Q4 2019 Quarterly Commentary (USD)

MARKET ENVIRONMENT

 During the fourth quarter, financial markets had a positive trend, as reflected by the performance of the fund. Spreads on subordinated debt of financials tightened during the quarter. The year ended strongly following positive developments related to Trade Wars and the UK General Election. The fund benefited from the income during the quarter as well as from price appreciation of securities held. Despite the continued dovishness of Central Banks, the 10-year Gilt rate went up during the quarter. Nevertheless, our fund performed strongly demonstrating its low sensitivity to interest rates. Within this low interest rate environment, we feel the fund is well positioned by capturing spreads of more than 400 basis points. Within the legacy space, prices of the securities continued benefiting from the positive developments linked to a number of issuers redeeming their old-style bonds. However, we feel that there is significantly more upside. Instruments which have been issued under Basel II and Solvency I do not comply with the new regulatory framework (so-called legacy/grandfathered bonds). Over time, these bonds are becoming inefficient. Therefore, there is a lot of optionality in terms of having issuers tendering or calling these bonds over the coming quarters/years at a significant premium to current prices, as has been demonstrated by Santander, Commerzbank and Ageas. During the quarter, we also saw very strong demand for new issues. Going forward we expect to continue to receive the high and predictable income from the companies we are invested in and this independent of market conditions. In addition, we believe that the fund should benefit from further price appreciation over the mid/near term. This might not necessarily happen in a straight line but given the attractive valuation levels of securities in our area, we believe that there is scope for further spread tightening. 

PERFORMANCE

 The price of the fund increased by 4.57% over the quarter, versus the Barclays GBP Aggregate Corporate Total Return Index, which decreased by 0.23%. 

There are two important sources of return for the fund. The first, which was significant and always positive, is the income from the underlying bonds. In line with expectations, we received 3.5% 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 going up and down. During the period, positive contribution from price appreciation was very significant as spreads tightened during the quarter.

Performance contributors

 The aggregate positive contribution of the top 20 contributors was more than 2.76%, with Direct Line 4.75% being the top contributor. UK names have performed strongly following the General Election. However, we feel that despite the strong performance during the quarter, these bonds remain very attractive with spreads above 400 bps. 

Performance detractors

 The aggregate negative contribution of the bottom 20 detractors was approximately 0.11%. We have seen small pockets of underperformance during the quarter. Some corporates underperformed despite no changes in fundamentals. 

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 fund is the bias towards financials, at 80.50%. 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 400bps, valuations remain extremely attractive. To put this into context, this is more than four 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. 

High income:

Income is a significant component of returns, with a yield to maturity of 4.94% compared with 2.12% for the benchmark. 

Low sensitivity to interest rates:

With more than 56% 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 

OUTLOOK

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 close to 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 Q4, 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 and capital structures. 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 at the beginning of 2018 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 it was seen with Santander, Commerzbank and Ageas. As issuers need to align their capital stacks according to on-going changing regulatory requirements, 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 GBP-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 4.94%, 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. 

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