JP's Journal: A love/hate relationship with benchmarks

I have a love/hate relationship with credit benchmarks. The hate part reflects the way benchmarks influence security selection. The love part reflects the same sentiment.

Benchmarks have a useful purpose: they are a gauge against which investors can assess the performance of their portfolios. But benchmarks have inclusion criteria. Take a typical sterling credit investment grade benchmark; requirements include a minimum issue size (£250m) and at least a BBB credit rating. This means that unrated bonds are excluded, as are bonds with variable income profiles, such as floating rate notes. Strategies that are benchmarked focused – exchange-traded funds, passives, the benchmark huggers – have a narrower opportunity set; but they also cause distortions by funnelling money into the same securities. In essence, we believe that better value can often be found in areas that are overlooked by our peer group. Ferreting around in under researched areas is more productive than trying to ‘out analyse’ hundreds of other researchers, going over the same financial information from the likes of GSK, Apple, VW and LVMH. We do our financial analysis but with a mindset that is less constrained. We think we have an advantage over competitors whose scale is so large that their focus has to be on mega issues. Conversely, we don’t have legions of analysts siloed across the globe. Overall, I’ll settle for where we are.

Those indices are changing

One significant development in sterling investment grade indices has been a changing maturity profile. Short-dated bonds (under five-years) now make up over half of all-maturity indices, by value. This reflects several trends. Most obviously, bond yields have risen, with the price impact being most felt at longer maturities – compounded by the recent yield curve steepening. Sectoral changes also play a part; we have seen a lot more financial issuance in recent years where maturity profiles tend to be shorter. In non-financial areas there is less supply of long-dated debt, perhaps reflecting the relatively strong cashflows generated by top tier companies. Bank weightings in benchmarks are still well below the levels seen prior to the financial crisis – but they are creeping up.  

The shortening of the maturity profile of sterling credit indices is one reason why, over the 12-months to the end of September 2023, the return from all-maturity credit was so much better than the return from all-maturity gilts. A prime reason has been credit spread compression, with non-gilt credit spreads falling from 1.9% to 1.3%. That accounts for more than half of the difference. But that difference was huge: +7.4% from credit and -2.5% from gilts. The higher yield or ‘carry’ was also a factor in credit’s favour. But so was the composition of the respective indices: ‘shorts’ represent just over 37% of gilt all maturity benchmarks, about 15% lower than the credit equivalent. One factor in the growth of private credit strategies has been the search for diversifying assets at longer maturities. Looking at a long-dated (over 15-year) sterling investment grade index shows that more than 20% by value is represented by social housing. There is a great choice in the sector but there are significant common factors that will influence the risk profile of all. There is more diversification in utilities, representing about 20% of long credit indices, although weightings are skewed towards UK water and electricity companies.

A good week for bonds

On the economic front, data was generally weak. Both the Federal Reserve and the Bank of England decided to keep rates on hold, although they sounded cautious on inflation in an attempt to dampen talk of rate cuts. Bond markets, however, took their cue from a slew of announcements that indicated that the 5% growth in US GDP was not being sustained. Payrolls were weaker than expected and the unemployment rate picked up to 3.9%. This bond friendly data was supported by average hourly earnings coming in at 0.2%, a touch lower than consensus.

In the UK, the Monetary Policy Committee voted 6-3 to keep rates on hold at 5.25%. The three dissenters noted rising household incomes, a relatively tight labour market and services inflation as reasons to hike. Coupled with the interest rate decisions was an update to economic forecasts. Consumer Price Index inflation is seen at 2.2% and 1.9% for the two and three-year horizons. The new GDP growth forecasts are downbeat, with a slight reduction from previous levels, but they don’t have a recession pencilled in – yet. Shipping rates are indicating a tough time for global growth next year and I would be surprised if the UK does avoid two quarters of contraction.

Bonds had a good week. Yields on 10-year US treasuries dipped to 4.6% whilst UK equivalent rates moved below 4.3%. Japan was the main exception, where the central bank signalled a greater tolerance for higher yields – although we are still talking of yields below 1% for 10-year rates. Globally, real yields moved down but I still think 20-year US Treasury Inflation-Protected Securities around 2.4% look good value. In credit markets there was a general tightening of spreads with sterling investment grade bonds recovering from the modest weakness seen in October. High yield bonds followed a similar pattern, with my favoured index showing a 30bps improvement on the week.

Our government bond team drew my attention to an interesting development. A couple of years ago many areas were showing negative yields – representing about 4600 bonds in total – but by last week there was only one such category: ultra-short-dated Japanese government bonds.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.