The
Fear of Uncertainty, and
New
City High Yield Income Fund Ltd
Image is courtesy of Wikipedia
Uncertainty, what uncertainty? The Vix
index of share volatility is running close to its all-time low, the price of
gold is 38% below its 2011 high, while the S&P 500 is flying high.
Investors, as measured by the AAII Investor Sentiment
Survey, are unusually bullish with bulls outnumbering bears by 3.5 to 1.
Yet for the seasoned, long-term investor the future is more uncertain
than usual. Consider the possibilities:
Scenario A - The Goldilocks Economy
Most investors are feeling positive. The
American and British economies are growing and unemployment is falling fast. Abenomics
seems to be transforming Japan, while even the EU, thanks to its central
banker, is no longer a big worry. It is only a question of time until economic
growth, interest rates and inflation return to normal levels, and we're back to
the pre-crisis Goldilocks economy (her porridge
was neither too hot nor too cold, but just right). In
this scenario, it makes sense to concentrate one's investments in the sector
which has most to gain - equities.
Yet the experienced investor recalls
that the earlier Goldilocks economy ended in the greatest recession since 1945.
The stock market crashed and it took six and a half years for the FTSE
All-share Index to recover its previous peak in nominal terms. In inflation
adjusted terms, the stock market is still about 10% below where it was in April
2007.
Scenario B - Back to the 1970s
Investors who saw their capital eroded by double-digit inflation in
the 1970s and early 1980s, peaking at 25% in 1975,
have the lingering fear that such times could return. Then prices tripled.
Gilts prices fell in real terms by three-quarters in the decade and equities by
16%. Gold, on the other hand, quadrupled in value and oil tripled in value in
real terms. Cash was trash. Bonds were trash. If you didn't buy
property, gold or oil, you were best off in equities.
Ø Will the vast increase in money supply via
so-called 'quantitative easing' eventually lead to a repeat of 1970s inflation
or worse? The consensus among economists, as in a recent
article in The
Economist, is that it hasn't and so it won't. But economists have such
a poor record of predicting outcomes, that the investor would be foolish to put
all his money on them. In the high inflation scenario, a mix of equities, property
and commodities (particularly gold and oil) provides the best defensive portfolio.
Scenario
C- Deflation and Stagnation
Ø
Will we
enter a period of deflation? No one in the West has
experienced the impact of deflation on economic activity in living memory. Yet
deflation is not far away. In the Eurozone prices are rising at 0.3%, in the US
by 1.7%, in China by 1.6% and in the UK by 1.2%.* Buttonwood,
in this week's Economist, fears that deflation looms. Our main
reference is Japan, where 14 years of gentle price declines coincided with
massive deflation in asset values, a shrinking GDP per capita, and abnormally
low interest rates. *July to September quarter at annual rate, source The
Economist.
Ø Will economic growth continue at its present
low level? Real world GDP growth, which averaged
3.3% in the ten years to 2007, averaged 2.2% in 2012 and 2013. And the outlook
is murky, in part because China's growth rate is falling fast. In a recent
article in the Financial
Times, Summers and Pritchett of Harvard reckon China's growth rate will
fall to 4% per annum for the next two decades. This compares to 9.1% p.a. in
the ten years to 2007.
Ø Will interest rates remain abnormally low? 10-year government bonds yields are at historic lows - 2.35% in the
US, 0.46% in Japan, 0.9% in Germany and 2.54% in the UK - while central bank
rates are near or are at zero. And government bond yields are still falling.
Ø When will government debt start falling? Net government debt in the advanced economies has increased from
46% in 2007 to 78% in 2013, according to
Economy Watch. And it is still rising.
If the world's economy does stagnate and
we are in for a long period of stable or deflating prices and ultra-low
interest rates, then the corporate sector will suffer. Revenues will stagnate,
as will profits and investment. The best defence is to own debt. As cash yields
next to nothing, government 10-year bond prices are at all-time highs, and equities
will not live up to current expectations, it pays to look elsewhere for a
steady income.
With these uncertainties, the individual investor should consider
investing for all three scenarios to reduce the
portfolio's risk. While reducing risk incurs the cost of lower returns, it
should provide the investor with smoother, less volatile returns. And investors
will sleep better at night, though they should be alert during the day. While I
invest for the long-term, thirty years in my case, I am alert to the fact that
events can change overnight. And the portfolio mix should be reviewed regularly
in the light of changing scenarios.
A possible portfolio could include:
1. Equities. Companies are always reluctant to cut dividends
when trading is weak and generally increase payouts when trading recovers. Over
almost any extended period, the 2012 Barclays Equity/Gilt study shows
that equities outperform bonds and cash (see
an earlier article).
