Quarterly Q3 2017 Commentary
During the third quarter the fund benefited from robust income and capital gains while the US Treasury bond yield ended the period little changed. There were gains in all our categories of fixed-rate bonds, fixed-to-floating securities and floating-rate notes.During the quarter, we invested in a wide range of bond opportunities including 5.375% Phoenix 2027, 6.625% Leucadia 2047, contingent capital securities of Credit Suisse, HSBC, UBS and old discounted floating-rate notes of DNB Bank and Nordea Bank. Later in the quarter, we added to our holdings of 6.15% Tesco 2037 at around 105% and BNP Fortis euro denominated securities at 84% paying 200 basis points above 3 month Euribor which we hedged back to US dollars.Fundamental results for our companies continue to show progress in the multi-year process of capital strengthening. This reinforces their value within the context of historically wide interest spreads.As we believe there is the probability of eventual interest rate rises, we selectively continue to buy floating-rate notes at discounted prices as well as higher coupon with short-dated calls. Meanwhile, many of our fixed-rate securities including contingent capital securities have a call date within five to ten years upon which interest is reset at a wide spread if the bonds are not called.
The USD ordinary class gained 2.21% over the quarter, comfortably outperforming the Barclays US Aggregate Corporate Total Return index, which gained 1.34%.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 current yield to maturity of 5.21%. On a quarterly basis, this is not necessarily the predominant feature, but it should not be underestimated. In particular, due to our 10.35% 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 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
The top three contributors included our large holding in 6.375% HSBC contingent capital securities where the price increased from 105% to 106%, 6.9% Glencore 2037 bonds where the price increased from 121% to 126% and 6.875% Trafigura undated securities where the price increased from 101.4% to 104.1%.
There were no material performance detractors during the quarter.
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 5.21% compared with 3.17% for the benchmark. This is despite significant 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. As they are discounted at prices within the 70% – 80% 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, generally 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 72.81%. 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 individual 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, which have issued mainly US-dollar denominated bonds.
The 10-year US treasury rate edged a fraction higher to 2.33% over the quarter and we remain focussed on the probability and expectation of higher interest rates.Over the quarter, two year interest rates increased from 1.38% to 1.48% and we would expect higher interest rates going forward. However, we do not believe that the rate of increase will be extreme and in some of the fixed-rate bond positions that we hold, a narrowing of interest spreads could continue to counteract the expected interest rate rises.Within the fund we will therefore continue to target yields of 5%, 6% or above for our fixed-rate holdings, most of which are issued by investment grade companies. We also benefit in a rising rate environment from our floating-rate notes which have continued to show gains over the quarter.We believe they may have further to rise in price, particularly as some of the old discounted floating-rate notes have been subject to company buy backs at higher prices, as they lose some of their regulatory capital advantages.For our financial companies, higher yields continue to provide benefits.Within Europe, a normalisation of interest rates should also strengthen financial companies and act as a positive catalyst for the junior debt of the good institutions.We will continue to maintain a good balance between fixed rate, fixed-to-floating and floating-rate securities in order to achieve a steady, high income and capital gains.
26 January 2018
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