Q3 2019 Quarterly Commentary (USD)
During the third quarter, despite strong earnings, markets were somewhat mixed due to on-going political headlines and macro uncertainties. The tone turned better in late August and September, following cuts in interest rates by both the ECB and the Federal Reserve. The fund mainly benefited from the income during the quarter as well as from further price appreciation of securities held. The ECB also announced the reopening of asset purchases, which despite being lower than expected at EUR 20 billion a month, is open-ended, which can be seen as a positive. Finally, the ECB has announced a new round of TLTRO at very favorable terms and deposit tiering where part of the banks excess liquidity reserves will be exempt from negative rates. This will alleviate some pressure around bank earnings and in tandem with further dovish monetary policy to boost the economy this is a strong positive for financials. Following the dovishness of the Central Banks, the 10 US Treasury finished the quarter at 1.67%. This makes the income aspect of our portfolio even more attractive on a relative basis, as we are capturing spreads well above 350 basis points. At the end of September, within the legacy space, we saw a positive development, which was that Santander called one of their floating rate notes at par at the end of the month. The bond was trading at 67% prior to the call at par. This had a positive impact on other legacy bonds that we own. However, we feel that there significantly more upside. Instruments which have been issued under Basel II and Solvency I do not comply with the new regulatory framework (so-called legacy/grandfathered bonds). Over time, these bonds are becoming inefficient. Therefore, there is a lot of optionality in terms of having issuers tendering or calling these bonds over the coming quarters/years at a significant premium to current prices, as has been demonstrated by Santander. During the quarter, we also saw very strong demand for new issues. Going forward we expect to continue receiving the high and predictable income from the companies we are invested in and this independent from market conditions. In addition, we believe that the fund should benefit from further price appreciation over the mid/near term, as already experienced year-to-date. This might not necessarily happen in a straight line but given the attractive valuation levels of securities in our area, we believe that there is scope for further spread tightening.
The price of the fund increased by 1.92% over the quarter, versus the Barclays US Aggregate Corporate Total Return Index, which increased by 3.05%. The benchmark has a strong sensitivity to interest rates, and because of that outperformed since interest rates fell during the quarter.
There are two important sources of return for the fund. The first, which is significant and always positive, is the income from the underlying bonds. In line with expectations, we received 1.42% in accrued income during the period. The second component of return for the fund is realised/unrealised capital gains or losses. In general, as the fund follows a fundamental buy-and-hold strategy, this component is largely the result of prices going up and down. During the period, positive contribution from price appreciation was 0.40%.
The aggregate positive contribution of the top 20 contributors was more than 1.13%, with Rabobank 6.5% being the top contributor. We feel that despite the strong performance during the quarter, this bond remains one of the most attractive securities within our space. Compared to Rabobank AT1 cocos, this bond trades extremely wide, and we feel that it is valued more than 10 points below its fair value, in addition to the income we receive. AT1 cocos also performed well during the quarter.
The aggregate negative contribution of the bottom 20 detractors was approximately 59 bps. We have seen small pockets of underperformance during the quarter. Some corporates underperformed despite no changes in fundamentals. Although some EUR-denominated legacy perpetuals have rallied following the Santander call, this has not fed through to all of those securities. For instance, the Standard Chartered floating rate note was one of the largest detractors. We believe this bond should benefit from the fact it is becoming more and more inefficient, and therefore we see significant upside going forward.
The fund invests predominantly in investment grade issuers, but we are prepared to go down a company’s capital structure to find the best combination of yield, value and capital preservation. One feature of fund is the bias towards financials, at 79.65%. For some time, we have positioned the fund to benefit from the continual improvement of credit metrics within European financials. Moreover, regulations are forcing financials to build up capital and strengthen their balance sheets, all of which are supportive from a credit perspective. We expect holders of financials’ subordinated debt to benefit the most from this. Furthermore, with spreads of these securities currently above 400 bps, valuations remain extremely attractive. To put this into context, this is more than four times the spread that was being captured from the Tier 1 securities of HSBC issued before the global financial crisis in 2007. This is despite the fact that, as mentioned above, financials have become much stronger from a credit quality standpoint.
Investment grade issuers: The spreads the fund seeks to capture should be more than that offered by European high-yield corporates, with the additional benefit that the average rating of the issuers held within the fund is BBB+.
High income: Income is a significant component of returns, with a yield to maturity of 5.07% compared with 2.91% for the benchmark.
Low sensitivity to interest rates: With close to 68% of the securities being either fixed-to-floaters or already floaters, the fund is positioned to have low sensitivity to interest rates. Fixed-to-floating bonds are bonds where the coupon is fixed until the first call date within five to ten years and then is re-fixed on a floating-rate note basis.
We invest in the bonds of high quality issuers and therefore we believe the fund will not only keep on capturing the steady income of close to 6% per annum, but we should also see additional capital gains as our base case is for spreads to tighten further during the rest of the year. During Q3, from a credit standpoint, the issuers we hold have behaved as expected. We have not changed anything in terms of the positioning of the fund, including the sub-sectors, types of securities and capital structures. The continuation of the multi-year process of capital strengthening for European financials, makes us feel very confident in the strong and improving credit fundamentals of our issuers. Furthermore, spreads are still significantly wider than at the beginning of 2018 and this makes us believe the valuations of our securities are extremely attractive. Regarding legacy capital securities, regulatory changes should lead to bonds being taken out and hence we see upside potential from early calls and tenders, as it was seen with the Santander call. As issuers need to manage their excess capital position, and there is increasing pressure from regulators to clean up capital structures, issuers are incentivised to redeem capital securities that are increasingly inefficient. We expect this to be an additional positive driver for future performance. We continue to believe that yields on USD-denominated securities that we own at close to, or above, 5% remain very attractive, particularly when they concern investment-grade-rated securities. With a yield to maturity of 5.07%, income will continue to be a strong driver of performance going forward. We also expect to continue benefiting from some capital gains and, therefore, feel that we are in a strong position regarding future performance.
30 septembre 2019
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