Q2 2019 Quarterly Commentary (USD)
During the second quarter, financial markets continued to have a positive trend, as reflected by the performance of the fund. Dovishness from both the Fed and the ECB contributed to stronger markets. However, we feel valuations are still very attractive and should continue to 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 a partial recovery of last year’s spread widening. There was extremely strong demand for new issues during the quarter. For example, Barclays came with a new AT1 GBP deal in early June, in part to refinance outstanding bonds which have call dates within the next year. They issued GBP 1 bn at a coupon of 7.125%, callable in 6 years. This means that it came at a spread of 6.579% above gilts. If not called in 6 years it refixes at a spread of 6.579%. There was approximately GBP 5 bn of demand for that deal and it is currently trading higher. One area in our fund that has underperformed during the month, due to lower rates, are the Discounted Floating rate notes (FRNs) that we own in order to protect the fund against interest rates. A dovish tone by central banks put further pressure on rates and since coupons on FRNs are reset based on these, price of FRNs declined in order to adjust for their potential lower future income and this independent of the credit quality of the issuers. We view our allocation to FRNs as a hedge against higher interest rates and consequently are not looking to change this exposure. What the market is also completely ignoring for now is that these instruments have been issued under Basel II and Solvency 1 and as these do not comply with the new regulatory framework (so-called legacy/grandfathered bonds), the optionality of these bonds in terms of having issuers tendering or calling them over the coming quarters/years at a significant premium to current prices is material. Spreads are still more than significantly wider than a year ago. Therefore, we believe that our securities remain extremely attractive. We will continue to capture the highly predictable income from the companies we are invested in. We also believe that we should benefit from further recovery in prices during the year and have already seen a small part of this during the first half of the year. This might not necessarily happen in a straight line. Given the cheapness of securities in our area, we believe that there should be further spread tightening during the rest of this year.
The price of the fund increased by 3.56% over the quarter, versus the Barclays USD Aggregate Corporate Total Return Index, which increased by 4.48%. The benchmark has a strong sensitivity to interest rates, and because of that outperformed since interest rates fell during the quarter, as indicated by the 5 year US government bond rates, which went from more than 2.3% to less than 1.8%.
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 1.31% 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 strong positive contribution.
The performance contributors were mainly AT1 CoCos, as well as to a lesser extent insurance subordinated debt. Some high coupon legacy securities also contributed to the performance during the quarter. The performance contributors during the quarter have been recovering from the spread widening of last year. The aggregate positive contribution of the top 20 contributors was more than 2.0%, with Rabobank 6.5% being the top contributor. Despite the positive contribution of these securities during the quarter, we still believe their valuations are attractive and that they trade well below fair value.
The detractors were mostly undated floating rates notes that are either legacy Tier 1 or Tier 2 securities that have lagged the risk-on move in markets due to lower rates and the dovishness of Central Banks. We own these securities to protect the fund against higher rates and see material delta from these positions as such securities are becoming increasingly inefficient for banks and insurers from a capital eligibility perspective and hence will need to be called at par or tendered at a significant premium. For instance, ING have given indications that will look to replace their legacy securities at the end of the grandfathering period for banks in 2022. In Q1, when they issued their RT1, Aegon had also given an indication of replacing their legacy securities at the latest in 2025. The aggregate negative contribution of the bottom 20 detractors was close to 52 bps.
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 bias towards financials, at 79.35%. 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 320 bps, valuations remain extremely attractive. To put this into context, this is more than three 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.
Income is a significant component of returns, with a yield to maturity of 5.20% compared with 3.16% for the benchmark.
Low Sensitivity to interest rates: With more than 65% 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 more than 5.5% 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 Q2, 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 in the strong and improving credit fundamentals of our issuers. Furthermore, spreads are still significantly wider than a year ago 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 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, 5.5% remain very attractive, particularly when they concern investment-grade-rated securities. With a yield to maturity of 5.2%, 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 juin 2019
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