Quarterly Q2 2018 Commentary (EUR)
During the quarter the fund declined despite no specific credit events. Clearly, there were concerns about political risk in Italy during the reporting period. This led to a widening of spreads on Italian government bonds, which translated into a risk-off environment, confirmed by 10-year German Bunds that actually tightened from 0.49% to 0.30% over the period. However, from an individual credit perspective there was general continuing improvement. Therefore, good opportunities for long-term investments exist as spreads have widened significantly above their fair value and do not reflect the strong underlying credit quality of the issuers we hold in the portfolio. For example, the 5.25% HSBC AT1 cocos currently yields 4% to the next call date, which represents a spread of approximately 400 basis points, meaning that we are capturing a higher spread from an “A” rated issuer compared to around 360 basis points that one would otherwise be captured from a European high yield bond. Another example is the 4.75% Santander AT1 cocos which now yields more than 6.0% to the next call date, or a spread of more than 650 basis points. The fundamental results of our companies, both bank and the insurance issuers, generally continued to show good progress during the current multi-year cyclical process of credit strengthening. The income offered by our portfolio continues to provide an attractive return and the fund is well positioned for an environment of somewhat higher rates. This is thanks to holding more than 70% in securities that are either fixed-to-floaters or are already floaters, as well as a number of high- coupon securities with relatively short issuer call dates.
The EUR institutional share class of the fund declined 4.18% over the quarter, versus the Barclays EUR Aggregate Corporate Total Return index, which lost 0.25%. There are two important sources of return for the fund. The first which is significant and always positive is the yield from the underlying bonds. Yield is the most important component of the fund, with a current yield to maturity of 4.90%. On a quarterly basis, this is not necessarily the predominant feature, but it should not be underestimated. In particular, due to our 16.11% weighting in both Libor-based and 10-year swap-rate-based floating-rate notes, which currently have lower yields than the average, the fixed-rate bonds provide a large part of this return. The second component of return for the fund is the realised and 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, there were fundamental improvements in many of our credits, but increased spread widening in many cases has led to lower prices.
The three performers included 5.5% and 5.25% Royal Bank of Scotland perpetual securities and 5.75% International Personal Finance 2021 denominated in euro. The two Royal Bank of Scotland bonds are both callable every three months, so we benefit from the interest paid, as long as these bonds are not called. The other top contributor International Personal Finance, is a credit lender in a number of European countries and Mexico..
The three performance detractors included Ageas floating rate notes where the price declined from 72% to 60%, Aegon floating rate notes where the price declined from 88% to 77%, and finally the 6% Deutsche Bank bonds, which declined from 100% to 89%. In all three cases we believe that the price declines are overdone.
We have for some time positioned the fund in anticipation of a normalisation in interest rates, even if this takes longer than originally anticipated. Yield is a significant component of returns with a yield to maturity of 4.90% compared with 1.01% for the benchmark. This is despite holdings in discounted floating-rate notes, where interest is re-fixed every three, six or 12 months, based on either short-term Libor or on 10-year government bond rates. These securities will benefit from higher interest rates: the higher the interest rate, the higher the re-fix rate. As they are discounted at prices within the 70% to 90% range, they not only provide a natural hedge for our fixed-rate holdings, but can achieve capital gains in their own right. We also take advantage of fixed-to-floating 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. This limits our exposure to rising interest rates. 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 holdings in financials at 85.58%. While many observers associate financials with universal banks, we like our investors to note that there are many differences in business models and balance sheets among our different holdings. We clearly distinguish between universal banks, asset managers, brokers, life insurance and non-life insurance companies. Our holdings in non-financial companies include a wide variety of global names.
While the market experienced distress during the quarter due to the Italian elections and geopolitical concerns, European economic activity continues to be satisfactory, while banks in general continue to improve their balance sheet strength. Yields on many of our securities have risen and we continue to believe that yields on euro denominated securities that we own at close to or above 4% remain very attractive, particularly when they concern investment grade rated securities. For the majority of financial institutions we expect the multi-year process of capital strengthening, cost-cutting and refinancing of business models to continue and to provide a positive effect on their credit valuations. For those institutions, which have been able to remain significantly profitable, these actions will continue to render their junior debt, including contingent capital securities, at very attractive levels.
19 July 2018
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