Q3 2018 Quarterly Commentary (GBP)
Following the strong ‘risk-off’ environment in Q2, prices continued to be weak, but 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 with, 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. 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 September at a coupon of 5.875%, which represented an issue spread of 427 basis points above mid-swap rates. It is callable in 8 years, and if not called, refixes at 427 bps over mid-swap rates. This is an extremely high spread for an ‘A’ rated issuer. Another example is 5.875% Barclays AT1 cocos which now yield almost 7% to the next call date, or a spread above 500 basis points.
The price of the GBP Institutional Acc share class of the fund decreased slightly (0.16%) during the quarter, versus the Barclays Sterling Aggregate Corporate Total Return Index, which lost 0.31%.
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 5.50%. 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, this had a negative contribution, despite the fundamental improvements in many of our credits.
The top three performers included Credit Agricole 7.5%, HSBC 5.25% and Deutsche Bank 7.125%, which, on aggregate, contributed 30 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 Trafigura 6.875%, General Accident 8.875% and Direct Line 4.75%, and they had an aggregate negative contribution of 36 basis points. Trafigura declined from 96% to 90%, despite remaining solid in terms of profitability and performing strongly from a credit perspective. In none of the cases was there any fundamental reason for the setback.
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 85.71%. 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 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 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 5.50% compared with 2.88% for the benchmark.
Lower interest rates risk: With more than 55% 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 remained weak and they have not recovered. 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. In addition, yields on many of our securities have risen and we continue to believe that yields on GBP-denominated securities that we own at close to, or above, 5% remain very attractive, particularly when they concern investment-grade-rated securities. With a yield to maturity of 5.50%, 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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