Market environment

Market sentiment has been extremely weak over the last three months despite the underlining quality of the credits in the portfolio having generally improved and 10-year US Treasury rates only rising 12 bps to 2.86% during the period. This has created good opportunities for long-term investors as spreads have widened significantly above fair value and do not reflect the strong underlying credit quality of issuers in the portfolio. We repeat the example of HSBC contingent capital securities which now yield above 6.5% to the call within 5 to 10 years and represent, in our view, excellent value relative to 10-year US Treasury yields. The income offered by our portfolio continues to provide an attractive return and the fund is well positioned for an environment of somewhat higher rates. This is thanks to owning 50% in fixed-to-floater bonds and almost 15% in discounted floating rate notes, as well as a number of high-coupon securities with relatively short issues call dates.

Performance

The USD institutional share class declined 3.91% over the quarter, versus the Barclays US Aggregate Corporate Total Return index, which lost -0.98%. The reason for this sharp decline occurred in February and March as a result of risk-off sentiment in markets caused by credit unrelated events. There are two important sources of return for the fund. The first, which is significant and always positive, is the yield from the underlying bonds. Yield is the most important component of the fund, with a current yield-to-maturity of 6.02%. On a quarterly basis, this is not necessarily the predominant feature, but it should not be underestimated. In particular, due to our 15.5% weighting in both Libor-based and 10-year swap-rate-based floating-rate notes, which currently have lower yields than average, the fixed-rate bonds provide a large part of this return. The second component of return for the fund is realised and 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.

Performance contributors

The portfolio contributors included the 6.15% Tesco 2037 where the price increased marginally from 106.5% to 107.5% and two high coupon callable bonds: the 8.25% Aviva/Swiss Re which has now been called for redemption and the 6.85% HBOS/Lloyds, which remains outstanding.

Performance detractors

Two of the performance detractors were Tier 2 floating rate notes from HSBC where the price fell from 90% to 77% and from Nordea where the price fell from 88% to 71%. This movement was caused by the fact that Nordea announced that they would not be calling the securities in the near future and HSBC reclassified these securities from grandfathered to fully eligible under CRR. We bought both securities at much lower prices and own them to protect the fund against interest rate risk and not for their potential capital gain in case of a call. However, we believe that current prices now undervalue these floating rate notes. The third negative performance was from 5% UBS contingent capital securities where the price fell from 93.625% to 88.5%, due to the low back-end that by nature makes it more price sensitive due to potential extension risk.

Positioning

We have for some time positioned the fund in anticipation of a normalisation in interest rates, even if this takes longer than originally anticipated. Yield is a significant component of returns with a yield-to-maturity of 6.02% compared with 4.02% for the benchmark. This is despite significant holdings in discounted floating-rate notes, where interest is re-fixed every three, six or 12 months based on either short-term Libor or on 10-year government bond rates. These securities will benefit from higher interest rates: the higher the interest rate, the higher the re-fix rate. As they are discounted at prices within the 70% to 90% range, they not only provide a natural hedge for our fixed-rate holdings, but can achieve capital gains in their own right. We also take advantage of fixed-to-floating bonds, where the coupon is fixed until the first call date, generally within five to ten years, and then is re-fixed often on a floating-rate basis. This limits our exposure to rising 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. One feature of the fund is the substantial holdings in financials at 81.42%. While many observers associate financials with universal banks, we like our investors to note that there are many differences in business models and balance sheets among our individual holdings. We clearly distinguish between universal banks, asset managers, brokers, life insurance and non-life insurance companies. Our holdings in non-financial companies include a wide variety of global names, which have issued mainly US-dollar denominated bonds.

Outlook

The 10-year US Treasury rate increased from 2.74% to 2.86% during the quarter and while we remain focused on potentially higher short-term and long-term interest rates going forward, we do not expect the 10-year interest rate to rise much beyond 3%. This means that many of the fixed interest rate bonds that we hold that yield well over 5% are relatively well protected. In addition, we own many fixed-to-floating securities where the interest rate will be re-fixed within the next few years or the bonds can be called for redemption. Finally, we have holdings in discounted floating rate notes, which benefit from rising interest rates and can achieve price increases. For our financial companies, higher yields continue to provide benefits within Europe, while a normalisation of interest rates should also strengthen them and act as a positive catalyst for the junior debt of good institutions. We will continue to maintain a good balance between fixed-rate, fixed-to-floating and floating rate securities in order to achieve a steady high income and capital gains.


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19 July 2018

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Fund Management Team


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