Q4 2018 Quarterly Commentary (EUR)

During the last quarter of 2018, the markets were handicapped by headlines related to Brexit, the Italian budget and trade wars. The fund was not immune to this and declined over the quarter despite the fact that there had been no negative credit events.

Throughout 2018, while the prices of our bonds fell, the credit strength of the individual companies we invest in has improved. Our fund generally invests in investment-grade financial and corporate companies yielding 5-6% or more and what drives the performance of the fund over time is the credit quality of the issuers that we hold, combined with the steady and predictable income that we capture from their bonds. 

Looking forward into 2019, as we listen to many differing forecasts and assess macro cross-currents, we will continue to focus on the simplicity of investing in a diversified portfolio of strong individual credits paying higher yields than in 2018 and collecting coupon income. With credit quality remaining strong and the effect in bonds – which is not there for equities – of pull to par, prices should recover once the dust settles. The price movements appear to us to be extreme and do not reflect the strong quality of issuers held in the portfolio, some of which have seen their ratings upgraded during the last quarter. 

Examples of what we perceive to be extraordinary value include 5.25% HSBC trading at just 99.5% despite a call option and interest reset in September 2022 at 4.385% over five-year swaps. Another example is Banco Santander, now trading at 79.6%, giving a running yield of 6% per annum to reset date at 4.097% above five-year rates in March 2025. We find these yields attractive in and of themselves and there is also the possibility of capital gain with a call at par (for a yield of 9.4% per annum) if, over the course of the next six years, the market goes through a period with a more positive tone. 

It is important to keep in mind that what drives the performance of the fund over time is the credit quality of the issuers that we hold, combined with the steady and predictable income that we capture from the bonds. Prices can drop because of negative sentiment, but as the credit quality has not changed, prices should recover once the dust settles. What is more, our blend of floater and fixed-to-floater bonds mitigates the sensitivity to any small movements in rates. 

During the quarter, the stress tests conducted by the Bank of England and the European Banking Authority were positive as banks performed well overall with improved aggregate, stressed core equity tier one and leverage ratios which reflects continued capital accumulation. This denotes the strength and resilience of UK and European banks and the banking sector. We have been managing this strategy since 1985, and on a gross as well as a relative basis, this is one of the most extraordinary times for investors. Paradoxically, and despite the ongoing improvement in credit metrics, spreads of subordinated debt have widened this year by more than 200 basis points. The level of spread that we are currently capturing does not reflect the strong fundamentals. 

As we enter 2019, we are assured that Income will be a strong driver of performance going forward. We also expect to benefit, at some stage, from capital gains.

 

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