Quarterly Q2 2018 Commentary (GBP)

Market environment

The second quarter of 2018 saw a decline of 1.82% in the GBP institutional share class of the fund, despite the fact that there were no specific credit events. There was a risk-off environment in May, which continued into June, and, therefore, a setback in the price of the majority of holdings. Fundamental results for our credits were credit positive, yet spreads continued to widen. This has created good opportunities for long-term investors as spreads have widened significantly above fair value and do not reflect the strong underlying credit quality of issuers in the portfolio. During the quarter, we bought the sterling issue 4.478% Quilter 2028 which has a coupon reset in 2023; we also added to a number of holdings in US dollars and Euro, which were then hedged back to sterling for names such as Julius Baer, Citadel, EFG, HSBC, Leucadia and Trafigura. The income provided by our portfolio – with its blend of fixed rate, fixed-to-floating bonds and discounted floating-rate notes – continues to provide an attractive return, as well as some potential for capital gains.

Performance

The GBP institutional share class of the fund declined 1.82% in the second quarter, versus the Barclays Sterling Aggregate Corporate Total Return Index, which lost 0.34%. 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 yield-to-maturity of 5.15%. On a quarterly basis, this is not necessarily the predominant feature, but it should not be underestimated. In particular, due to the inclusion of floating-rate notes, which currently have lower yields than the average, fixed-rate bonds provide a large part of this income return. 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 with limited turnover, this component of returns is largely the result of prices being marked up and down.

Performance contributors

The top performers had marginal gains and included 6.75% Standard life Aberdeen perpetual notes, 6.375% Enterprise Inns 2031 secured bonds and 10.375% HDL Mortgage Debentures 2023.

Performance detractors

The largest performance detractors included: 4.75% Direct Line securities, where the price declined from 99.5% to 92.1%; 4.75% HSBC, denominated in Euro, where the price declined from 104.3% to 99.7%; and 7.5% Credit Agricole, denominated in sterling, where the price declined from 111.4% to 108.9%. In none of these cases was there any fundamental reason for the setback.

Positioning

For some time, we have positioned the fund in anticipation of a normalisation of interest rates, even if this takes longer than originally anticipated. Yield is a significant component of returns, with a yield-to-maturity of 5.15% compared with 2.75% 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 rates. These securities will benefit from higher interest rates: the higher the interest rate, the higher the re-fix rate. We also take advantage of fixed-to-floater bonds, where the coupon is fixed until the first call date (generally within five to ten years) and is then 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 holding in financials, at 84.89%. While many observers associate financials with universal banks, we like our investors to understand that there are many differences in business models, and balance sheets, among our different holdings. Therefore, we clearly distinguish between universal banks, asset managers, and brokers, as well as between life insurance and non-life insurance companies. Our holdings in non-financial companies include a variety of names which have issued sterling-denominated bonds. 

Outlook

During the quarter, the 10-year Gilt yield declined from 1.35% to 1.28%. However, there are wide interest-rate spreads on our bonds, which mainly represent investment-grade companies with interest yields accruing 5%-6% per annum. Most of our long-dated securities yield over 5% and we have many high-coupon bonds with likely calls in the next few years, as well as fixed-to-floating bonds and some discounted floating-rate notes. Fundamentally, the results of our financial companies continue to show capital strengthening and we believe that currently wide interest spreads should compress over time. Although we can expect rising rates due to inflation, and there may be unexpected twists and turns in the Brexit negotiations, interest rate hikes are likely to remain limited in absolute terms; this is because growth remains weak, there are structural deflationary forces in place (due to the impact of cost-cutting and technology), and sterling has recently stabilised. Therefore, our current high yields should continue to be beneficial given returns elsewhere remain low.


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19 July 2018

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