2. Gold and Oil are two commodities that offer defensive
qualities and are fairly independent of the financial markets. While I prefer
oil to gold, gold has a long history of protecting wealth in inflationary
periods. This is discussed further here.
3. Alternative income producing investments, such as UK commercial
property and Japanese residential
property, the subjects of my previous two articles, offer a steady source
of income that is relatively independent of the vagaries of the stock market.
4. Corporate preference shares and bonds continue to yield income,
unlike government bonds, well in excess of inflation. These high-yield fixed
return investments come into their own in a stable price, slow growth economy.
To obtain a good spread of such securities, it makes sense to opt for a
collective investment. I have
explained why investment trusts are a superior vehicle to open ended funds
or exchange traded funds for most equity investments. The same arguments hold
good for corporate fixed income. One such investment company is the New City
High Yield Investment Fund.
---------------------------------------------------------------------------------------------------------------------------
New
City High Yield Income Fund Ltd
Sir
Michael Hintze, founder, courtesy CQS website
Since CQS took over the New City High Yield Income Fund Ltd (NCY) in
2007, the fund has done what it set out to do -
provide a capital gain with low volatility and a growing income for its
investors. It has been helped by the low interest rate, low inflation
environment. As such, it provides the investor with a good defence against the
deflation and stagnation scenario.
The price (in blue) and net asset value (NAV in red) of NCY
has bettered the FTSE 350 High Yield index (in olive green) over the past five
years:
NCY price and NAV compared to FTSE
350 high yield in green, courtesy Investors Chronicle, click to enlarge
NCY has been managed by Ian Francis of CQS since 2007. He and his team have invested in bond-like instruments in companies
that are located in jurisdictions with a good record of ethical behaviour and
legal integrity. It is heavily weighted to the UK and sterling. And the fund's
debt amounts to just 8.6% of its equity.
At the current offer price of 64p, NCY trades on a 5% premium to net
asset value and yields 6.5%. It is incorporated in
Jersey and is listed on the main market of the LSE. NCY has a market
capitalisation of 192 million pounds and a total expense ratio (TER) of 1.2%,
which includes the annual management fee of 0.8%.
NCY is, within the high yield sector, conservatively managed:
Ø The fund is widely spread geographically in
developed markets. 60% of its assets are in
sterling, 21% in US dollars, 8% in Euros and 6% in Australian dollars. The
remainder is denominated in Swedish, Norwegian and Swiss currencies. NCY
has no exposure to emerging markets, where the risk of default is higher.
Ø NCY is heavily invested in bonds (76% of assets) with the remainder in preference shares (11%) and
convertibles (5%) and just 8% in equities.
Ø The fund is invested in 137 different issues. The largest, Phoenix Life Floating rate note 2021, accounts for
only 3.6% of the total. All issues are backed up by listed companies.
Ø Dividends paid to investors are covered by
revenue earnings per share, allowing capital gains
to be reinvested. The fund has a revenue reserve of 3.5p a share that would
allow it to continue to payout dividends at the current rate were revenue
income to fall.
Ø Gross debt is just 8.6% of equity.
Ø The company manages its premium and discount
to NAV, thereby dampening the volatility of its
share price. Also, by selling new shares at a premium and buying back issued
shares at a discount, NCY increases the NAV for its shareholders. It placed 30
million pounds of shares in December 2013.
Ø It helps that one of NCY's board
members, with 1.8% of its equity worth 3 1/2 million pounds, has a large stake
in its future. And seven institutional investors hold a further 44% of its
issued capital.
NCY presently trades at a premium of 5% compared to its latest NAV
of 61.2p a share. This is at the lower range of the
premium that the fund habitually commands. NCY rarely trades at a
discount to NAV.
NCY premium/discount to Net Asset
Value, courtesy Investors Chronicle, click to enlarge
Investors will note:
1. As a predominantly fixed income fund, NCY would
perform badly if inflation and central bank interest rates were to head
considerably higher. NCY is a bet that central banks in the US, UK and
EU primarily, keep inflation within their targets, which are around 2 to 3%.
2. It is possible that a prolonged period of very low sovereign
bond yields will reduce the income that NCY obtains from corporate
borrowers. On the other hand, in this case, the capital value of the fund
should rise.
3. The possibility of
default should always be in the mind of the investor in debt issues. While
its present portfolio looks fairly solid, it would be a miracle if NCY
avoided default at some point on one of its 130 holdings. In a severe financial
crisis, NCY's portfolio is at a far greater risk of default than holders
of sovereign debt in the countries in which it is currently invested. The
investor must assess whether NCY's superior yield - 6.5% compared to
2.5% for a 10-year Gilt - is worth the risk.
Disclosure: I hold no position in NCY.