Artemis High Income Fund update

Source for all information: Artemis as at 30 June 2024, unless otherwise stated.

•  The fund was the top performer in its peer group over the first half of 2024.
• We continue to find upside in selected short-dated high-yield bonds.
• We positioned the fund in anticipation of a volatile summer for bond markets.

Performance

Over a choppy quarter for bond markets, the fund generated a total return of 1.6%, outperforming its peer group, the IA’s £ Strategic Bond sector, where the average return was 0.4%. That strong performance capped off a good start to 2024: a total return of 5.2% over the year to date made the fund the top performer among its peers.  

As the table shows, the fund’s commitment to delivering a high level of income has resulted in a significant margin of outperformance relative to its peers over the long term. Thanks to the rise in yields seen over the past two-and-a-half years, we believe focusing on income will continue to pay dividends going forward.

The main drivers of the fund’s returns over the quarter included:

Its lack of exposure to longer-dated government bonds relative to the peer group was helpful. ‘Stickiness’ in inflation, uncertainty about the timing and extent of rate cuts, worries about government debt burdens and political flux resulted in a difficult and volatile quarter for the major government bond markets.

On the credit side, a number of our holdings in the high-yield space delivered useful returns with limited levels of volatility. The biggest contributions came from:

• Heimstaden (European real estate),
• Pfleiderer (construction materials), and
• Victoria (carpets).

We saw useful contributions to returns from the equity portion of the portfolio, notably from our holdings in 3i and in UK banks Barclays and NatWest.

Inevitably, not every holding outperformed. On the negative side, underperformers over the quarter included:

• Medical Properties Trust, the US hospital REIT (bonds);
• Melrose, aerospace (equities); and
• Sotheby’s, the auction house (bonds).

Activity

The importance of switching…

Although space constraints prohibit us from listing every trade made over the quarter, a recent switch within the capital structure of portacabin-leasing business Modulaire helps to illustrate an important part of our approach. Here, we switched out of its higher-rated secured bonds and into its lower-rated unsecured bonds. Clearly, the unsecured bonds should trade on a discount (offer a higher yield). But how wide should that discount be? Oscillations in the spread between the two bonds tend to be driven by changes in sentiment and by technical factors rather than by fundamentals. That presents us with an opportunity: by switching between the two bonds as the spread narrows and then expands we hope to find the optimal balance between risk and reward and potentially generate capital gains.

We continue to actively exploit similar switching opportunities elsewhere. Sometimes (as with Modulaire) these switches are between different parts of the same company’s capital structure. On other occasions, they are between bonds denominated in different currencies or between the bonds of similar companies. We expect this active approach to be an ongoing source of returns for the fund.

Adding new issues….

Away from switches, we bought a number of new issues over the quarter. They included:

• Herc Rentals, the US equipment rental firm;
• BlueNord, a Danish oil & gas producer; and
• MasterBrand, the market leader in household cabinetry in the US.

Both Herc Rentals and MasterBrand are BB-rated and we viewed both as being attractively priced bonds from high-quality issuers. BlueNord’s bonds are unrated, but we find its combination of low-cost production, its conservative approach to managing its balance sheet and the imminent re-opening of one of its highly profitable energy fields as being a fundamentally attractive combination, especially given the 9.5% coupon on offer. (As a reminder, the fund’s exposure to unrated bonds is minimal; they currently account for just 1.4% of the fund.)

We also added a new issue from Bertrand Franchise, a French business which owns the master franchise agreement for Burger King in France. We have lent to the Burger King France business before and have seen it deliver excellent operational performance and growth. We believe that they have attractive longer-term growth prospects given the relative under-penetration of the French market. Its franchise model means that cash generation is very strong, and the company is likely to de-lever over the next few years as it prepares for a potential IPO.

We continued to find compelling opportunities among short-dated high-yield bonds…

To recap, shorter-dated high-yield bonds tend to be less volatile than the broader high-yield market. They also have a tendency to be redeemed early, creating capital gains for their holders. It is this capital upside that we believe isn’t being fully recognised by the market. One of the companies we use to demonstrate this opportunity is Perenti, an Australian mining contractor. It partially redeemed its short-dated bonds during the quarter at a premium to par i.e. it paid us extra to redeem them ahead of schedule.

This quarter, we added short-dated bonds of IMA – an Italian producer of specialist packaging machinery for pharmaceutical, dairy, and other consumer goods – to the portfolio.

In the secondary market…

We added a position in Isabel Marant, a French fashion label. Like much of its sector, it has struggled amid a weakening in consumer confidence but we believe its core brand remains intact. The secured nature of the bonds, along with what we believe is a manageable level of leverage and the company’s low liquidity needs, led us to believe that the sell-off had been overdone.

We added positions in two cruise operators: TUI and Carnival. We believe both companies have strong market positions and will benefit from consumers’ ongoing preference for spending on experiences over physical goods. Both companies have begun taking steps designed to improve their credit quality.

On the sale side of the ledger…

We sold a number of bonds that had performed strongly and which, in our view, offered little further prospect of further outperformance. This is a core part of running a fund with a focus on higher yielding bonds. Unlike equities, we need to continuously rotate our winners into new ideas for the simple reason that the upside is – unlike an equity – absolutely capped. These included:

• La Doria, the Italian manufacturer of canned and bottled foods, whose bonds we had bought at the time of issue earlier in the quarter;
• Consensus Cloud, the provider of online fax solutions;
• Teva, the global generic pharmaceuticals company;
• Legends Hospitality, an operator of sporting concessions;
• JB Poindexter, the US truck parts manufacturer;
• Veritext, the US legal services firm;
• Dufry, the operator of duty-free stores;

We still like these companies fundamentally and may invest in them again if or when their relative valuations become more compelling.

Outlook

Over the summer, liquidity tends to dry up as market participants head towards the beach and away from their Bloomberg screens. This year, the summer holidays coincide with an unusually intense political environment and they arrive just as concerns about the long-term sustainability of government debts are increasing.

In our eyes, then, there is no simple directional trade to be made this summer. We often see market moves over the summer – particularly in government bonds - being amplified by a lack of liquidity; I see little reason to think that this year will buck the trend. So this is not a time to make any big macro bets. Our approach will continue to be to focus on income generation. As part of this, we have slightly trimmed the fund’s duration in recent months, taking it from 6.1 years down to 5.5 years. This does not mean we are bearish on bonds; we simply want to be in a position where we have flexibility to benefit from any outsized moves that may occur.

As a final – but related – point, the core of this portfolio remains high-yield corporate bonds. At present, this segment of the market is offering a yield of around 8% in sterling terms. The shorter duration of the high yield market relative to investment-grade and government bond markets appears particularly attractive at moments of heightened macro uncertainty and the levels of income on offer in the high-yield market means we don’t need to make big calls on duration and the yield curve to generate meaningful returns.