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.