainly a lot of high yield bonds available, so if that's the case, it's a very exciting time for me to be able to talk about such a high bond market. and bibs um bips itself is a £320m investment

trust

.

It's where I can invest in higher bonds, but I can really make full use of the investment

trust

structure, which I think suits the high bond market very well. um uh, the dividend yield today uh, if I start, there's about seven percent based on today's share price. um, the trust is actually earning more than that, um, but that's based on paying a dividend of 11 and a half pence. That dividend was recently announced by the board as an increase actually uh and you should think about that as it is based on what we believe the current portfolio can achieve in the next two or three years uh and the board of directors of the trust are very interested in that we don't increase the dividend and then cut it again in a year's time and the idea has always been for bips and the predecessor trust which merged to create bips last year.

It's always been a very clear message to shareholders in terms of what to expect from dividends. um so it used to be 11p which is 11 and a halfp and obviously with that people can very easily calculate what dividend yield they can earn based on the current share price. So currently paying seven percent, as I say, we're earning pips is earning a lot more than that and of course that extra

income

will be held in trust and reinvested and obviously you'll see that in the net asset value, another Which is why I'm really excited. markets right now and beeps um is the potential for capital gains in the bond markets from this point on in addition to a good level of income and that's really very simple because bonds are a contractual obligation of a company or government, but we focus on the issuance of bonds by companies, so they must be redeemed at a price of 100 uh at maturity, that is the typical redemption price for a fund for the vast majority, it is a contractual obligation, and with an average price in the portfolio today of around 86 because we've had this wild revaluation of the bond markets this year and excuse me, an average maturity of around five years.

You can add what we call the pull to the part so that the capital increases as the bonds retreat from the average price of 86. today to 100 in the five years, you can add that uh pull to par um that yields to the income and you get a pretty attractive all-in yield uh today specifically for bips um the funds current gross redemption yield is around 9.6 um No I don't know how familiar listeners are with bonds, but each gross redemption yield can be Sounds complicated itself if you're not a bond person, but essentially the gross surrender yield is just the total yield, so you add in, uh, the interest portion. plus the capital appreciation part, if it's there, which it certainly is at this point, as a bond returns to par over time, so, as I say, that's about 9.6 today in the portfolio and then the final part of the puzzle to get excited about. bips specifically, so I managed three funds, but bits is the investment trust that I manage because it's an investment trust, it's a closed-end fund, obviously, I can use leverage or the borrowing has to be done carefully, of course, and today They are around of 20 net asset value, so, yes, I'm sure everyone appreciates how this works, but that increases the size of the portfolio by 20 and of course that means it amplifies the 9.6 return of the portfolio by another 20, so that gives us a more double-digit yield profile, so I know it's a good time for me to be able to talk about the bond market higher and the bips, because there is a lot more yield available today, having That being said, I can't just uh, yeah, I shouldn't just sit here and wax lyrical and ignore the challenges that await us over the next year.

There are many macroeconomic issues to worry about. Everyone is aware that we have a cost of living. Create mortgage prices. rates have skyrocketed, an energy crisis underway, inflation remains high, none of which is good for consumers and for economic growth and certainly for high yield bonds, that's something we still need to worry about over the next few quarters, but we can manage the fund with that in mind, you know, some of the Mystic

interview

s that we hold are a very diversified portfolio, so we have bonds from over 180 different companies within the trust, we have a team of very experienced credit analysts which was my background before we became a fund manager and our job as a team will be to navigate the portfolio through a more challenging economic environment in the future and really the good news today is that we can get very good income right now without having to do it. venturing into the riskier parts of the premium bond market, um, and if your listeners are familiar with the race, the rating agencies, um, and they are, broadly speaking, talking about the Triple-rated portion of the premium bond market.

C, which is the part of the market that worries me most for next year, generally speaking, and perhaps to give an example, give a very good example, actually, of a recent purchase of a bond from a company with the which people will be familiar with, but It's in the very low, low credit risk category, so it will continue to pay Bips an attractive return for the next 10 years, thanks James, it's not actually in the presentation, but I'll talk about these bonuses right now. um uh uh centric bonds um three or four weeks ago during the pension fund terminal uh the early terminal I in the UK was able to buy central centric bonds um with a coupon of seven percent, so these are bonds rated investment grade, but they were issued in September 2008, so during the financial crisis, when the market was really demanding a high coupon level of seven percent, you know, for a company like this, obviously, for the next decade with yields falling to the levels they fell until the price of that bond increased dramatically to around 160.

