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Fallen angel ETFs face potential fall from grace

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Investors who bought fallen angel ETFs at their lows in 2020 benefited from stellar returns by the end of the year, but a potential return to inflation could have a negative impact on this market in 2021, some industry figures say.

The number of fallen angels — investment-grade bonds that have been downgraded to junk status — sharply increased last year when the bonds of a swath of companies in the energy, transportation, retail and leisure sectors were downgraded when the coronavirus pandemic hit, causing their price to slide. Yet while most of these bonds rallied later in the year, 2021 could be a different matter.

“No different than any other fixed-income instrument, fallen angels and the ETFs that own them will see their value eroded by inflation. A sudden, unexpected inflationary shock would be especially harmful,” said Ben Johnson, director of global ETFs and passive strategies research at Morningstar.

A potential rise in inflation, in Johnson’s view, means investors should not expect a repeat of 2020 performance when, from its low point in March 2020, the Bloomberg Barclays US HY Fallen Angel 3% Cap Total Return Index had risen 47.6 per cent by the end of December, according to TrackInsight.

Fran Rodilosso, head of fixed income ETF portfolio management at VanEck, which offers a fallen angel ETF, said: “Fallen angels and high-yield bonds, from a credit fundamental and credit spread perspective, tend to do OK in an [inflationary] environment.”

However, he added: “But overall with yields in credits at historically low levels, there is going to be some sensitivity to rates.”

Also denting the outlook for 2021 is the expectation that there will be fewer downgrades of investment-grade bonds to junk — the volume of downgrades in 2020 also boosted the returns of fallen angel ETFs.

The iShares Fallen Angels USD Bond ETF held paper from 117 issuers in December 2020, compared with 100 at the beginning of the year, while the number of bonds in the underlying index skyrocketed from 233 to 392 over the same period.

Fallen angel bond ETFs outperform the broader high-yield universe

“The large wave of downgrades last year coming in at very deeply discounted prices — higher than average — really was a tailwind to performance,” said William Sokol, senior ETF product manager at VanEck.

“More than two-thirds of the index, by market weight, ended up being comprised of bonds that had been downgraded to high yield in 2020,” Rodilosso said.

All three fallen angel ETFs ended the full year in positive territory, outperforming the broader high-yield universe, according to TrackInsight, despite suffering steep losses in March. The iShares Fallen Angels USD Bond ETF, which tracks the Barclays index, jumped 47.6 per cent from its low point in March 2020 to the end of December.

The VanEck Vectors Fallen Angel High Yield Bond ETF, which tracks the BofA Merrill Lynch US Fallen Angel High Yield Index, rebounded 41.9 per cent over the same period, while Invesco’s US High Yield Fallen Angels UCITS ETF gained 46.3 per cent.

Line chart of US 10-year break-even rate, % showing Market measure of inflation expectations climbs

However, despite the conventional wisdom that bonds perform badly in an inflationary environment, BlackRock’s Karen Schenone argued that fallen angels would still look attractive to yield-starved investors.

“Inflation can reduce the overall purchasing power of savings. With the US Federal Reserve signalling to the market that inflation can increase over their 2 per cent target, investors need to seek income above the inflation cost. With investment-grade bonds barely yielding 2 per cent, high-yield bonds in funds like FALN [the iShares fallen angel ETF] offer more income.”

Asset managers such as BlackRock will also have been encouraged by assurances from the Federal Reserve’s chairman Jay Powell, who said last month that the Fed would not reduce the scale of its asset purchasing programmes, which include high-yield bonds, any time soon, even if there was a sudden inflation spike above the Fed’s 2 per cent target

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Analysis

McKinsey partners sacrifice leader in ‘ritual cleansing’

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The news this week that Kevin Sneader would be McKinsey’s first global managing partner since 1976 not to win a second three-year term stunned many of the consultancy’s partners and influential alumni. 

Few could point to any one mis-step that had felled the 54-year-old Scot. “It added up,” one veteran said simply of the litany of reputational crises he had tried to resolve. 

