MARKET ENVIRONMENT

Markets were challenging during the quarter, driven by the economic ramifications of the Covid-19 outbreak. This has led to a sharp sell-off between the second half of February and the first half of March, which impacted the subordinated debt markets as well as wider credit and equity markets more generically. We saw prices stabilise and a move towards recovery as sentiment improved during the second part of March as consequence of central banks, governments and regulators all taking extraordinary measures to support the economy through this period of uncertainty.While the prices of our bonds have been negatively impacted by the sell-off, the credit quality of our issuers continues to be extremely strong as reflected by the average rating of BBB+ at the issuer level. Financials remains one of the strongest sectors within credit markets, and, in our view, banks are able to pursue their role of lending to the real economy and being part of the solution (compared to being part of the problem during the Global Financial Crisis (GFC)). Since the GFC, very strict regulations have led to extremely strong capitalisation levels and very strong de-risking of the banking system. The outcome is reflected in the results of the stress test, where banks are able to sustain an apocalypse scenario worse than the GFC with average capital ratios of 10%, or around twice the level of capital pre-crisis. Clearly beyond a small number of sectors, the current situation for corporates (especially large corporates) is a liquidity issue rather than a solvency issue. As governments and central banks have been committed to supporting these institutions during this period, through buying commercial paper or providing government guarantees on bank lending, the impact for banks’ asset quality should ultimately be limited. Central banks and governments have shown their willingness to do “whatever it takes” to support the economy, with unprecedented monetary and fiscal stimulus.The ECB issued a recommendation to European banks to refrain from paying dividends to shareholders as well as to conduct share-buybacks, at least until 1 October 2020, in line with previous communication that banks need to fulfil their social duty to keep all available resources in order to maximise their support to their clients in times of uncertainties. This decision has no impact on payment of interests made on additional tier-1 contingent convertible bonds (AT1 CoCos), Tier 2 bonds as well as preference shares, but will impact the income on the 6.5% Rabobank Perp held in the fund as this security has been issued as an CET1 instrument (as in, equity and not an AT1 instrument). We therefore continue to see strong visibility on the income captured by the fund.

PERFORMANCE

The fund (USD Inst share class) declined by 14.3% over the quarter, versus the Barclays USD Aggregate Corporate Total Return Index, which decreased by 3.6%.

Performance of fund for the period

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 5.47%. We received 1.09% 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, this had a positive contribution.

Performance contributors

Contributors have mainly been senior unsecured bonds that were less impacted by the beta of the market.

Performance detractors

The aggregate negative contribution of the bottom 20 detractors was approximately 7.06%. The main detractors of the funds have been Tiers 1s (including AT1 CoCos and RT1s), mostly reflecting the composition of the fund given the broad-based sell-off – with EUR AT1 CoCos down 13% on the month. AT1 CoCos from very high quality issuers, such as the Banco Santander 7.5% Perpetuals (callable in 2024), were hit by the sell-off, down approximately 19% on the month, now yielding more than 11% to call and approximately 7% to maturity (if not called, the coupon refixes to the 5-year USD swap rate +498.9 bps).Société Générale 7.875% Perpetual AT1 CoCos, are ineligible under CRR2 as written under English law (problematic in case of bail-in), and therefore will be disqualified if not called before June 2025. These currently yield of approximately 11% and no extension risk, reflecting the amazing opportunities we are able to capture in a dislocated market. Some legacy bonds, such as RBS’s perpetual floating rate Tier 1s (Libor+232 bps) that can be called at par in December 21, have dropped 16% on the month, now offering more than 13% yield to call. RBS has already started taking out legacy bonds in 2018-end and will continue to do so as these lose their capital treatment in December 2021. We are therefore able to capture amazing opportunities both in new and old-style bonds.Rabobank 6.5% Tier 1 certificates were impacted (down 29% in March) as the ECB issued a recommendation to European banks to refrain from paying dividends to shareholders as well as to conduct share-buybacks, at least until 1 October 2020. This impacts the income on the 6.5% Rabobank Perp held in the fund, as this security has been issued under Basel II as an CET1 instrument (and not an AT1 instrument). The bonds will therefore not pay dividends in March, June and September (coupons are non-cumulative), however the bank has full discretion of future amounts paid after that and could potentially increase pay-outs to compensate bondholders. This does not reflect the fundamentals of the bank that are rock solid, with a top-tier CET1 ratio of 16.3% and EUR 13 billion of excess capital. Finally, Trafigura hybrids were also impacted by the sell-off with bonds down 25% in March, with bonds now yielding 26% to the next call date and approximately 10% to maturity. The group’s fundamentals are very strong, and Trafigura is set to benefit strongly from the move in oil prices, as volatility has increased and the market is now in contango and profits are not sensitive to absolute oil prices.

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 the fund is the substantial holding in financials, at 83.87%. 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 of these securities currently above 550 basis points, valuations are extremely cheap. To put this into context, this is more than six 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 more than what one would get for 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 5.47% compared with 3.43% 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 10 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 profiles.

OUTLOOK

Given the sell-off seen in markets, valuations are extremely attractive and we are able to capture spreads of more than 550 bps. Furthermore, markets have become dislocated, with indiscriminate selling across the capital structure. This has created significant buying opportunities, especially as virtually all of the subordinated financials market is trading to perpetuity – with large upside for bondholders on a re-pricing to call. Furthermore, several specific instruments have been heavily impacted by the sell-off, irrespective of the characteristics of the bonds. For example RBS’s legacy perpetual floating-rate notes in USD (paying a coupon of Libor+232 bps) has fallen by 16% YTD and now yielding 14% to a call in December 2021 (close to 1300 bps of spread), at which point the bonds lose all capital value and become expensive funding for the bank. Overall, the re-pricing of bonds to perpetuity reflects the overselling and therefore a very attractive entry point into the asset class.

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