Investment Management

Negative Reality Inversion*

Quarter 4 2016

Remarkably, not only was this bond issue apparently oversubscribed (there were more buyers than available stock), the short-list of successful (?) applicants reads like a European Who’s Who of institutional investors. It is unlikely that these bonds will ever find their way into private client portfolios. Without exception, investment managers are tasked to increase the value of portfolios, either through capital appreciation, income generation, or both, whilst simultaneously controlling the level of risk. Ensuring the polar opposite is unlikely to result in a long and distinguished career in managing other people’s money. And yet, in the bizarre world of finance, buying such a loss-making investment is clearly considered by some to be the right thing to do. The German logic is that the yield, whilst bad, is less bad than holding cash, which is very bad indeed. Abandon all hope, ye who enter here, as Jean-Claude Juncker might have written, had Dante not got there 700 years earlier.

The question for new Henkel bondholders is: why didn’t you buy the equity? Shares in Henkel are yielding 1.2%. This is a great company now awash with cash (thanks to the bond issue), so the dividend is unlikely to be cut any time soon; indeed, it will most likely rise over time, especially if inflation, which is creeping higher in the US, reaches Europe.

There are, of course, any number of reasons why institutions can’t do the logical thing and buy Henkel shares instead of the bonds. Fund managers are strictly bound by asset allocation models, often set by pension trustees. These models will include bonds, and lots of them. Given the turmoil which would occur in bond markets should interest rates rise unexpectedly, buying short-dated paper like the Henkel issue could be the least worst option, even if capital losses are guaranteed.

The obvious remedy would be to change the mandate. However, for many life and pension companies, bonds form a cornerstone of their regulatory capital and are formally ranked as lower risk investments than equities. In essence, the regulator is encouraging companies to lock in poorer returns to mitigate risk. We think that this is a big mistake at this stage of the cycle, no matter how well intentioned.You probably (hopefully) don’t hold the new Henkel bonds. However,

Last month, the respected German household goods company Henkel raised half a billion Euros on the bond market. In most circumstances, this would have been an unremarkable, even routine, transaction. What caught the eye was the fact that the bonds carried a negative redemption yield. In other words, investors were guaranteed to lose money between the date of issue and the date of redemption, two years down the line.

FIM Capital Limited. Licensed by the Isle of Man Financial Services Authority and authorised and regulated by the Financial Conduct Authority.

*Impressive sounding but meaningless term created by Ben Elton & Rik Mayall for ‘The Young Ones’ BBC2 1984 – when UK bond yields were over 10%.

+44 (0) 1624 681250 enquiries@fim.co.im www.fimcapital.co.im

“I won’t say anything because no-one ever listens to me anyway. I might as well be a Leonard Cohen album.”

your pension fund might. Annuity rates, or the level at which life companies distribute income to pensioners are at historic lows, in part because bond yields are also low. Annuities have long been a gamble on life expectancy and the odds are stacked against the annuity holder. With the average UK life expectancy now at 82 years, current annuity rates for a 65 year old guarantee a capital loss to the investor after the 17 years it takes to reach that point. Live another 5 years and you break even. This is Henkel bond territory.

The previous Chancellor of the Exchequer, George Osborne, recognised this problem and changed the rules to allow retirees far more flexibility in how to deal with their pensions than ever before. He also improved Independent Savings Accounts or ISAs (which we can now offer to Pound a Day PortfolioTM investors) all of which were intended to encourage saving for the longer term in a tax-efficient package.

Breaking through the glass ceiling of the often ridiculously complex pension industry can be hard to do. A modern pension, however, should be flexible, tax-efficient and cost-effective. It should also be transparent and easy to understand. Your pension should be all of these things. If it is not, you may wish to speak to your pension adviser and then to us, to ensure that you are holding Henkel’s shares, or their equivalent and, for pity’s sake, not those bonds.

Russell Collister INVESTMENT DIRECTOR - OCTOBER 2016

Buckarooed“You gotta find me a woman who can ride like Annie Oakley, shoot like Belle Starr and who ain’t afraid of nothing.” (Bronco Billy, 1980)

Aside from growing up without farm animals and being plonked on the back of a racehorse at the Dublin Horse Show as a 6 year-old “just for fun”, I suspect that Buckaroo also contributes to my mild hippophobia. First made by Hasbro in the 1970s, this game of dexterity invites players to place plastic gold-diggers’ paraphernalia on the back of a spring-loaded toy mule, trying not to trigger the point at which everything is kicked off at high velocity. Being a sedentary child, this was quite an adrenalin rush; being last in line to rest a plastic bucket on an overloaded ass.

