It's difficult to send out a weekly newsletter without mentioning the entry into force of customs duties, but we'll keep it very brief as this had already been announced several weeks ago and there was no reason or indication of negotiations to suggest that it wouldn't happen wouldn't happen... No surprises, in short, even though the equity markets reacted on Thursday as if they had just heard some bad news... Simply because, until the last moment, many thought, “They won't do it...” We have often talked about optimism bias in our publications, and this type of consensus on the possibility that a negative event that has already been announced and is more than likely to happen will not materialize is characteristic of this bias.

There will therefore be no additional long-term impact on the markets beyond what was already expected: more uncertain and weaker growth on both sides of the Atlantic, a sharp sectoral divide and complementary drivers of inflation in the US and Europe. This is therefore one step closer to a stagflation scenario, putting central banks in a difficult position, increasing the likelihood of high long-term interest rates, raising government credit spreads and volatility, and accentuating the correction in long-term asset valuations.

But that is another topic we wanted to address in today's weekly report: in recent weeks, following announcements of investment plans and funds related to defense, a number of people have asked us whether bond funds could be one of the vehicles to support such an initiative, if desired, while maintaining a cautious stance.

We do not believe that a defense bond fund is really feasible, given the structure of the bond market, the specific characteristics of companies in this sector and, more generally, the irrelevance of thematic bond funds.

Let's start with the simplest aspect of the subject, the available pool, because it is always easy to talk in theory, but you can only invest in what exists. We will approach this subject from the perspective of the number of bonds available, since a thematic or opportunistic fund with a few tens or hundreds of millions in assets under management has no reason to invest based on the total size of the market and the total assets of issuers, but rather based on the bonds available that it finds attractive given its own constraints, in this case the defense sector.

The market for bonds issued by European issuers (since the current topic of investment in defense ties in closely with that of European sovereignty) worth more than €100 million (which excludes most customized micro-bonds, particularly structured products) in which an investment of €1 million to €3 million can therefore be considered, comprises around 28,000 bonds distributed as follows:

• 5,000 sovereign bonds or equivalents (including 4,000 denominated in euros)
• 15,000 corporate bonds, particularly banks and insurers (including 10,000 denominated in euros)
• 8,000 non-financial corporate bonds (including 5,000 denominated in euros)

Applying a filter for the “Aerospace and Defense” sector to the pool of 8,000 European corporate bonds, this leaves a total of... 80 bonds spread across 17 companies! In other words, it would be presumptuous, not to say misleading, to claim to have built a diversified and selective bond fund from this investable universe, which includes Airbus, MTU, Leonardo, Thales, BAE, Safran and Rolls-Royce, some of which are much more closely linked to aerospace than to the defense sector.

“Yes, but...” some will say, ”we could consider that anything that promotes and advances European defense can be included in the investable universe, which makes it de facto broader.” Based on this principle, we could therefore consider that heavy industry is useful for defense, that governments are useful for defense, and that the automotive, IT, telecoms, and even agri-food industries are useful for defense.

Ultimately, only a few very specific sectors would be excluded, such as gaming, leisure, and fashion, resulting in a completely ordinary bond fund with only two main characteristics:

• European companies
• Good marketing justifications for each investment not directly related to the defense sector, a characteristic that we also see in many “thematic” funds on a wide range of topics...

But why is the aerospace and defense sector so underrepresented in the bond market?

Without dwelling too long on the subject, here are a few explanations for large companies in the sector:

1. A monopolistic or oligopolistic market linked to history, European regulations, and barriers to entry
2. Strong ties to governments, which can sometimes translate into capital links or debt-free financing (co-financing, research programs, advance payment of orders, etc.)
3. The need for these companies to have and maintain excellent credit quality (i.e., low debt and few bonds on the market) in order to
   1. Guarantee the execution of contracts with a small number of customers, often government entities
   2. Finance long and costly research and investment projects
   3. Limit dependence on investors, shareholders, or creditors (concept of “delegated sovereignty”)

At the other end of the chain are a multitude of small subcontractors, often specialising in a very specific link in the final value chain, working for only a few, or even a single, client and generating tens or hundreds of millions of euros in revenue, a phenomenon that is even more pronounced than in the automotive sector, for example. These companies are often far too risky and confidential to obtain financing on the bond market. However, they can be found in unlisted asset funds, particularly private equity or project financing, which could therefore be more suitable vehicles for a defense fund.

If defense is not suitable, are other sectors more suitable for thematic or sectoral bond funds?

Thematic funds are fairly common in equity markets because they allow investors to take a position on a long-term economic or social trend. The stocks in such a fund therefore have one major thing in common and, once fundamental analysis has been carried out, it is reasonable to assume that they will be driven by the same underlying trend in the long term.

