Holly Cook: Welcome to the Morningstar series, 'Why should I invest with you?' Joining me today is Dickie Hodges. He is manager of the L&G Dynamic Bond Trust, which is rated Silver by Morningstar's analysts.
Dickie, thanks for joining me.
Dickie Hodges: Thank you for inviting me.
Cook: So you manage a – what is essentially a strategic bond fund. You can invest anywhere in the credit or interest rate markets. What is the main risk in your eyes to basically your day job, interest rates presumably is the main thing on everyone's mind.
Hodges: It's the key thing on everyone's mind at the moment. We are now on to the understanding that over the course of the next one to two years, interest rate is going to rise. What we have to do and what I'm doing is trying to prepare for that event. So unlike many traditional single strategy or fixed income fund returns, we will actually be looking to generate a positive return in a rising interest rate environment, which is something which we can achieve on dynamic bond trust through many of the hedging techniques.
Cook: So what do you see as your sort of time horizon to play with? When this change happens, how long have we got to prepare for it?
Hodges: I think the change is happening now. I think we're in a regime change. We have been told by central banks both in the U.S. and indeed the U.K. that interest rates over the course of next two years are more likely to rise. Rising interest rates would dictate falling bond prices. But in a fund like Dynamic Bond Trust, we can actually generate a return out of rising interest rates by taking shorter positions to interest rates and generating a positive return in that rising yield environment.
Cook: So as you mentioned you can invest essentially anywhere that you like. Where are the most attractive areas for yield?
Hodges: Well, I think, over the course of next 12 months, demand would dictate and we are in an environment where we are all looking for a round up still around about a 6% level of income or return, demand would dictate. But the three areas that you need to invest are going to be high yield; that will benefit from a low interest rate environment for the next 12 months. It will also benefit from maybe an increase in M&A activity, larger companies trying to buy smaller weaker companies.
The next area would be obviously subordinated levels of financial debt. The reason, again, yield. It is a much riskier sector to invest in, but conventional wisdom would dictate, the banking sector has improved, it's deleveraged; and as far as we are concerned, we are out of the woods with regard to an imminent increase in default probability.
The final sector will be peripheral European governments. Now, that sounds – it does and did sound risky, but the fact to the matter is that it is the only place that will give you a yield that would meet your environment. And what we have seen over the course of the last 12 months is people moving into peripheral European governments and what I mean here is Portugal, Spain and Italy.
Portugal over the course of the year-to-date has been the best performing bond market on the planet and yet we are still seeing demand for that. So those are the three areas that I think over the course of the 12 months, we ought to be investing in. But they do indeed, have risk.
Cook: So you are saying that in the course of 12 months. So as this regime changes, what happens in 12, 15, 18 months' time? Do you have to undergo a certain sort of strategy shift to accommodate those rising interest rates?
Hodges: No, because we are actually doing – undertaking these sort of shifts now. The key issue, obviously, is when the cost of funding, like financing the leverage in the world. Interest rates are 0.5%, assets yielding 6% looks attractive. If that interest rate doubles to 1% and then doubles again to 2%, which the probability is over the course of next two years it will actually happen.
Assets yielding 6% were little less and less attractive. So what I am doing now today is to prepare for that environment that I think we can now move into, but I don’t actually think we are going to get to that stage until the second half of 2015. So one would argue this is the sweet spot, but I would argue that when you are in the sweet spot, you actually have to put investments or strategies in place for the eventuality of what's going to happen to interest rates.
Cook: So unfortunately, market timing really is key but you are preempting and you are trying to get ready for the hit?
Hodges: Essentially yes. I mean, you generate returns out of moves in people, investors' expectations rather than the consensus. So what we are trying to do is to move ahead of the typical behavior I would expect to see out of investors and actually take that move today so that we can benefit from that.
Cook: Well, Dickie thanks very much for explaining your rationale and your tools for investing in the fixed income environment.
Hodges: My pleasure. Thank you.
Cook: For Morningstar, I'm Holly Cook. Thanks for watching.
