Q4 2018 Quarterly Commentary (USD)

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 these movements and suffered a decline over the quarter, mainly during October and November, despite ongoing income of approximately 0.5% per month and the 10-year US Treasury bond yield declining from 2.99% to 2.68%.

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. What is more, our blend of floater and fixed-to-floater bonds mitigates the sensitivity to any small movements in rates.

For example ,6.375% HSBC, one of our larger holdings, with a call option and reset in September 2024 at 3.705% over five-year swap rates, now trades at 93.8% with a yield of 6.9% to maturity. 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 7.74% per annum) if, over the course of the next five years, the market goes through a period with a more positive tone.

The stress tests conducted during the fourth quarter 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 continued to reflect 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 150 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.




11 october 2018

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