But nor did many think that Sven Smit or Bob Sternfels, who beat Sneader to the last round of voting, would represent a cleaner break with the past — or that whoever won the final vote in the next few weeks would face an easier task than he had. 

Within days of taking over in 2018, Sneader flew to South Africa to apologise for failures that had embroiled the firm in a corruption scandal. “We came across as arrogant or unaccountable,” he admitted in a speech that began with the word “sorry”.

That set the tone for a tenure defined by the need to make up for other crises that largely predated his promotion, from damaging headlines about McKinsey’s contracts in authoritarian countries to US states’ lawsuits over its work to boost sales of highly addictive opioids

Speaking to the Financial Times less than two weeks before senior partners voted him out, Sneader said he had focused on making the private firm more transparent, more selective about which clients it took on and better structured to avoid surprises in a global group whose rapid growth had made it more complicated. 

According to people who witnessed those efforts, though, pushing them through consumed much of the political capital Sneader needed to win re-election. For some, particularly younger staff, his reforms did not go far enough. For an older group more prominent among the 650 senior partners who vote on their leadership every three years, they went too far.

Kevin Sneader’s failure to win a second three-year term as McKinsey’s global managing partner has stunned many at the consultancy © Charlie Bibby/FT

Sneader’s downfall looked like a case of “the partners not wanting to take the medicine”, one former partner said. Another argued that Sneader’s push for more oversight over partners who prized their freedom had made the firm “too corporate”, while some Sneader allies saw the “protest vote” as a rejection of his reforms rather than a clear mandate for Smit or Sternfels. 

Sneader was not helped by the timing of this month’s $574m opioid settlement with 49 US states, added Yale School of Management professor Jeffrey Sonnenfeld, who said that consultants outside the US did not understand why he agreed to the payout.

Sneader might have been able to reassure them in person, but with McKinsey’s frequent-flyers grounded by a pandemic, “there are limits to what you can do with Zoom”.

‘In business, as in poker, there is uncertainty’

Laura Empson, author of Leading Professionals, said one question now was whether the vote against Sneader was “a ritual sacrifice to appease the bad PR” or a sign that McKinsey’s partners were willing to take more radical action. 

The run-off between Sternfels and Smit may not resolve that issue, say people who know them both, who note that they are of a similar age to Sneader and members of the leadership council that signed off on his reforms. 

Sternfels, a California-born Rhodes scholar who joined McKinsey in 1994, was the runner-up to Sneader in 2018. As head of “client capabilities”, he has a role akin to that of a chief operating officer and is closely associated with the rapid expansion of the firm under Dominic Barton, Sneader’s predecessor. 

Based in San Francisco after six years in Johannesburg, the former college water polo player is known as an effective operator and, the second former partner says, “the guy who built the new business models”. 

But some of McKinsey’s newer activities have dragged him into controversies: last year, he was called to testify in litigation brought by the restructuring specialist Jay Alix — the founder of rival consultancy AlixPartners — over McKinsey’s disclosures while advising clients in bankruptcy. 

When a frustrated judge asked whether he was dealing with “a group of people who are so educated, so arrogant, that they just can’t admit that they’re wrong”, Sternfels apologised, insisting that “we try and not foster arrogance”. 

Smit, who joined in 1992 and is based in Amsterdam, is known inside McKinsey as a more cerebral figure. Now co-chairman of the McKinsey Global Institute, the consultancy’s research arm, “there’s not a university campus he couldn’t parachute into and be received as one of the smartest people in the room,” Sonnenfeld said. 

The Dutch mechanical engineer earlier ran McKinsey’s western European operations and may attract less support from US peers, but the first former partner describes him as “the conscience of the firm”, who will say no to ideas with which he disagrees. The second thinks he may “take the firm back to more of an old-school McKinsey”.

Smit’s writing on topics from urbanisation to the future of work made him popular with clients and provided a glimpse into his thinking on strategy, which he likened in one report to poker. “In business, as in poker, there is uncertainty, and strategy is about how to deal with it. Accordingly, your goal is to give yourself the best possible odds,” he wrote.

Discontent runs deep

Whether the cards fall for Smit or Sternfels, colleagues past and present question whether either will reverse the reforms that seem to have triggered unrest about Sneader. 

“I don’t think Kevin had any choice but to centralise,” said one Sneader ally.

One of the former partners added: “What were the alternatives? It’s a large firm to govern and you do need structures.”

What the election result has already revealed, however, is that discontent with the state McKinsey finds itself in runs deeper than had been obvious outside the firm. 

Whichever candidate triumphs, they will need to listen seriously to the concerns of alumni, clients and policymakers and make clear that he plans meaningful cultural reforms, Empson says.

Sneader’s successor will also have to defy the odds in professional services firms, she adds. “Often with partnerships, when something goes wrong, they appoint someone else in reaction to the problem and that isn’t the solution either and they cycle through another round of leaders quickly,” she says: “It’s almost as though they have to go through this ritual cleansing.” 

McKinsey, which does not disclose its financial performance, earned annual revenues of $10.5bn in 2019 by Forbes’ estimate. Sonnenfeld points to the irony that the firm, which charges a premium for its services, has stumbled in this way.

“It’s odd that McKinsey doesn’t create the kind of leadership that would thrive in a crisis,” he reflected. Before the succession process starts again in 2024, “they need to go into overdrive on leadership development”.



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Investors look to Sunak for clarity on new UK infrastructure bank

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Ever since chancellor Rishi Sunak announced the setting up of a UK government infrastructure bank last autumn, investors have wondered what its role will be. Next week, in the Budget, they will get the answer.

The Treasury has only said it will focus on supporting new technologies that are too risky for private finance and would contribute to meeting the government’s target of net zero carbon emissions by 2050. As examples, it gave carbon capture technology and the rollout of a nationwide network of electrical vehicle charging points. 

The selection process has just begun for a part-time chair, working two to three days a week, and it is scheduled to open on an interim basis on April 1.

The bank’s creation has prompted a debate about how infrastructure should be funded in the UK, at a time when the government’s finances are stretched and customers are likely to resist tax or bill increases, the means by which many sectors — such as ports, airports, energy, telecoms, water, and electricity — are funded. 

Many of these assets in England are owned by sovereign wealth, pension and private equity funds, and regulated by arm’s length bodies, under one of the most privatised infrastructure systems in the world.

The government’s finances have been stretched by the coronavirus pandemic, limiting funds for infrastructure projects such as rail © Niklas Halle’n/AFP

Dieter Helm, a utilities specialist at Oxford university, said the bank was “a good idea but it needs scale — a balance sheet and capital funding from the state, in which case you’ve essentially created a new arm of the Treasury”.

“The question is whether this is going to be the primary vehicle through which the government implements infrastructure,” he said. 

John Armitt, chair of the National Infrastructure Commission, a government advisory body, suggested it needed an initial £20bn over five years to make an impact and reach projects the market might be unwilling to support.

The institution, which Sunak has said will be based in the north of England as part of the government’s levelling up agenda, will partly replace the low-cost finance provided by the European Investment Bank, which is no longer available since Brexit. But it is unclear if it will be able to match the €118bn the EIB has lent to the UK since 1973.

Sunak has promised that the government, which spends much less than most European states on infrastructure, will spend £600bn over the next five years. But ministers hope that more than half their national infrastructure plan will be paid for by the private sector. However, private finance is generally more expensive than government borrowing and requires taxpayers to underwrite the construction and financial risks.

Infrastructure spending (as a % of total government expenditure) for Netherlands, UK and Germany. Also a band showing the min and max for all 31 European countries

“The government wants the public to believe that the country can have this wall of private sector investment without higher bills and taxes now but investors will only come if the government will guarantee they will receive a return and it acts as a backstop,” Helm said.