That meant the yield went down about one and a half percent and then a few weeks ago, obviously this has been a bad year for bonds, so those bonds are trading down, then we had some forced selling and most likely we were buying these bonds from a forced seller in that market and picking up those bonds at a price of a hundred, so we went through from 160 in 2021 to 100 and 10 years old. It remains to maturity paying seven percent interest each year, um, that's not even a high yield bond, it's an investment grade bond and I can buy it piecemeal and feel very comfortable that it would pay our shareholders that they contracted and, again, that's very important, it's very different.

To do that, it then contracted seven percent every year for the next decade, and that example is before I've even ventured into the world of high-yield bonds, where you have to think more about the credit risks of the company. . uh your bonds are buying so yeah I think there are still a lot of challenges ahead for economies but for income investors today there is the potential to put together a really good portfolio that is designed to overcome those challenges okay , so I actually called. this side is a little early, maybe um, but this is an example of what you're really saying about the price, yes, it is, yes, I mean, we've put three examples here that I've been talking about recently. uh all the bonds that we've purchased recently um and uh yeah so let me talk about them so on the left side these are what we call primary issuances primary purchases as well as on the new bonds that were issued in market, but the top left is very safe, very safe, a Swiss alarm and security company issued a bond in October with a five-year maturity until October 27 and had to pay a coupon of nine and a quarter per hundred. uh the second bond there, uh, we call it the called bond, so this is what they were refinancing, um, which only had a three and a half percent coupon in 2021, they had come to the market and issued a bond with a coupon of only three and a quarter percent for a six-year maturity, so you can see how to go from issuing a bond at three and a quarter percent on 21 to October of this year, yes, and the company does not looks dramatically different, but but the market is dramatically different and the market is demanding nine and a quarter percent compensation and you know that's a really attractive prospect because if a company can pay that much higher level of interest on its debt.

They're great, we can buy them, we can put them in portfolios and we can feel very comfortable, and really all that's happening there is we're seeing creditors, so it's a bonus. Investors, we are creditors, we are lenders. for these companies, suddenly we're getting the profit, the value, from these companies instead of the previous shareholders, and in this case, it's private equity, so it's cool to see that kind of change from the investment side. capital. next to the creditors um and this year we have seen very, very limited new issuance, as expected, this is very typical when the market is volatile and weak um very limited new issuance, but when we have seen new issuance um the coupons that are broadcast are dramatically different.

In the second example, there is Deutsche Bank. They issued a bond with an even higher custodian of 10 percent. And again, it's very good news to get income like that into the trust and certainly Deutsche Bank has had problems. in recent years, but the bank has taken many positive steps since then, on the primary side, and this is a 23 to 24 story, as companies start issuing bonds in the future, we expect to pay much higher coupons and that is going to be very good news for bond investors looking for income. At the same time, you know, we're not just waiting for that to happen.

It seems that the new bonds that will be issued this year are very, very limited. On the secondary market. Yes, there really are some. interesting opportunities at the moment so I've included on the right side of this slide an Asda bond um this is their senior secured bond um so they also have junior bonds that were issued in um uh 2021 uh over a very good period. moment in the market, uh, and then the market at that moment said, "Okay, we'll do it, we'll lend to you at four and jumps and coupons for five years subsequently, we've gone through this huge revaluation, you know, of high yields, um , uh across the board.” uh and then the price of that Bond fell from its issue price of 100 to um the price we bought some that I have included here of 77 and uh 0.75 so call it 78. um so so Fallen uh 22 points um meaning you know, for when we get back to 2026 as long as Asda hasn't gone bust and we don't think they will as they will have to pay us back 100 in February 2026 and that's 22 points ahead of where we bought.

Meanwhile, we will also earn during those three and a half years the four and a half percent coupon, so that's four and a half points. Multiplied by three and a half to give you another 15.75 coupon points. Add that in with the capital gain as we've taken it to par um and you're looking at a total return profile close to 50 percent for that bond over the next three and a half years and you would actually expect to get um as well. get to that point sooner than three and a half years because companies typically refinance a bond about a year before the actual maturity, so as long as we've extended the credit, as long as we understand the risks with Asda, then yes. that that's a fantastic performance profile for us to invest in um and it actually compares pretty well to what you can get from stocks, um, thekey difference is that you are contractually, um, obligated, um, and I think so, yes, please, will you?