Furthermore, hoping to obtain higher returns on bonds means positioning oneself on companies in difficulty, since the instantaneous return depends on the instantaneous situation of the company. Thus, a high-yield theme is, by definition, counter-cyclical and therefore less in line with the “thematic” logic that generally rides on a trend favored by the market. Here are the reasons why we believe that a sector bond fund is not a relevant vehicle:

• When it comes to bonds, it should not be forgotten that the “sector” component is ultimately fairly moderate compared to the other components that will determine a fund's performance and behavior.
  • Interest rates: on a BBB bond, for example, only 20% to 30% of the yield can be considered to come from the “company” component.
  • Duration: positioning oneself on the bond market means above all choosing an investment horizon of between 1 and 50 years on a credit risk category. However, not all sectors offer all types of credit quality (for example, defense will have little or no high-yield quality) and not all issuers offer all maturities. Therefore, limiting oneself to one sector and a few companies can be too restrictive in terms of duration positioning.
  • Maturity of securities: positioning oneself on a long-term theme such as defense or senior citizens requires time to make the investment profitable. However, bonds have a maturity and it is never certain that the portfolio will remain homogeneous over time depending on the maturities of the bonds. Bank refinancing, deleveraging, changes to the maturity profile or rating upgrades can therefore significantly alter a thematic bond portfolio. For example, a commodities portfolio would have been high yield in 2016-2018 and investment grade from 2020-21, which fundamentally changes the risk and return profile of a fund of this type.
  • Fundamental credit analysis and bond picking do not place as much importance on the sector as equity analysis for two reasons:
    • First, bond yields are capped and only apply at maturity, which limits the appeal of focusing on a particular theme since the expected long-term return would be the same as in other sectors, with less diversification. In a non-sectoral but ESG example, a few years ago we saw the emergence of “green bond” funds, which were ultimately a category of bonds equivalent to others in terms of issuers but more restricted by a specific characteristic. Ultimately, due to this restriction on the investment universe and the flows of these “trendy” funds, green bonds offered lower returns, and therefore lower expected performance, than equivalent bonds not labeled “green.” Lower performance for the same risk, or even higher risk since the potential volatility was de facto greater, is the opposite of what is expected from a financial manager and what can also be expected from a thematic fund, which is supposed to position itself on a long-term “promising” trend.
    • Secondly, in credit analysis, the balance sheet situation and financial policy ultimately play a greater role than the sector, and while it is currently advisable to avoid the automotive sector in equities because the outlook for growth and earnings is gloomy, there are, on the other hand, a few companies in the credit market with sound balance sheets, relatively prudent financial policies and yields of over 10%, which may be just as good as investing in a telecommunications or retail company, sectors that are a priori less cyclical and more favorable, over-indebted or systematically disadvantaging creditors (who have no voting rights) in favor of shareholders, as was the case with Casino and Altice in their day.
• Because long-term equity returns can theoretically be infinite, a theme can attract investors over a long period without losing its potential and appeal. Conversely, because bond yields are limited to the coupon yield and 100% repayment at a given maturity, a bond theme will generally be short-lived and will struggle to last long enough to justify creating a specific fund, unless there are high sustainable yields in a segment of the market, which is rare and inevitably requires a crisis.
• Sector-specific waves of debt or major, widespread credit crises affecting an entire sector, which could justify a thematic fund with a given maturity, for example, are not very frequent, and are even very rare, especially in Europe. Notable examples include the 2008 banking crisis, which gave rise to a few specialized funds in the sector but whose relevance is less obvious now that most bond teams have assimilated the regulations and yields have more or less normalized, the 2016 commodities crisis, which mainly affected the US and its many companies that had invested in unconventional oil, and the ongoing European real estate crisis.
• The opportunities for a “thematic” bond fund offering higher long-term returns therefore come from major crises in a particular market segment. and by definition, a crisis means major investor mistrust of the theme in question, which generally runs counter to the possibility of creating a fund at that moment, since very few investors would feel comfortable positioning themselves on these companies in crisis (otherwise their yields would not be so high)... “QED,” some would say.

In conclusion, we do not believe that a bond fund managed according to the logic of risk/return in portfolio management, financial analysis and credit analysis in particular can be set up on a theme as restrictive as a sector such as defense. However, broader themes such as sovereignty, as some of our colleagues have done, can be addressed but require in-depth analysis of companies that is very similar to ESG, with perhaps an emphasis on the S and on themes that are currently not covered very well by rating agencies or analysis firms: the share of local or foreign suppliers and customers, the share of local or foreign creditors and shareholders, dependence on raw materials from a particular geographical area, the importance of the company's offering to a country's independence in a particular field.

We therefore do not believe that there will be any “defense” bond funds in Europe, but bond investors, whether private or institutional, will still be the main contributors to all European government investment plans in this area, as these will inevitably involve public finances... and government bonds, whose abundant supply in the future should give free rein to all possible fund creations across all maturities and with yields that are likely to be increasingly high...