Quarterly Fund Commentary EUR

MARKET BACKDROP

Despite the 10-year German Bond yield increasing from 0.33% to 0.47% the fund nevertheless posted a positive return of more than 4% over the second quarter. There were significant price gains in both fixed rate holdings and floating rate notes. Examples include the 5.25% fixed to floated HSBC contingent capital securities where the price increased from 101.6% to 107.2%, 6.5% Rabobank fixed rate perpetual notes where the price increased from 112.5% to 118.5% and the Rothschild floating rate notes based on 10-year swap rates which increased from 72.5% to 80%. As time has gone on, some of the stronger financial companies have continued to strengthen their balance sheets and the example of the take-over by Banco Santander of the weakened Banco Popular showed that there continues to be progress in the rehabilitation of the banking sector. This has led to the tightening of credit spreads in the strong bank contingent capital securities which nevertheless remain attractive when compared with their credit ratings. While prices have risen, however, we remain selective in our purchases and our decisions. For example, we declined the offer by Tesco to buy back its senior euro denominated 5.125% Tesco 2047 euro denominated bonds at an offer price that we believed to be opportunistic

PERFORMANCE

The fund increased by 4.51% over the quarter, versus the Barclays EUR Aggregate Corporate Total Return index, which gained 0.36%.

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 yield from the underlying bonds. Yield is the most important component of the fund, with a current yield to maturity of 4.36%. On a quarterly basis, this is not necessarily the predominant feature, but it should not be underestimated. In particular, due to our 13.05% 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 capital gain or loss. In itself this can be broken down into 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, and returns achieved due to interest yields were supplemented by higher prices.

Performance contributors

The top three performance gainers added 0.98% to the value of the fund. They included 6.5% Rabobank where the price increased from 112.8% to 118.5% following a recovery from the lower price levels resulting from their issuance of an additional tranche during the first quarter. The second performance gainer was 5.25% HSBC where the price increased from 101.6% to 107.2%. The third performance gainer was the floating rate notes of Aegon where the price increased from 68% to 75.5%.

Performance detractors

There were no performance detractors of any significance.

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 4.36% compared with 0.93% of the benchmark. This is despite holdings in discounted floating rate notes, where interest is refixed 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 refix rate. As they are discounted at prices within the 70ies - 80ies range, they not only provide a natural hedge for our fixed-rate holdings, but can achieve capital gains in themselves. 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 refixed 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 72.73%. 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.

OUTLOOK

Economic growth remains low in Europe and quantitative easing measures remain in place. However, we have already seen a gradual pick-up in European generic rates as the 10-year bund rate has risen from 0.325% to 0.465% and the European activity has picked up. While we do not expect the rise in interest rates to be very strong, we believe that it must be monitored. Nevertheless, yields on selective Euro denominated securities above 4%, many of them investment grade securities, remain attractive to us despite the price rises that we have already seen. For financial institutions we expect the multi-year process of capital strengthening, cost –cutting and refining of business models to continue and to provide a positive impulse to their credit valuations. For those institutions, which have been able to remain significantly profitable, this will continue to render their junior debt, including contingent capital securities, very attractive.

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