Have I ever bought floating rate there or is all of this interest fixed most of this portfolio is fixed rate um we are not uh we don't invest in leveraged loans Leveraged loans are typically floating rate uh they are always floating rate there are floating rate bonds of interest that exist, um, they are a relatively small part of our market, um, and they often don't behave in the way that you would expect them to, I mean, they do, you can eliminate the element of rate sensitivity interest that is. Great, but they don't just sit there at a par price, there's still the credit risk component, which has to be priced in, which is why a lot of floating rate bonds have been priced over the years, over the years. years, for the benefit of the issuer.

So they're getting because people, uh, investors. They're worried about the powerful job worried about the possible rate increase, the issuer said okay, but we'll pay you a little less in the overall coupon at the beginning, so They haven't necessarily stacked up well compared to your fixed bonus. equivalent fixed rate bond um and then as I say you know credit risk still matters uh and it's been repriced so a lot of floating rate votes are still trading um below par I mean there's other tools we can use if we are concerned about rate sensitivity and that's what we did earlier this year, so keeping rate sensitivity in the portfolio low, which is what we had earlier this year, That means you already know. people from our holdings in short-term bonds that have shorter duration, avoiding bonds, many of the bonds that have been issued in recent years with very low coupons and the factors that influence rate sensitivity during a The bond It's not just the time to maturity, it's also the coupon, so a low coupon also increases that rate sensitivity, so for us, we haven't been particularly enamored with the yield levels that have been offered. in the market for a number of years and certainly at the end of last year, after a very strong rally that came out of February, March of 2020, at the end of last year we felt that the returns were generally quite low, so the portfolio reflected that we had liquidity, we had a shorter duration, uh, short, which means less sensitivity to rates and a more cautious profile, uh, in terms of credit quality, um, obviously, there is leverage in the portfolio, so when I'm when the market falls, that offsets and amplifies the impact of market declines, but I'm actually quite happy that, given the leverage that we have, we have managed, for most of the year, to be ahead of the index in Europe , and we will, and very recently, It's very close in terms of performance.

Obviously what we have now is that we have a portfolio that has leverage and that leverage will help us on the positive side and get back to that point that separated us. Sure, do you really measure what the duration of book value is? It is something that is actually a kind of Objective. Yes, we measure it to be around 3.5, so it's a modified duration figure. So, going back to that point I mentioned about the average portfolio maturity is five um, but because the coupons are a little bit higher, you end up with a modified duration of 3.5 and the modified duration just means, In theory, if a bond or a portfolio bond is in a market. where the yields rise by one percent and then the price falls by 3.5 percent, so it's as simple as that, it gives us a rough idea.

It never works exactly like that, but it gives us a rough idea of ​​what it is. the price sensitivity, sorry, the sensitivity of the portfolio in terms of price is to a change in returns, they say it's controversial and then this business sector should be really concerned about what is the navigation return or Danny's number V, or should they Look at the total return of the overseas portfolio, yeah, I mean, I would always say look at the total return of this portfolio, and that's because you know we've had a period of low returns and So The priority has been to achieve a decent level of income and it has been difficult to obtain capital gains.

On top of that, obviously bond yields are rising in price and that has been reflected in the portfolio. over the last decade and more recently, um uh, it's a lot harder, yeah, and the lower the returns, the less upside there is today, yeah, it's like I say, it's a great position, it's a great starting point. I've been through a pretty horrendous, um, wild, uh, bond market this year, so yeah, I mean, we look at the total. We would say, please look at the total performance, uh in the browser, uh, for this month. Fair enough, now, this is a bearable photo.

By credit rating, how many types of green do you give to third party credit ratings? um and the market will have figured things out long before the credit rating agencies move forward with credit or rating. I mean, they certainly give you a very good idea to talk in general terms about what the credit risks are. a double b rated company, we know it's a good quality company and it won't be, it won't be, you know, in our opinion, something that should have a single b or triple C week rating, but we have ours. I know that we have our own team of analysts, as I say, that is my experience, and really for us it is very upward, it is meeting with companies, listening to them present every quarter, ideally if the majority of companies in the domestic market do it, they report quarterly basis. uh so reviewing your financials really focusing on the cash flow statement, that's incredibly important for us as bond investors because we're concerned about the coupon, getting the coupons and getting paid.

