Q1 2019 Quarterly Commentary (EUR)

MARKET BACKDROP

During the first quarter, financial markets had a positive trend, as reflected by the prices of the securities within our fund.  Positive developments on trade wars, as well as the fact that a no-deal Brexit scenario seems to be extremely unlikely, have provided support to the markets and spreads for our securities tightened. However, we still feel our securities are very cheap and should benefit going forward from the strong credit fundamentals of the companies in which we are invested. Moreover, the spread tightening that we have experienced this year is only part of the recovery of the spread widening of last year.  There have been concerns regarding a potential slowdown in growth, but at the same time central banks have turned much more dovish than expected.  This last factor is good for credit and maybe less so for equity. There was extremely strong demand for new issues during the quarter. This included a BBVA 6% AT1 coco in euros which is callable in 5 years.  The strong demand for new deals associated with the more limited number of new issues should serve as a positive technical factor going forward. There was also a new RT1 issued by Aegon which came at more than 500bps above with a coupon of 5.625% in euros. This security is very attractive and is rated IG by two of the rating agencies. Another important aspect about this new issue is that they are using the RT1 to replace grandfathered legacy securities. This should be very supportive for legacy securities in general.  Spreads are still more than significantly wider than a year ago. Therefore, we believe that our securities remain extremely cheap. We will continue to capture the highly predictable income from the companies we are invested in. We also believe that we shall benefit from a recovery in prices during the year and we have already seen a small part of this during the first quarter. This might not necessarily happen in a straight line. Given the cheapness of our securities, we believe that there should be further spread tightening during the rest of this year.

PERFORMANCE

The price of the fund increased by 5.51% over the quarter, versus the Barclays EUR Aggregate Corporate Total Return Index, which increased by 3.20%.

Performance of fund for the period

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. As expected, during the quarter all the coupons were paid and received. Income is the most important component of the fund, with a current yield to maturity of 4.48%. We received 1.13% 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 being marked up and down. During the period, this had a positive contribution.

Performance contributors

The performance contributors are mainly AT1 cocos and insurance subordinated debt. The top contributor was Rabobank 6.5%. The performance contributors during the quarter have started recovering a bit from the spread widening of last year. The aggregate positive contribution of the top 20 contributors was more than 3.3%. Despite the positive contribution of these securities during the quarter, we still believe their valuations are extremely appealing and that they trade well below fair value. 

Performance detractors

These are mostly undated floating rates notes that are either legacy Tier 1 or Tier 2 securities and that have lagged the risk-on move in markets due to lower rates. We own these securities to protect the fund against higher rates and see material delta as these securities are becoming increasingly inefficient for banks and insurers as losing capital eligibility and hence will need to be taken out. The aggregate negative contribution of the Bottom 20 detractors was less than 20 bps.

POSITIONING

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 the fund is the substantial holding in financials, at 78.67%. Therefore, 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. Subordinated debt holders of financials should benefit the most from this. Moreover, with spreads of these securities currently above 450 basis points, valuations are extremely cheap. To put this into context, this is mor than 4 times the spread that one was capturing for 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 captures are more than what one would get for 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 4.48% compared with 0.84% for the benchmark.

Low Sensitivity to interest rates:  With more than 70% of the securities being either fixed-to-floaters or already floaters, the fund is very well positioned for an environment of somewhat higher 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

Our holdings in non-financial companies enable us to increase the diversification within our funds and benefit from strong credit stories.

OUTLOOK

We invest in the bonds of strong issuers, and therefore we believe the fund will not only keep on capturing the steady income of close to 5% per annum, but our base case is for spreads to continue to tighten significantly during the rest of the year. During Q1, 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, capital structures, and issuers. The continuation of the multi-year process of capital strengthening for European financials, makes us feel very confident regarding the strong, and improving, credit fundamentals of our issuers. Furthermore, spreads are still significantly wider than a year ago, and this makes us feel that valuations of our securities are extremely cheap. Regarding legacy capital securities, regulatory changes should lead to bonds being taken out and hence we see upside risk from early calls and tenders. As issuers need to manage their excess capital position and there is increasing pressure from regulators to clean-up capital structures, issuers are incentivized to redeem capital securities that are increasingly inefficient. We expect this to be a positive driver for future performance. We continue to believe that yields on euro-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 4.48%, income will 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.

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