Dissatisfaction with UK infrastructure has been widespread for years: a CBI/Aecom survey in 2017 found that nearly three quarters of businesses were unhappy with facilities in their region.

The lockdowns have taken a heavy toll, for example forcing the renationalisation of rail services. At the same time the Eurostar train service, airports and airlines have called for taxpayer bailouts, while the government is also paying for some households’ broadband.

Although the prime minister has in the past year given the go-ahead to some rail and road schemes, including a tunnel under Stonehenge, other projects — including £1bn of rail improvements — have been axed. 

A road tunnel under Stonehenge is one of the infrastructure projects given the go-ahead © Matt Cardy/Getty Images

Meanwhile, local authorities — which are responsible for urban roads and other key infrastructure — have been forced to shift their limited financial resources to care for the elderly and vulnerable during the pandemic and so want more central government help.

Despite this growing demand, some investors have questioned the need for the new bank, even though they are popular elsewhere — such as Canada, which established one in 2017. 

“Given there is at least $200bn of international capital looking for projects in which they can invest, the government has to be careful it doesn’t just crowd out existing finance,” said Lawrence Slade, chief executive of the Global infrastructure Investor Association, which represents private sector investors.

He argued the new bank, which will take over the government’s guarantee scheme, should only take on projects that are “too risky” for institutional investors, pointing out that the Canada Infrastructure Bank was mandated to lose up to C$15bn (£8.45bn) over 10 years. “It’s not yet clear what question the new infrastructure bank is trying to answer,” he said.

Ted Frith, chief operating officer of GLIL Infrastructure, a £2.3bn fund backed by UK pension funds, said the EIB loaned money at competitive rates to projects that also borrowed from capital markets. “This is a global market and there are plenty of alternative sources of finance to replace the EIB,” he said. However, he added that the infrastructure bank could play a role in addressing the shortage of available projects.

While investors will put equity into existing or smaller infrastructure projects — such as an airport extension or a wind farm — they are wary of new projects, according to Richard Abadie, head of infrastructure at consultancy PwC, because the latter carry long term construction risks and do not provide an income stream for several years.

“The NIB can play a role de-risking projects but the main challenge is how we can afford and manage the cost of energy transition, not whether finance is available to bridge the cost,” he said.



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H&M experiments as it refashions stores after the pandemic

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The Hennes & Mauritz flagship store on Stockholm’s main square is trying to break the mould. A woman sewing a patch on to trousers, party dresses for hire, a beauty salon and a personal shopping service is not standard fare for most fast-fashion outlets.

But it could be a taste of things to come as H&M, the world’s second-largest clothes retailer, works out what to do with its vast network of 5,000 stores after a pandemic that has increasingly pushed shoppers online. The Swedish chain is not just looking at services such as renting and repairing clothes, but on whether its shops can play a role in the logistics of online selling.

For Helena Helmersson, appointed last year as the first H&M chief executive outside the company’s founding Persson family, it is all about boosting relationships and engagement with customers.

“The physical store network that we have is one of our strengths. It’s the different roles the stores can play, the different formats. What kind of experiences are there in a store? Could they be part of an online supply chain? There are so many things to explore . . . it’s almost thrilling,” she told the Financial Times.

Helmersson, 47, has had a tough first year as chief executive. At the height of the first wave of the Covid-19 pandemic, four-fifths of H&M’s physical stores were closed and a big push online was unable to offset the hit. Sales fell a fifth in H&M’s financial year until the end of November to SKr187bn ($22.6bn), while pre-tax profits plunged 88 per cent to SKr1.2bn, interrupting a nascent recovery after years of decline.

Line chart of Ebit margins (%) showing H&M has lagged behind Inditex's profitability

Sales plunged in March and April, before rebounding strongly in the summer, and then getting hit again around Christmas.

But as the pandemic has forced H&M into speedier decision-making and increased flexibility and with Helmersson forecasting a wave of pent-up demand when Covid-19 comes under control, the chief executive is emboldened to say: “Overall, we will come out of the pandemic stronger.”

