RL Ethical Bond Fund 10 year anniversary

Eric Holt, Head of Credit

31 May 2017

Since launching in January 2007, the Royal London Ethical Bond Fund has grown in size to £427.2m*. Externally-validated ethical screening excludes companies that generate more than 10% of their turnover from any one or a combination of the production or sale of alcohol, armaments, gambling, tobacco and pornography, as well as companies with inappropriate or inadequate policies or systems regarding animal testing, human rights and the environment.

Structure and security

With income generation likely to be a significant part of producing attractive returns going forward, we focus on delivering consistent and incremental yield, and combine this where possible with market opportunities to deliver attractive returns. One major way we seek to achieve this is through selecting bonds that feature risk-mitigating characteristics that are undervalued by the market and therefore offer a favourable balance of risk and return.

The Fund’s redemption yield is 3.1% compared to 2.1% for the benchmark index*. This is not a reflection of increased risk, as the additional yield is achieved through the Fund’s bias to secured and structured bonds. These bonds are frequently unrated and may not form part of the index. However, they combine investment grade characteristics with a favourable risk:return profile, as they have a claim on assets and are structured in a way that supports their credit worthiness. Exposure to these bonds in the Fund is much larger than in the index, which largely consists of agency rated, unsecured bonds. This orientation to invest outside of the benchmark index, where bonds are attractively priced and feature robust risk characteristics, increases the Fund’s opportunity set and therefore its ability to achieve attractive returns.

The single largest holding is currently in covered bonds of the Co-op Bank, an issuer that has faced many challenges over recent years. However, the covered bond of the bank benefits from security and a robust regulatory framework: investors have a first claim on a pool of residential prime mortgage assets, which are replenished over the life of the bond and, according to our analysis, provide approximately a five-fold level of collateralisation, based on underlying property values. However, rating agency methodologies are constrained by the rating of the unsecured bank debt, and so the covered bond is only rated BBB. This would take the bond out of scope for many passive managers, but we place greater importance upon the robustness of the bond’s structure and its value, and we believe a yield approaching 2% is very attractive for a relatively short-dated bond, given the underlying security of the asset.

Ethical constraints

Intuitively, any constraint placed upon a Fund will clip performance at the margin rather than enhance it, but the Fund’s ethical restrictions apply only to a relatively modest part of a wide total opportunity set. In addition, the Fund has benefitted from market developments in areas that are aligned to its ethical bias. One example is the social housing sector, which has developed substantially in recent years and demonstrates many of the characteristics we like, such as secured, asset-rich bonds and very visible cashflows. The sector is not without its challenges, but it is one where we see good opportunities and our overweight position versus the benchmark has helped performance.

*Source: RLAM as at 30.04.2017. The Fund's benchmark is the iBoxx £ Non Gilts index.. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.Sub-investment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk.