Q4 2019 Quarterly Commentary (USD)

MARKET ENVIRONMENT

During the fourth quarter of 2019, financial markets enjoyed a positive trend, as reflected by the performance
of the fund. Spreads on financials’ subordinated debt tightened during
the quarter. The year ended strongly following positive developments related to trade wars and the UK general election. The fund benefited from income during the quarter, as well as from price appreciation of securities held. Despite the continued dovishness of central banks, the 10 year US treasury rate went up during the quarter. Nevertheless, our fund performed strongly demonstrating its low sensitivity to interest rates. Within this low interest rate environment,

we feel the fund is well positioned by capturing spreads of more than 300 bps. Within the legacy space, security prices continued to benefit from the positive developments linked to a number of issuers redeeming their old-style bonds. However, we feel that there significantly more upside to come. Instruments which have been issued under Basel II and Solvency I do not comply with the new regulatory framework (so-called legacy

/ grandfathered bonds). Over time,
these bonds are becoming inefficient. Therefore, there is a lot of optionality
in terms of issuers tendering or calling these bonds over coming quarters / years at a significant premium to current prices, as has been demonstrated by Santander, Commerzbank and Ageas. During the quarter, we also saw very strong demand for new issues. Going forward, we expect to continue receiving the high and predictable income from the companies in which we are invested, independent of market conditions. In addition, we believe that the fund should benefit from further price appreciation over the mid- /near term, as already experienced in 2019. Prices may not necessarily rise in a straight line, but given the attractive valuation levels of securities in our area, we believe that there is scope for further spread tightening.

PERFORMANCE

The price of the fund (USD institutional share class) increased by 4.98% over the quarter, versus the Barclays US Aggregate Corporate Total Return Index, which increased by 1.18%.

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. In line with expectations, 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 going up and down. During the period, the positive contribution from price appreciation was significant given the spread tightening during the quarter.

Performance contributors

The aggregate positive contribution
of the top 20 contributors was more than 3.03%, with Ageas floating rate notes (FRNs) being the top contributor following the partial tender of these securities. Other legacy securities performed strongly during the quarter. We feel that despite the strong performance within the legacy space, there is more significant upside as these securities become inefficient over time. AT1 contingent convertible bonds (CoCos) also performed well during the quarter.

Performance detractors

The aggregate negative contribution of the bottom 20 detractors was approximately 11 bps. We saw small pockets of underperformance during the quarter, with some corporates underperforming despite no changes in their fundamentals.

POSITIONING

The fund invests predominantly in investment grade issuers, but we are prepared to go down a company’s capital structure to find what we believe is the most attractive combination of yield, value and capital preservation. One feature of the fund is its bias towards financials, at 82.3%. For some time, we have positioned the fund to benefit from the continual improvement in credit metrics within European financials. Moreover, more onerous regulations are forcing financials to build up capital and to strengthen their balance sheets, all of which are supportive from a credit perspective. In our view, the holders of financials’ subordinated debt will benefit most from these trends. Furthermore, with these securities’ spreads currently above 300 bps, we believe their valuations remain extremely attractive. To put this in context, this is more than three times the spread captured from the Tier 1 securities that HSBC issued before the global financial crisis (GFC) in 2007. And this despite the fact that, as mentioned above, financials have become much stronger from a credit quality standpoint.

Investment grade issuers:

The spreads that the fund seeks to capture should exceed those offered by 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 the fund’s total returns, with a yield-to-maturity of 4.85% compared with 2.84% for the benchmark.

Low sensitivity to interest rates:

With more than 69% of the securities either fixed-to-floaters or already floaters, the fund is positioned to have low sensitivity to interest rates. (Fixed- to-floating bonds are bonds whose coupon is fixed until the first call date within five to ten years and is then re-fixed on a floating-rate note basis).

OUTLOOK

We invest in the bonds of high-quality issuers and, therefore, we believe the fund will not only keep on capturing steady income of close to 5.5% per annum, but we should also see additional capital gains as our base case is for spreads to tighten further during this year. During Q4 2019, from a credit standpoint, the issuers we hold behaved as expected. We have not changed anything in terms of the fund’s positioning, including the sub-sectors, types of securities and capital structures. The continuation of the multi-year process of capital strengthening for European financials makes us feel very confident in the strong and improving credit fundamentals of our issuers. Furthermore, spreads are still significantly wider than at the beginning of 2018 and this makes us believe that the valuations of our securities are extremely attractive. Regarding legacy capital securities, regulatory changes should lead to bonds being taken out and hence we see upside potential

from further early calls and tenders. We expect this to be an additional positive driver for future performance. We continue to believe that yields on USD-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 4.85%, income will continue to be a
strong driver of performance going forward. We also expect to continue benefiting from some capital gains and, therefore, feel that we are in a strong position regarding future performance.