To me, horses (and their relatives) are beautiful but unpredictable beasts and I’m convinced that they instinctively dislike me, possibly because I share Arthur Conan Doyle’s view: that they are “dangerous on both ends and crafty in the middle”. The same could be said of bond markets today, where the various players have loaded the spring to excess and the mule is ready to kick (or bite). We suggested that investment grade bonds were overvalued about five years ago, before monetary policy was “NIRPed” (see our last Briefing). Yet, investors still made money on this asset class, by “virtue” of NIRP’s cousin, TINA (There Is No Alternative) and the occasional bout of haven-seeking indigestion (Brexit, China, Greece, Oil Prices - take your pick). TINA might be the market’s new best friend, but she’s hardly conducive to stable long-term returns, especially when one considers who else is playing the bond game and how cantankerous that old mule is already.

Sitting at the “AAA” table is the Bank of England, owner of around one quarter of all gilts and still buying thanks to Mr. Carney’s plans to “QE” the UK economy by a further £60bn. Another big participant looming light-fingered over the bucking bronco is the pension fund industry, which owns approximately 30% of the gilt market, bound by a Faustian obligation to match long-term liabilities. These are not what you would call “willing” market participants, so it seems unlikely that Mr and Mrs Private Investor could win a long-term game. When the CIO of a renowned bond fund management house (Royal London Asset Management’s Piers Hiller) suggests to the Financial Times that the only solution to ever-lower discount rates and yawning pension deficits, is to enable managers to invest in infrastructure via government sponsored funds, you know that AAA-rated bonds are piling hard onto a loaded spring. Demand may be more fragile than many safe-haven seekers realise and they are within biting distance. The other dangerous end, waiting to kick out at safe-haven bond seekers, is valuation. It’s good to know that we are not the only ones calling time on this asset class, as Mervyn King expounded in his March 2016 novel, The End of Alchemy:

“…when long-term rates are close to zero, bond prices are not likely to rise much further but could easily fall sharply.

Investment in bonds is almost a one-way bet, with all the risk on the downside.”

“Almost” is the operative word, Lord King. A pre-“Brexit” gilt spree breathed life into the old mule, distorted by fear and fed by political and monetary shenanigans. A surge preceded a plunge, as investors realised that those fearsome hippophiles, the Four Horsemen of the Apocalypse, had postponed their British summer holiday, instead carrying away George Osborne, down to media perdition. Emulating the All-Gilts Index at this stage might well result in a plastic bucket in the eye. The UK gilt market sports a generous maturity profile (to the relief of Philip Hammond), with a duration of around 12 years. Buying scantily clad coupons with long maturities is a recipe for a good kicking when interest rates eventually turn. This may take time, but Mark Carney has only to glance at his continental cousins; the ECB eating its way heartily through €1trn of a �€1.7trn quantitative easing programme with nary a glint of inflation in the Eurozone’s eye and GDP growth expanding at its slowest pace for 18 months. As Draghi might proffer, Carville-style: “It’s government reform, stupid”.

If Mr Hiller is right and the next benefactor of “TINA” is infrastructure, or perhaps equities, this bodes well for investors. What about fixed income mandates? Are they even at the table? When seeking new bond ideas, I’m like Bronco Billy, looking for the perfect solution to a very tall order in a market some describe as “broken”. At the risk of short-term underperformance, we avoid the coltish All-Gilts Index, instead hugging the ballast of donkey-like short duration funds and floating rate notes. We will ride a bucking bronco (emerging and high yield credit) if saddle soreness is sufficiently soothed by decent yields. The annoying grammatical meme of “verbing” is currently all the rage and who am I to buck (argh) the trend? At the risk of inciting the wrath of the FT’s Lucy Kellaway, this is my treatise for “buckarooed” to qualify for inclusion in the Oxford English Dictionary, preparing those unfamiliar with the ways of that crafty old mule.

Mary TaitINVESTMENT DIRECTOR

Quarter 4 2016

“Ouch. Ouch. Ouch.” The sound of a bond investor too long in the saddle.

A Creeping Erosion

As a technophobe in the eyes of my children, I marvel at being able to order an entire drama series at the blink of an eye, downloaded to my Amazon “Fire Stick” before the charge has even hit my credit card. Happy Mary, happy Barclaycard. One such series was Showtime’s cutting-dialogue drama, “Billions”, allegedly based on the financial crimes crusader, “Preet” Bharara, US Attorney for the Southern District of New York, via his fictitious persona, Chuck Rhoades Jnr. Pitched against him is genius hedge-fund trader, Bobby Axelrod (cue enormous injections of testosterone just for that name alone). Even female characters seemed infused with male hormones in this gloriously over-the-top sparring match, with bags of conflicted interests and oodles of greed and fear, not to mention an absolute screamer of a short-squeeze (this is a financial term, should anyone think otherwise) thrown in for good measure.

