MARKET ENVIRONMENT

The securities held within the fund performed well during the second quarter. Concerns over the nature of inflation, on whether it is temporary or enduring, created interest rate volatility. This has not been a significant concern for the fund, as it is positioned to have low sensitivity to interest rates, notably through the exposure to fixed-to-floaters and floating rate notes. Moreover, subordinated debt, especially subordinated debt issued by the financial sector, tends to benefit from a rising rate environment. This is because the profitability of financials increases as interest rates rise, and this should lead to tighter spreads for the securities held within the fund. This is exactly what we saw during the first half of 2021. Therefore, the fund performed well once again during a period of rising interest rates. Moreover, valuations of the securities we hold still remain wider than pre-Covid-19, despite strong fundamentals. We are capturing spreads of close to 330 bps, highlighting the attractiveness of our asset class. On the Covid-19 front, we have seen vaccines rollout going on well in Europe. As such, economies have been reopening. Therefore, we believe the fund is well positioned to benefit in the second half of 2021.

We continued seeing positive developments on legacy securities, with a number of securities being called or tendered at premiums to market levels. We expect similar outcomes on other legacy securities going forward.

Q1 bank earnings were released during Q2 and demonstrated once again the resilience of European financials. This was one of the strongest earnings seasons we have seen in the last decade, as indicated by liquidity and solvency ratios of European banks, which are at an all-time high, despite the real-life stress test of the Covid-19 pandemic.

 

PERFORMANCE

The fund increased by 2.3% over the quarter, versus the Barclays USD Aggregate Corporate Total Return Index, which increased by 3.6%. The Barclays USD Aggregate Corporate Total Return Index has a significantly higher sensitivity to interest rates, and therefore performed strongly during the quarter, as we saw the 10-year US Treasury rate decrease from 1.7% to 1.5%. However, the fund is up 3.1% year-to-date, versus the Barclays USD Aggregate Corporate Total Return Index, which decreased by 1.3%.

 

Performance of the 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. The yield to maturity of the fund is 3.4%. We received 1.0% 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 or down. During the period, this had a positive contribution.

 

Performance contributors

The aggregate positive contribution of the top 10 contributors was approximately 1.0%. The top performer was the Rabobank 6.5% securities which have been lagging prior to this quarter and we expect them to continue performing strongly in the coming quarter. Apart from that, a combination of different types of securities, such as AT1 contingent convertibles (CoCos) and legacy securities were the other top performers. We believe that there is more significant upside among these securities as spreads remain wider than pre-Covid levels.

 

Performance detractors

The aggregate negative contribution of the bottom 10 detractors was less than 1bps.

 

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 78.2%. Therefore, for some time we have positioned the fund to benefit from the continual improvement of credit metrics within European financials. Moreover, regulation has forced financials to build up capital and strengthen their balance sheets, all of which are supportive from a credit perspective. All the regulatory measures taken in the last 12 years have enabled financials to withstand the Covid-19 crisis. From a credit standpoint, financials are in an even stronger situation than prior to Covid-19, and this is despite taking significant provisions for expected credit losses. Subordinated debt holders of financials should benefit the most from this strength. Moreover, with spreads of these securities currently above 300 bps, valuations are extremely attractive. To put this into context, this is more than three 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 3.4% compared with 2.0% for the benchmark.

 

Low sensitivity to interest rates:

With more than 66% of the securities being either fixed- to-floaters or already floaters, we believe the fund is 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. During this quarter, the fund delivered a positive performance despite the rise in interest rates.

 

OUTLOOK 

From a credit standpoint, we have possibly seen the strongest results
of financials in the past decade. We have seen capital and excess capital at very high levels. This is despite all the issues linked to Covid-19, as well as the provisions for expected credit losses that banks took in the last 15 months. Due to the very strong credit metrics of the companies we own, we feel we have strong visibility regarding the income we will receive. Moreover, we expect financials to remain very strong going forward, especially as they could benefit from interest rates rising as their profitability should increase. Additionally, due to our exposure to fixed-to-floaters and floaters, we are well positioned for a period of rising rates. At the same time, we are capturing spreads of around 300 bps within subordinated debt of financials. Unlike in other parts of the bond market where spreads are near historical lows, valuations on subordinated debt of financials remain attractive and are wider than pre-Covid-19.

To summarise, our outlook remains positive, as the credit quality within our companies remains very strong. This ensures strong visibility of high income within the current low interest rate environment. At the same time, as we have seen, we have a low sensitivity to interest rates. Valuations remain wider than pre-Covid-19 levels, and therefore we expect to benefit from potential price appreciation. Finally, technicals are supportive. The first half of the year was marked by a healthy supply of issuance, which helped to maintain a balanced market. However, we expect a limited net supply in the second half of the year. Consequently, demand should be higher than supply, which should support the valuation of the securities held within our fund.

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