Artemis High Income Fund update

The fund rose 0.6% over the quarter, ahead of the £ Strategic Bond Average of -1.2%. Year to date the fund has delivered a net total return of +3.6%, with strong contributions coming from both the bond (+2.8% contribution) and equity (+1.4% contribution) sides of the portfolio. 

New positions added during the quarter included Merlin, the global operator of the Legoland theme parks, along with Madame Tussauds and Alton Towers. This is a business we have followed for a number of years, having initially taken exposure to it back when it went private in 2019. We sold it in late 2021 as we no longer saw valuations as compelling. A new issue from the company gave us an attractive opportunity to lend to the company again. We like the company’s excellent brand position, strong management, and solid cash generation.

Another company we took exposure to was LKQ. Again, this is a company we know well and have lent to in the past. The core of the business – working with auto repair shops globally, and both providing and sourcing replacement auto parts through them – is a business we have observed to have little cyclicality, be very profitable, and where there is a clear benefit to being a market leader.

As such, we really like the fundamental positioning of LKQ. We switched out of our holdings in Ford to fund the purchase of out LKQ bonds, as we believe that we are transitioning away from a lower-volume, higher-margin environment in auto sales (which significantly benefit Ford’s, along with other OEMs’, bottom lines) to a higher-volume, lower margin environment.

The root cause of this is the reduction in supply chain pressures (particularly around chips) and a more cost-conscious consumer. While given this backdrop the move from Ford to LKQ made sense, we also believe it should provide a high degree of support for many of our holdings in autoparts companies – which have, over the past 18 months, had their profitability somewhat held back by the reduced level of total volumes of vehicles sold.

We also made a switch in the consumer apparel side of the portfolio. We sold our position in Wolverine Worldwide, a company that operates a number of footwear brands (including Merrell and Wolverine) as well as Sweaty Betty, the lifestyle apparel brand. Against this we bought a position in Crox, the producer of divisive rubber footwear.

We believe the market to incorrectly assess Crox as simply being a Covid beneficiary and not having developed an enduring enough market position – rather, we believe Crox has actually created a brand new segment within the market and is in fact seeing that segment solidify and grow post-Covid rather than fade. We also have a strong belief that more broadly high yield investors fail to adequately appreciate the value of strong brand equity, and Crox definitely appears to us to fit into this mould.

We bought a number of investment-grade-rated positions that were trading at spreads comparable to (or in certain cases wide to) BBs. This dislocation was happening in GBP-denominated BBB credits, and we are happy to be on the other side of this in lending to these companies at very attractive levels. Examples of this were Inchcape (automotive distributor), Close Brothers (UK financial services), and Weir Group (engineering solutions).

On the government bond side of the portfolio, the major change was to switch from UK government bonds (both nominals and inflation-linked) to US Treasury Inflation Protected Securities (TIPS – US government inflation-linked bonds). We switched for three reasons. The first (and most important) reason was simply that the role of these bonds in the portfolio is – alongside providing a respectable income – to act as something of a hedge to the riskier credit/equities within the portfolio. We were worried that UK government bonds had the potential to become positively correlated with wider risk sentiment, and therefore would act as a poor hedge relative to alternatives.

The second was that the supply picture for UK government bonds is significant over the coming months, and that large amounts of buyers will need to be found – potentially creating a negative technical. Thirdly, while valuations on UK government bonds have moved significantly relative to their post-GFC trading range, valuations don’t look objectively very cheap against alternatives given the UK’s inflation backdrop. 10yr Gilts currently trade c. 60bps back of 10yr US Treasuries – which doesn’t seem ridiculous considering the UK appears to be having much more significant issues in controlling inflation.

Likewise, in inflation-linked terms, 10yr UK government bonds are trading with a real yield of 0.8% and a comparable break-even (an implied level of inflation) of 3.4%. US 10yr government bonds are trading with a real yield of 1.8% and a break-even of 2.3%. In other words, US inflation-protected securities are offering a greater level of inflation protection (remember – you want to buy inflation-linked bonds when the break-evens are low, as this means you’re not paying up for inflation protection) and more than double the level of real yields. Given all this, we felt US government bonds (specifically TIPS) were the better place for us to allocate as the “hedge” within the portfolio.

Equities

Within equities, strong performers over the quarter included Melrose, who raised their medium-term cash generation targets materially on the back of a recovery in the civil aerospace markets. 3i continued to perform well, as the quality of their discount chain Action is starting to be recognised more broadly now it is over 60% of the NAV. Elsewhere we remain positive on UK financials which offer attractive growing yields supplemented by large share buybacks. As interest rate expectations move higher we have sold out of our position in property company London Metric and re-invested the proceeds into Deutsche Telecom, where fears over Amazon's entry into the US mobile market have seen the shares re-trace more recent gains.

Outlook

The overarching theme of the first half of 2023 has been the creeping fear that whilst inflation is certainly rolling over, there is increasing uncertainty as to where it rests. Central banks may have to tighten policy more than previously expected to reduce inflation and this has had a significant impact on interest rates at the front-end of global bond markets.

Accordingly, any notions of cuts have been priced out of the market for the end of the year and the conversation has changed from when cuts start after this pause, to whether there will be the need for further hikes after the pause. This change in dynamic is important because it ultimately is likely to influence the extent of economic damage that occurs and by extension what the default picture for high yield looks like over the coming years.

As a result, we have added higher quality exposure where we believe we were being well compensated for it, and we have reduced lower quality exposure where we believe volatility will be felt should recession fears increase further. Broadly, the bonds we are trying hardest to avoid are businesses with very high levels of debt that will struggle with the combined impact of higher funding costs and lower demand.

However, investors should take comfort from the strategy’s tiny exposure to CCCs and our disciplined approach to managing volatility. Notwithstanding this, we still retain exposure to cyclical businesses and fundamentally believe taking such risks represent outstanding risk / reward in the current environment.

We have spoken a lot about how the reset in valuations that has occurred over the last 18 months has created huge opportunities for strategies like ours that focuses on providing investors with attractive recurring income. It also has meant that strategies like the High Income Fund can use a much broader array of securities and risk buckets to deliver income without compromising on either total return or risk.

We hope to continue this trend, and believe that the fund is a hugely interesting proposition for clients given the changes in the market we have seen over the past 18 months.