Introduction to the Nomura Global Dynamic Bond Fund

Dickie Hodges, Head of Unconstrained Fixed Income, Nomura Asset Management UK, discusses the aim and objective of the fund, what makes his approach unique, what the main risks are for bonds and his favoured markets in 2017.

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  • 17 mins 08 secs
PRESENTER: For an introduction to the Nomura Global Dynamic Bond Fund I’m joined now by the Manager, Dickie Hodges. Dickie, thanks for joining us. What’s the aim and objective of the fund?

DICKIE HODGES: Well this is a total return fund, so what we’re looking to do is generate returns both out of income and capital in an environment I would argue where it’s increasingly difficult to find these returns from income, and indeed from capital itself.

PRESENTER: And just how unconstrained is the investment approach?

DICKIE HODGES: Completely unconstrained. In as much as we have a broad opportunity set, which gives us a diversification, not necessarily a diversification at all time as the fund is invested, but certainly diversification of opportunities that we look to, we can generate returns from, and I would argue this gives us a greater ability to generate consistent returns, which in this environment is very important.

PRESENTER: And what’s the underlying philosophy behind this approach?

DICKIE HODGES: Well what we’re trying to do is, the way I manage funds is, and I have managed the fund over the course of the last seven years, is to actually look at immunising the portfolio against certain risk events. Which in doing so this gives me the flexibility of actually investing where we perceive we’re going to get superior returns out of these asset classes. So from my perspective it’s about protecting the fund, and that should at all times give me the ability to invest where I think we are going to generate.

PRESENTER: And what would you say is unique about your approach, what makes you different from other people in the sector?

DICKIE HODGES: I think it’s the opportunity that we look for in asset classes. If you believe that an asset class goes from a level of 100 to 102, we’re looking at a 2% return. Within these asset classes I certainly believe there’s opportunities where assets go from a level of 100 to 110. Having an unconstrained approach gives us the ability to actually look in all of these asset classes for those opportunities where we’re going to generate the superior return. Within, if you’re forced into investing in a single asset class, I would argue it gives you less opportunity to generate consistent levels of performance.

PRESENTER: But isn’t there a danger with that approach that you’re looking for the really big payoff?

DICKIE HODGES: Certainly I think there is, and in fact I think a lot of people are looking for a very big payoff. The fact of the matter is you’ve got a greater opportunity of having that success if you’re looking at areas that typically other people aren’t looking at, or using these different tools in a way that other people are not necessarily utilising them to the best extent.

PRESENTER: Well could you give us an example? I mean let’s think of a big example last year, the Brexit vote that seemed to catch the City pretty unaware that we were going to vote out of the EU.

DICKIE HODGES: Yes, I think in this particular example we’re in a position where almost 90-95% probability that UK would remain within EU was priced into asset classes. So this represented a good opportunity inasmuch as literally at five o’clock before I left to vote to remain I might add, the last thing I did was starting receiving sterling five-year fixed interest rates as a hedge against the potential negative implications. Three weeks prior to this I was buying call options expressing rising government bond markets in the US. Prior to this, also, we were buying long dated sterling corporate bonds. The world had moved into a position where it was underweight UK and had absolute confidence that we were staying.

But as a result of this we instantaneously changed our expectations and that was that interest rates would be cut, government bond markets rallied as a result of this. The sterling depreciated as a result of this. But more importantly everyone moved to a position where they now saw opportunity in the UK asset class, the UK fixed income and generically UK incorporated. And the performance that we saw out of the UK asset classes post the Brexit was quite considerable. I mean we saw a 35% uplift in the performance in the return of long-dated sterling corporate bonds in the space of three weeks.

PRESENTER: So stripping the technicals of that out, what in essence was the bet?

DICKIE HODGES: Once an uncertainty becomes a certainty then people can invest based off of the new information that they’ve received. So it was our contention that post this uncertain event then people would either be buying more expensive UK asset class as a result of them moving to more of an overweight position as they have more confidence in the asset class, or indeed they’d look to buy an ever increasingly cheaper asset class. Well the result was the same: the cheap asset class lasted for approximately two weeks.

PRESENTER: So where does a fund like this fit in an overall investor’s portfolio?

DICKIE HODGES: Well I think you’ve got to look at this in context of other investments. Some people can view this fund as a hedge against some of their other traditional long-only type sort of investments, because obviously this fund can and has proved to produce positive returns even in a negative environment for an asset class. So from my perspective I would look at this as a core proposition, because we should be able to generate positive returns in fixed income at all times, and give some consistent returns, and I think it will probably be prudent for people to use this as a core, and then have a satellite approach around this for certain other risk areas of the market that they might look to perceive to generate a greater return. But I think this is probably I would argue an unconstrained fixed income approach at this point in time and looking forward into the future for the next two or three years, it certainly should be viewed by everyone as a core part of their proposition.

PRESENTER: But in this world of high bond prices and low yields, are you confident you can generate decent returns for investors?

DICKIE HODGES: Very much so, and certainly from this portfolio and this fund and this type of strategy, you should indeed, or you have the ability to generate returns in both environments: in an environment of falling interest rates and falling government bond yields and lower inflation, as well as an environment where you see the opposite. And certainly we’ve demonstrated over the course of the last year that that is indeed the case. I mean from my fund in the last quarter of 2016 for example you saw generically negative returns from global bond markets. This was either government or indeed corporate. The fund returned, my fund returned a positive 1¼% in an environment where you had minus 4% returns out of a traditional fixed income asset class. So it is possible to produce positive returns in both environments, and that’s the key thing about this unconstrained asset class.

PRESENTER: Inflation seems to be making a bit of a return, certainly here in the UK. Again, how do you generate returns if inflation is going up?

DICKIE HODGES: What you’ve got to actually understand about how inflation works, and more the dynamics of how inflation materialises in asset classes and certainly inflation asset classes. I can tell you that in the middle of 2016 you saw a significant rise, a gradual but significant rise in inflation as measured by any financial instrument that you can invest in in capital markets. Obviously when we moved into the surprise election result in the US with Trump winning, we suddenly moved into an environment where everyone talked about reflation. You had another significant rise in the level of inflation, and actually during the summer of 2016 and by the end of November 2016 global financial markets had discounted a 1% rise in the future level of inflation.

DICKIE HODGES: Now, if we’re looking at where inflation is as discounted in financial assets, today it is actually lower than it was at the end of November 2016. So to have invested in an inflation asset class by the end of last year you would have made no material or any returns out of that inflation. Now I perceive that we will be in an environment where for the next two, three, four, five months you are going to see the level of inflation that’s released by Office of National Statistics, and globally the level of inflation will rise. But what I have less confidence in is whether or not the level of inflation will be rising over the next six quarters rather than the next six months. So I think there are going to be opportunities that arise from this, but I think the majority of the returns made out of owning inflation products were made in the last six months of 2016.

PRESENTER: You mentioned Donald Trump there, how big a role do you think geopolitical risk or political uncertainty is going to play in 2017; we’ve got the French elections coming up, the German elections later this year?

DICKIE HODGES: Well I think these give us opportunities for investment. And I think in a world where it’s increasingly difficult to generate a level of income. Because as we know interest rates are very low, we perceive they will remain low for a significant period of time, so it is very difficult to generate income. So all we can do is look at opportunities in which we can generate capital. For us to generate capital out of opportunities we need events. And the market is relatively self-fulfilling. It’ll create a level of volatility ahead of these specific events, which will allow us to have the opportunity of investing, so geopolitical events are a great opportunity in which to capitalise from. But I think longer term the outcome of these political events will be very much discounted in capital markets ahead of the event itself. So whilst I think it does play a significant event, certainly in a world where we lack information, the extent of how these events impact financial markets I think will be fairly limited as we move forward.

PRESENTER: Looking at the bond markets as a whole what would you say are the main risks out there in 2017?

DICKIE HODGES: Well if you break this down into several components. From a government bond portfolio it’s very much perceived that interest rates are going to rise. We have this infatuation with what is known as the dots, and Federal Reserve members are looking to vote for future rises in interest rates. What drives expectations, what drives markets are changes in expectations. Rising government bond yields or rising interest rates, certainly in the US, I would argue have almost certainly been fully discounted. So it would take a material change in people’s expectations on the future level of interest rates to give further deterioration in government bond market returns, and very much so from a credit perspective as well.

