Q3 2018 Quarterly Commentary (USD)
Following the strong ‘risk-off’ environment in Q2, prices somewhat stabilised during Q3. Concerns regarding trade wars, Italy, and Brexit have continued to dominate the headlines, in addition to developments in Turkey and Argentina. In spite of that, the credit metrics of the issuers within our fund remain very strong. All of our issuers reported results which were in line, or better than, expectations during the Q2 earnings season. What we saw across the board was further capital build up, continued de-risking activities and ongoing cost-cutting initiatives. This should lead to further reratings as credit metrics keep on improving. Subordinated debt holders should be benefiting the most from that. There has also been concern about rising rates during September, with the US 10-year Treasury yield rising to 3.06%. However, with more than 65% of the securities either fixed-to-floaters or already floaters, the fund is very well positioned for an environment of somewhat higher rates. Moreover, spreads are currently extremely wide, especially given the credit metrics of the issuers within our fund. Therefore, we believe there are good opportunities for long-term investments as spreads are still significantly above their fair value and do not reflect the strong underlying credit quality of the issuers held in the portfolio. For example, Credit Suisse issued an AT1 coco in July at a coupon of 7.5%, which represented an issue spread of 460 basis points above mid-swap rates. It is callable every five years, and, if not called, the coupon refixes at 460 bps over mid-swap rates. Another example was the new AT1 issue of Barclays in August, which came with a coupon of 7.75%, which represented a spread of close to 500 basis points. The Barclays new issue has a similar structure to the Credit Suisse bond, but with a coupon refix of 484 basis points over mid-swap rates.
The price of the USD Institutional Acc share class of the fund returned 1.19% over the quarter, versus the Barclays US Aggregate Corporate Total Return Index, which gained 0.97%.
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 5.99%. This has been the driver of performance during this quarter, since 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 being marked up and down. During the period, prices were relatively stable, despite the fundamental improvements in many of our credits.
The portfolio’s top three contributors included HSBC 6%, HSBC 6.375% and Deutsche Bank 7.5%, which, on aggregate, contributed 34 basis points. Deutsche Bank performed well following strong earnings, as well as positive developments from a credit perspective. These three contributors are fixed-to-floating rate notes. If not called, their coupons reset at large spreads above mid-swap rates. 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.
The top three performance detractors included BNP Paribas floating-rate notes, Trafigura 6.875% and Standard Chartered floating-rate notes, and they had an aggregate negative contribution of 20 basis points. Trafigura declined from 96% to 90%, despite remaining solid in terms of profitability and performing strongly from a credit perspective. The BNP and the Standard Chartered instruments are both floating-rate notes and should, therefore, benefit from higher interest rates.
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, as well as to capture the higher income. One feature of the fund is the substantial holding in financials, at 81.65%. 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 on some of these securities currently above 400 basis points, valuations are extremely cheap. To put this into context, this is approximately four 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, in a lot of cases, more than what one would get for 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 5.99% compared with 4.07% 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 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.
The first half of the year has been extremely challenging in terms of price volatility, especially as we are in a non-systemic environment. Price volatility that we experienced during the second quarter somewhat took us by surprise, but this is now behind us. In Q3, prices have stabilised, but have not fully recovered yet. During this year, we have not experienced any idiosyncratic events and have not changed anything in terms of the positioning of the fund including the sub-sectors, types of securities, capital structures, and issuers. The EU is still growing strongly and above its growth potential. This, combined with 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, the large spread widening this year makes us feel that valuations of our securities are extremely cheap. As mentioned previously, there have been concerns about rising US interest rates, but with more than 65% of the securities being either fixed-to-floaters or already floaters, the fund is very well positioned for an environment of somewhat higher rates. Moreover, our holdings in discounted floating-rate notes should benefit from rising interest rates and can, therefore, achieve price increases. Furthermore, with a yield to maturity of close to 6%, we feel relatively well protected against rising rates. This means that income will be a strong driver of performance going forward. We also expect to benefit from some capital gains and, therefore, feel that we are in a strong position regarding future performance.
11 october 2018
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