While I largely enjoyed this capitalist romp and the superb acting of Paul Giamatti (Rhoades) and Damien Lewis (Axelrod), my husband, whose feet are more firmly planted in the realities of life than in the abstracts of finance, found the series entertaining, but also rather tiresome. The same verdict followed the US version of “House of Cards” starring Kevin Spacey and Robin Wright as the scheming Mr and Mrs Underwood. In his summation, the words “selfish”, “cruel”, “greedy” and “shallow” featured heavily, and while I could not disagree, I found myself instantly regretting the pleasure attained from watching this riot of slander and blackmail. After all (my argument went), this is only fiction. If this were reality, I would be ashamed of it. But is this reality? Would I thrive on it? Am I in denial? In late August, the acclaimed FT columnist Martin Wolf suggested that “if the legitimacy of our democratic political system is to be maintained, economic policy must be oriented towards promoting the interest of the many, not the few”. As entertaining as Bobby Axelrod was, on more than one occasion I heard myself saying indignantly: “but we’re not like that! We have the interest of the many at heart”. Not long after our domestic debate, James Anderson, lead manager of the Scottish Mortgage Investment Trust, differentiated between investing in shares of a company for its long-term future (the primary tenet of capitalism) executed by traditional “long-only” investment managers, and the jet-fuelled short-term speculative activity of short-trading, borrowing shares in a company to make a quick turn. As Mr Anderson rightly defined, owning part of a company versus borrowing stock are two very different things. One is intentioned towards the creation of value and shareholder rights while the other is primarily designed to destroy capital value (but to make “billions” for the Axelrods of the world). I can just hear the army of super-smart CFAs galloping towards me in

Major Danby: “Ideals are good, but people are sometimes not so good. You must try to look up at the bigger picture”.Yossarian: “When I look up, I see people cashing in. I don’t see heaven or saints or angels. I see people cashing in on every decent impulse and every human tragedy”.(“Catch 22” Joseph Heller, 1961)

Mary, computer says “No”.

an indignant herd (more horses) to protest…..or perhaps not: one of the benefits of living on a small island surrounded by rough seas.

On the US attorney’s team, another lawyer, Bryan Sacker, is warned by his father that “principle doesn’t go away all at once, it’s a creeping erosion” referring to both civil servants and their hedgie prey. Here lies the rub: do we justify our actions as investment managers as being purely for the good of our clients, even if it might be to the detriment or disrespect of others? Am I just another “money changer in the temple”, as I was once described by a friend? It is not the first time I have considered this dilemma during my 23 years as an investment manager, my stomach turning over the cross examination of Wells Fargo CEO, John Stumpf, by senator Elizabeth Warren, concluding that he “squeezed…employees to the breaking point so they would cheat customers”, firing 5,300 “twelve-dollar-an-hour employees” with no detriment to management or the executive. One of the biggest sticking points of “Billions” was Bobby Axelrod’s decision to trade as the twin towers fell on 9/11. Paul Crocker reminded me of the general ban we had on dealing at Standard Bank that day; able only to watch the nightmare unfold on our screens with disbelief. Nevertheless, at another firm, when the “7/7” London terrorist attacks took place, my colleagues and I took advantage of unexpected market bargains, confident that prices would bounce back quickly. At FIM last year, we sold down holdings in shares of BHP Billiton, the failure of Brazil’s Fundao Dam and the flooding of Billiton’s Samarco mine giving management a perfect excuse to cut an already strained dividend (which they subsequently did). Was the loss of 17 lives a secondary consideration? I am ashamed to say that it was not foremost in my thoughts as I executed those trades, listening to the sound of my principles creeping away. Deal now, repent later; like a bad dieter on a binge. For the most part, investment is a positive experience, which is why I have stuck at it all these years; I have the increasingly rare pleasure of actually enjoying my job. Yet, there is always that “Catch 22”, where doing good for one party may ignore the tribulations of another, not dissimilar to the actions of those short traders I vilify. Like Captain Yossarian, I too may be denied my angels and saints when the time comes.

Mary TaitINVESTMENT DIRECTOR

Investment Management Briefing Editor: Mary Tait, Investment Director

Brown Shoes and Greedy SeagullsPerceptions of life on a small island differ widely. A fine example was served up by the former Ofsted boss, describing the Isle of Wight as a “ghetto where there has been inbreeding” a view perhaps shared by Queen Victoria, whose concerns drove her to station numerous troops on her beloved island.