Boarded up H&M store in Minneapolis, Minnesota, US, in April 2020
With four-fifths of H&M’s stores closed at the height of the first wave, pre-tax profits plunged 88 per cent © Ariana Lindquist/Bloomberg

Anne Critchlow, analyst at Société Générale, said that relatively small increases in sales at H&M could lead to bigger rises in profits. “Potential recovery is part of the attraction of H&M to investors at the moment: it’s very highly operationally geared. H&M should be the fastest to recover,” she added.

But she argued that Inditex, the Spanish owner of Zara that overtook H&M as the world’s biggest fashion retailer by sales a decade ago, was a “better quality company”, and that the Swedish group may be a “bit slower” at returning to its pre-pandemic profit levels as some customers steer clear of its stores.

H&M’s shares fell consistently from 2015 to 2018, before largely treading water since then, although they have climbed 50 per cent since their Covid-19 low in March last year.

Helmersson, a H&M lifer who joined the retailer in 1997 as an economist, said she started to see “light at the end of the tunnel” after a “very demanding” period. “I have super-high expectations on myself. Adding a crisis on top of that, it’s been a really tough year.”

Now, however, her focus is moving to a critical question for H&M: “Where do we need to move faster?”

Line chart of Total sales growth (%) showing H&M's sales have kept pace with Inditex

Despite being in fast fashion, critics said H&M had become slow, outpaced by nimbler Inditex and online retailers such as Zalando and Asos. Inditex could get new clothes to Zara stores in weeks from nearby manufacturing sites in Europe while H&M, with more sourcing in Asia, took longer. Opening new stores gave the Swedish group an easy path to sales growth but did not help its profit margins, which have been declining consistently for the past decade.

Helmersson said H&M took “really, really fast decisions” at the start of the pandemic on how it bought garments, worked with its supply chain, and moved to selling more online. She pointed to how technology allowed designers, suppliers and the production office to work together at the same time to produce new clothes, rather than waiting for one to send a garment to another.

H&M’s rental service at a store in Stockholm, Sweden
It is ‘difficult to gauge how big’ trials such as clothes rental could become, said the H&M chief © DAVID THUNANDER

“It sounds really basic but if you do that in many processes you can be much faster. You also have data to give you more customer insight, which means you can act much quicker,” she said, adding that accessories can now go from conception to store in a few weeks, T-shirts in six weeks, and trousers in eight.

H&M is also trying to increase its speed on sustainability, bringing in a target of using 30 per cent recycled materials by 2025. Critchlow said that the group was leading the industry in its attempts to become circular, although many voice concerns over how much fast-fashion groups encourage excess consumption. Strong investor demand this month led to H&M reducing the interest rate for its maiden sustainability-linked bond, which was 7.6 times oversubscribed

Line chart of Share prices rebased showing Inditex has outperformed its rival over the past decade

Helmersson, a former head of sustainability at H&M, said that the hardest task for the retailer was decoupling its growth from its use of natural resources. She added that the trials in repairing and renting clothes as well as selling second-hand garments through the website Sellpy, in which H&M is the majority owner, were important but difficult to gauge how big they could become. “We have such a size that we can to some extent influence customer behaviour. But we will also see how willing they are,” she added.

Critchlow said H&M deserved “full credit” for the trials but that they were unlikely to lead to soaring profit margins. She added that the crucial questions were how fast H&M returned to pre-pandemic sales and profit levels and whether it could go further. “It requires H&M to manage the costs of the stores,” she said, adding that renegotiated leases during the pandemic had only helped a little.

There is also a debate about how much increasing online sales — expected to rise from 28 per cent of H&M’s total last year to about 43 per cent in 2025, according to Critchlow — help given that they come with additional costs such as delivery and returns as well as in logistics.

Helmersson is unbowed, arguing that H&M will offer multiple ways for customers to engage with the retailer through various store formats offering different services, online, and its own club. “The customer journey is constantly evolving,” she said. “We will follow, and influence. Before, it was about transactions, now it’s about relationships with customers.”



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