We're less concerned with the story, which is uh, you. I know it's more important to an equity investor simply because we get the interest, we get our money back, but we don't share in the upside the way shareholders do if a company does very well. In fact, we'd prefer slightly more boring companies that don't have big growth plans, in a way, because it means we have more certainty about what their financials will be like. Airport so it's a very granular bottom up approach meeting with companies uh um looking at their results every quarter um and then and thinking about the company thinking about their sector thinking about the challenges that they face in trying to do a credit opinion so what are they? credit risks? what are the risks? um for me as a creditor and then uh contrasting that with where their bonds are trading and we think that's enough yield uh or not enough yield uh uh you know, you know it's a bond that offers a lot of yield um for those credits risks uh and then that will dictate if we want to add sell hold a particular bonus, so you said it's kind of like 20 gears on the phone, what kind of what are you paying for that and make us look at the structure of Well, it was free and at one point I they were paying, they were actually paying us to borrow money, so that's a great position, I mean, that helps when the returns are very low, because obviously, the borrowing.

The cost and returns we can invest in are very closely linked today we are around two percent on average and we borrow through repos. It's not as complicated as it seems, it simply means taking a bonus. the wallet, go to one of our four bank accounts and get a quote in terms of how much they would charge us to hold it as collateral against a loan from them over a three month period, pick the cheapest one, and then sure enough the bank can keep the bond as collateral, but we receive all the benefits, so we receive the coupons, you know, the benefit of the bond going up in price, you know, it's just a loan from the bank. using bond principal as collateral now this slide answers one of the questions here about how many holdings you have, so it's actually quite a bit, I mean it's a very diversified portfolio, what was the reason behind that?

Yeah, so just to be clear issues versus issuers um so one issuer is uh yeah Lloyd's at the top Lloyds could have several bond issues uh so you're going to end up with a lot more individual bond items 255 than issuers uh issuers 185 um the logic really is. a higher bond fund is a different risk reward profile than a stock fund um going back to that earlier point about the advantages, so for a stock investor um the advantages are theoretically unlimited uh for a bond investor the advantages are limited are the coupons when you buy a bond in a new issue or if you buy them now in a wheat market, is that you know upwards at par plus the coupons, but it is not unlimited in the way that stocks are the downside, uh, no, I mean The downside in stocks is a total loss for downside bonds, it's lower with creditors, so we're ranked above stocks, but the risk reward for us We just have to be careful to take into account the fact that the advantage is. it's much more limited and the downside doesn't look dramatically different, we can still lose 50 60 of the principal on a particular bond, even going through a restructuring and coming out the other side gaining the principal, so I really think it's diversification. something very important for a higher bond fund because it's a different risk reward profile than a stock fund uh and um, you know, we have stock colleagues who have funds that might have 30 or 40 positions, it's an approach very focused, very different, um, that's fair, um, how much type of dating are you doing in this sense, how often do you keep things until maturity until called, yeah, so obviously we've been very active this year , uh, very, very much. doing, thinking and negotiating, in and out, and I would say this year the turnover is around 25 to 30 of the fund, and normally it's a little less than that, the way I explain it is when we buy. a bond, we have to think about holding it to maturity, that's what we know, we have to be comfortable, we can hold it to maturity and we have a good enough view of the credit profile that we can say with confidence that we would be happy to do That, then of course what happens is that things change, the fortunes of the company change, you know, what we're really looking for are companies that are on an improving trend, and if so, that could mean that their bonds The price starts to rise as the yield falls and then we can review whether we think we are receiving enough yield at that time for our understanding of credit risks and then conversely a bond could be a company that issues the The bond could start to perform more poorly and therefore we may decide to reevaluate and we may not get paid enough so we may try to sell a position, so we will be constantly evaluating all the holdings in the portfolio. based on what the credit analysts are thinking in their um, the most recent view of a particular company, okay, so there are some performance numbers in there, so obviously yours have been going up, which has been bringing down the navigations because obviously the existing portfolio portfolio is just a high return low, so looking forward, so what is this kind of outlook for the fund? framework, we're going back to the starting point where the total return on the fund today is 9.6, that's the gross redemption yield, the average maturity is about five years, and then of course we have the leverage on the upper part. of 20, so you're looking on that basis, um, that's a double-digit return per year for five years and that's theoretical based on um, you know what the bond math is right now, um, but always that we do not provide We do not have too many defaults in the portfolio and that is also a very important issue.