But Britain is also an island and attitudes differ from those of mainland Europe, where one could argue that nations should be categorised by climate, rather than borders. Forty winks during a summer’s day in Spain makes more sense than in Sweden, with 24 hours of sunlight and billions of hungry mosquitos looking for a quick snack. Other factors make British Europeans different, apart from driving on the correct side of the road. We queue, we envy the French with their unsustainable shorter working week and generous pensions. We are also jealous of the Spanish, spending August on the beach. Recently, a Social Mobility Commission’s report deemed it unacceptable for anyone except continental Europeans to wear brown shoes in the City. The executives interviewed seemed oblivious to the fact that city dress code limited social diversity within the square mile, yet most voted to stay in Europe.

But what of the Scots, who wish to go their own way and stay in Europe? Perhaps they are sick of queuing, want a better (unaffordable) pension and to spend more time on a beach in Ibiza where they can turn into lobsters and sell Scotland’s national health drink (Irn-bru) to the hungover masses. Would they start driving on the right (wrong) side of the road as well? I suppose it makes no difference on a narrow highland road.

By contrast, the Welsh seem content to show the rest of the UK how to play football. They can also say whatever they want about everyone else, in Welsh. I have lived in Wales on two occasions and the only indigenous words I know are “Cymru”, “gwasanaethau” and “moron” which mean “Wales”, “services” (as in motorway) and “carrots”. I used to watch an S4C series in Welsh starring Dai Jones and while not understanding a single word, I used to find it highly entertaining, albeit coinciding nicely with my evening tipple. Another example of Welsh humour occurred one election year, when I noticed a car coming up a farm track. Out jumped a well dressed gentleman who immediately gabbled something in Welsh. I looked at him blankly, apologising for not understanding a word, to which he responded “well, I don’t suppose you’ll be voting for Plaid Cymru then!”

Last year I ventured back to Wales and met a retired farmer called Ivor. He asked numerous questions in a mellifluous Welsh accent and the topic of hens arose. He kept them for many years in the yard where we now stood, as had his parents before him. They sold eggs and made good money until an accident befell him one day, never eating an egg or keeping a hen since. As he sat by a stone outbuilding chopping sticks, he was momentarily distracted and took the end of his finger clean off.

Wrapping the bleeding stump calmly in a handkerchief, he walked to the house to tell his wife, who rushed him to hospital some distance away. He was seen by a doctor who enquired as to the location of his finger in order to reattach it; however it was still on the ground where the hens were scratching around. His wife phoned home and asked their son to bring it to the hospital, but it had gone, presumably eaten by a hen. His justification for not eating (or keeping) eggs was that you just don’t know what the blighters do when your eyes are turned. A bit like European bureaucrats, I thought. From my experience, hens only ever have two thoughts: Firstly: “is it edible?” and secondly: “how do I get it down my neck?” Wiser than a seagull, perhaps, which fails to ask the second question until something deemed edible is squarely lodged in its throat.

So how does this relate to Brexit? Well, barely, but given the huge piles of rubbish written by so-called experts on the subject, I thought I would add a bit of humour, rather than scaremonger and speculate when no one really knows what will happen. I feel sorry for those who panicked out of the market. What do they do now? Highly-paid experts, who forecasted a recession the moment we voted, have clearly lost sight of the Britain lying beyond their black shoes; perhaps a good rationale for employing those who wear brown. Respectable economic data has been released since the referendum and equity prices have surged, despite not knowing how or when Brexit will occur. Our strategy is therefore simple: wait until there are some facts on the table, be mindful of what may lie ahead and learn from Ivor’s misfortune not to turn our back on the state of play. Much can go wrong and Theresa May and her team cannot afford distractions once Brexit negotiations start. Certainly, there will be no end of black-shoed opportunists waiting to pounce, ranging from Ms Sturgeon to Mr Juncker. If they do, then let’s hope it’s with the mentality of a seagull rather than a hen. I wonder if grey shoes will ever return?

Paul CrockerINVESTMENT DIRECTOR

Editor: He neglected to mention the Irish. Phew.

Quarter 4 2016

+44 (0) 1624 604700rcollister@fim.co.im

Russell CollisterInvestment Director

+44 (0) 1624 604701pcrocker@fim.co.im

Paul CrockerInvestment Director

+44 (0) 1624 604702mtait@fim.co.im

Mary TaitInvestment Director

+44 (0) 1624 604704mcraine@fim.co.im

Michael CraineJunior Investment Manager

+44 (0) 1624 604712brhodes@fim.co.im

Barbara RhodesHead of Settlements

Black shoes, brown shoes. Tell me, which would you choose?