MARKET ENVIRONMENT
Markets continued to rebound during the third quarter following positive economic data combined with the large monetary and fiscal stimulus. Despite the recovery in prices, spreads are still extremely wide for the securities we hold. With spreads of around 580 bps, valuations within our securities are still close to two times wider than where spreads were in February. This is despite the fact that the credit quality of our issuers remains very strong, as reflected by the average rating of BBB at the issuer level.On the financials side, the European Banking Authority (EBA) and the Bank of England (BoE) believe that banks started this crisis with extremely high levels of capital and should be able to withstand the shock through pre-provisioned income, as banks should generate enough income to cover future expected credit losses, as well as the excess capital they have built up. Moreover, the BoE believe credit losses should be smaller than the levels originally anticipated in May. This is in-line with our view that the Covid-19 crisis remains an equity story for European financials, and not a balance sheet story. Q2 earnings also went in that direction. During the end of quarter, legacy securities performed strongly. This was in part due to the tender of two legacy Natwest Tier 1 bonds with around four percentage points of upside compared with previous trading levels. After the announcement, we saw increased interest within the legacy space, leading to prices moving higher. However, we feel that there is significantly more upside. Moreover, during Q4, the European Bank Authority (EBA) will publish a note clarifying the prudential treatment of legacy instruments. This should create another positive catalyst for the legacy space. Therefore, there is a lot of optionality in terms of having issuers tendering or calling these bonds over the coming quarters or years at a significant premium to current prices, as we saw with the NatWest bonds this month. We expect prices to continue to recover in the coming quarters.
PERFORMANCEÂ
The fund’s net asset value increased by 3.5% over the quarter, versus the Barclays GBP Aggregate Corporate Total Return Index, which increased by 1.5%.
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. The yield to maturity of the fund is 4.67%. We received 1.31% 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 as prices continued recovering.
Performance contributors
The aggregate positive contribution of the top 10 contributors was approximately 1.71%, as securities continued recovering. One of the main contributors to performance was the position that we have in Rabobank 6.5% as the price of the securities increased by 12% during the quarter, following the announcement by the management that it would explore alternative way to pay coupons (including arrears), such as scrip dividends. We feel that despite the strong performance within our securities, there is more significant upside, as spreads remain extremely wide. Moreover, a large portion of our securities are trading to perpetuity. Therefore, there is large upside for those securities on a re-pricing to call
Performance detractors
The aggregate negative contribution of the bottom 10 detractors was approximately -0.09%. We have seen small pockets of underperformance during the quarter. These were mainly some corporates which have been lagging the move to the upside.
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 83.69%. 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 580 bps, valuations are extremely attractive. 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:Â The spreads the fund captures are more than 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 4.67% compared with 1.78% for the benchmark.
Low Sensitivity to interest rates:Â With more than 57% 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 stories.
OUTLOOKÂ
Valuations remain extremely attractive, in our view, and we are able to capture spreads of more than to 580 bps. Furthermore, the 580 bps does not fully reflect the upside potential, as a large portion of the subordinated financials market is trading to perpetuity – with large upside for bondholders on a re-pricing to call. Furthermore, we have seen some positive developments within the legacy space with the NatWest tenders, and expect more to come. As the regulatory story has not changed, it means that price recovery on these instruments should be even more pronounced over the coming quarters.