So that's what the portfolio will do on average over five years and obviously it will never look as smooth as that, but that's what it is. "This is a good way to look at the portfolio in terms of an anticipated performance profile going forward. I think we need to talk about this before we wrap up, so obviously this is the kind of downside." If the returns go up but the default risk goes up, that's something that you worry too much about with the portfolio um yeah, we always worry about defaults yeah, I mean, it's our um, you know, that's what every analyst has to focus on. in which ones they are.

What are the credit risks and how to avoid defaults? So firstly, what do I think of the outlook for defaults? You know, I've mentioned that borrowing costs are rising for businesses. I think we are in a structural change towards higher levels. returns, um, and as companies come back into the market and look to refinance,they will have to face higher levels of cost of borrowing and for some, and this is where the term zombie companies comes in, for some, um, it will be a problem, so I think that over time, given the fact that we are in This, I don't think yields will go back to where they were in the short term.

I'm not going to rule it out because who knows what's going to happen in the world. but, at any time for sure, um, yeah, I'm comfortable saying that, given that you're going to see a lot of companies exposed to this high cost of borrowing environment, plus, of course, we have what looks like a difficult year in terms of threats. of recession next year, so we have to think about that, so I think that with companies facing high borrowing costs and a weaker economic environment generally, it is sensible to expect default rates to be higher than before. for several years, so again it's our job as analysts and managers to navigate that environment very carefully, the graph that you have up here, this is Moody's, um, uh, at the end and then everything that follows the rate of breach and then all to the right. of that purple line is their forecast um and that's what you know, any forecast is impossible um they got it, they are totally wrong uh at the beginning of 2020 or during the start of the covert crisis in 20. um and without a doubt this will be wrong, these Figures will be wrong, but I think directionally.

I agree with this. I see no reason not to think that directionally. Defaults will increase, but the other point I would like to make is that, yes, and a default rarely means a total loss for the bondholder, we are creditors, so there is usually something of value to be redeemed, and a typical process is that The balance sheet will have to be restructured in some way and that will involve reducing debt and typically that will mean that holders agree to reduce their debt in exchange for equity, so that the security transfers all transfers of ownership from shareholders to bondholders and that in itself can sometimes be a very attractive investment in its own right and it's something we refer to again as distressed investing because defaults come with the territory of high yield investing, it's something that We obviously have driving experience. the team um we know how to approach a difficult situation we've been through restructurings uh at Invesco um the desk at Henley uh so my team we are a very important player in the European hope bond market, which means that we will normally terminate if we want to. have a place on a restructuring committee, then maybe four to six investment firms that want to drive the process, on behalf of all the bondholders, to get the best outcome, then I have I have experience in that over the course of the years, most of my colleagues have experience with that over the years, um and sometimes, as I say, buying a bond at a distressed price, meaning investing in distress or adding to a position, um , because we think there is value to be had in going through a restructuring by buying bonds at a price of 40 or 30 uh because we think there could be profits within two or three years, which is equivalent to something more like 80 or even a price of a hundred and that's something We have a lot of experience on the team, so defaults are not always as scary as they seem.

And I will often say: You know there are a couple of difficult situations within the portfolio and they may not be situations that Actually, we have actively classified them and a great example will be the Petro diamonds, so during the covert crisis they bought their bonds between 30 and 35. with the intention of going through a restructuring. and coming out of that as 95 shareholders, so only 95 of the equity and based on the old bond term, the recovery was about 80 cents on the dollar, so that's a 100 return on an investment in difficulties, yes, not bad if you can get it, yes, but it is always a very marginal part of the portfolio, but it can be very profitable, great, thank you, we have covered a lot of ground unconsciously, but here we go, thank you very much for your time obviously there's a lot of questions we couldn't even get through so we'll call you back soon and a couple more of those but in the meantime good luck with everything and we'll talk to you again soon thank you thank you thank you all uh we'll be back next time week talking to Stuart Wilson uh the disin he's holding I think right now because he's just in a couple more parts of the things in his portfolio uh and then the 16th is CC Japan and revenue and growth and then we'll pause for the New Year's Christmas period, but Andrew will be back with me on January 6th and I think we'll apparently be a sort of Recap of 2022.

Again, thank you very much for listening today and I'll see you next week.