Spotlight : Credit Opportunities 2020 Outlook

We are very constructive going into 2020, with the subordinated debt asset class supported by robust fundamentals and attractive valuations in a ‘lower for longer’ interest rate
scenario. Key areas of focus for the fund remain unchanged

ie diversification across Tier 2 bonds from banks / insurers, legacy bonds from banks / insurers, corporate hybrids, AT1 CoCos from banks and RT1 bonds from insurance companies – where we capture attractive spreads and see significant price upside.

High quality income in a low interest environment

Subordinated debt continues to stand out as offering highly attractive yields for very high quality / investment-grade issuers, despite the ongoing downward pressure on yields. Issuers’ credit quality continues to strengthen, notably in the European banking sector where ongoing capital accumulation reflects ever-tightening regulation. We have strong visibility on the future path of capital accumulation over the coming decade – with Basel IV due to be implemented from 2022 to 2027, again setting the bar for capital requirements higher, we expect to see continued strengthening of European financials’ fundamentals. Stress tests have shown the banking sector’s resilience to severe shocks in the financial system – for example, the Bank of England stress test in December 2019, which showed banks would have, even after the impact of the adverse scenario, more than twice the equity buffer that they held before the GFC.

Past performance is not an indicator of future performance and current or future trends. The performance is net of commissions, fees and other charges. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Allocations and holdings are subject to change. The views are those of the manager and are subject to change.

Positively, the fund’s sensitivity to interest rates remains extremely limited. During Q4 2019, interest rates rose significantly, which weighed on corporate bond valuations despite strong investor sentiment and tighter spreads. Our funds performed well during that period (see Chart 2), which reflects their positioning to be agnostic to interest rates. We seek to achieve this goal via instrument type diversification, using a combination of fixed rate, fixed-to-floating and floating rate notes to mitigate interest rate risk. Although our base case is that rates will remain low for an extended period, limited sensitivity to rates is an attractive feature should we see an unexpected rise in rates, in which scenario traditional bond prices would fall.

Valuations are more than compelling, as we capture spreads of 300 bps or higher. We continue to expect income yield to be the main driver of performance in the long run, nevertheless with valuations so attractive we believe there is scope for further price appreciation. Compared with other high income segments, subordinated debt remains cheap, offering close to 150 bps extra spread compared to BB-rated EUR high yield for example. In our view, accommodative central banks will further support valuations – given the ongoing hunt for yield and the European Central Bank (ECB) purchasing corporate bonds – demand for the asset class is expected to remain very strong.

Opportunities in legacy Bonds

Within our positive view of the asset class, one area of focus stands out for 2020.

Legacy bonds came back into focus in late 2019, on the back of several very positive take-out stories. We have seen a number of par calls of legacy floating rate instruments trading well below par, for example Commerzbank’s old perpetual FRNs (coupon of Euribor + 200 bps) called at par, previously trading at around 95%. Banco Santander also redeemed a legacy perpetual FRN at par, which was trading at a price of 67% prior to the call. In December 2019, Ageas, the leading Belgian insurer, tendered one of its legacy FRNs at 59%, a 10% premium to the market price of 53%. Since the tender, demand for these bonds has been very strong and prices have rallied further to 62%. As we progress through the grandfathering period (ending in December 2021 for banks and December 2025 for insurers), further management of old-style bonds that become ineligible as capital is to be expected. We anticipate significant upside for the old bonds as they are taken out. For example, we own ING legacy perpetual FRNs denominated

in EUR, with a yield of 7.4% to December-2021 (when they
lose their full regulatory value), given their deeply discounted price of c. 86%. Even for bonds trading above par, we believe there can be significant upside for bondholders. For example, Commerzbank 8.151 2031 old Tier 1 bonds trading at 135% can be redeemed from December 2021 (when, again, they lose their regulatory capital value) at a very favourable price (140% based on current market conditions) – equivalent to a 7.6% yield.

Past performance is not an indicator of future performance and current or future trends. The performance is net of commissions, fees and other charges. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Allocations and holdings are subject to change. The views are those of the manager and are subject to change.

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