I think the biggest risk to credit markets is higher government bond yields. When you have the income element, the yield on European high yield is now around about 2¾%. That in itself I don’t find very attractive. But putting it into context of owning your choice of owning a German government bond at minus ½% and earning 2¾% on a high yield portfolio, one can understand why you’ve seen these moves; very much so in the US as well. US high yield portfolios are yielding less than 6% now. Now if you were to strip out a lot of the volatile components of this it’s yielding more like 5%.

So the biggest risk I perceive to things like credit markets and high yield markets is the absolute level of government bond yields. Because if US 10-year yields were to go to 3½% then suddenly high yielding 5% looks materially less attractive from an investment perspective. Plus, you’ll be able to generate, much closer generate a level of income from investing in what is perceived the riskless asset class.

PRESENTER: Well, final question, if those are the risks, what are the favoured markets and traits for 2017?

DICKIE HODGES: For 2017, well I’m still optimistic about equity markets for instance as well. And very much so I’m looking for areas that aren’t the typical areas that other people from fixed income might look at. I’m certainly very positive on Asian convertible bonds. Broad-based Asian convertible bonds and broad-based Asian equity markets for instance, even though I’m a fixed income investor, if I perceive that as an area of opportunity, then I will obviously use the financial instruments available to me of which to generate returns.

Now the reason why I favour Asia and the Asian convertible bond market is twofold. First and foremost in Japan we now know two things, if you’re an investor you know two things. You cannot reach a level of income by owning Japanese government bonds. Now the Bank of Japan are doing yield curve controls, so also you know that you cannot generate capital out of owning Japanese government bonds. Therefore you’re faced with two options. And the only two options I can see are to buy overseas bonds, because the yield is available there, and also to buy domestic equity.

So one of the way for capturing improvement in the Japanese equity market and broad-based Asian equities is to actually own Asian convertible bonds. So that’s one of the favoured positions. And even though I appreciate that we’ve seen significant returns over the course of the last nine months out of equity markets, I still perceive that Japan are doing an all-encompassing debt for equity swap. So from that environment I think the most capital I can generate is from there.

PRESENTER: Yes.

DICKIE HODGES: Elsewhere I think you need changes in expectations to drive significant return generation moving forward in the future. I don’t perceive you’re going to generate return out of inflation at the moment until we have more confirmation from Trump and his policies and how he intends to finance these policies. Once we do get this more information then, I think, you are going to, you have the possibility of generating returns out of inflation. And the final one I’d like to just is Brexit.

We’ve all been investing under the premise that we’re going to have what is classed as a hard Brexit. I completely disagree with this. The reason is because I cannot understand how it is possible for the UK government to negotiate with 27 countries in a period of two years. I find it farcical if we think that that’s going to be an option open to us. In this regard I think therefore the actual time period over which these negotiations are going to take are going to be significantly longer. Under this scenario I think that the pound can recover, because the pound, we’ve had a 20% depreciation of sterling. I think you can absolutely see the pound recovering more than 50% of that depreciation.

I think the UK economy has a greater opportunity to grow and flourish and sustain if the negotiations take longer, more like a five-year negotiation period. And from that regard any of the asset classes that have been materially impacted by the effect of a hard Brexit should also have the ability to recover. So I favour UK retailers for instance. And I think these are the areas that you have to look at it. It’s investing for the unexpected. Investing for that almost instantaneous change in market expectations is where you’re going to generate the superior returns on any fund.

PRESENTER: So they talk a lot about it in the equity markets, but for you would you class yourself as a contrarian investor?

DICKIE HODGES: If I look at what I’ve done over the course of the last 18 months, very much so. I look at the risk points and where the probability is very skewed, then I typically take the other side of that investment or that probability. And the reason why I do this, well it’s cost. If much of this is priced into an asset class, then for me to take the other side, a contrarian view as you said, the cost to the impact of performance has been very minimal. And actually I would say looking over the course of the last year it’s been a very positive contribution from performance of taking that contrarian view.

PRESENTER: We have to leave it there. Dickie Hodges, thank you very much.

DICKIE HODGES: Thank you.