Quarterly Fund Commentary GBP

MARKET BACKDROP

The fund posted good positive results over the quarter despite a marginal increase from 1.14% to 1.26% in the 10-year gilt yield. As we have highlighted in previous reports the yields on our fixed rate securities are significantly above those of UK gilts with many of them still earning 5.5% - 6% or more for names such as Aviva, Lloyds and National Westminster. Thus they will be less affected by rises in government bond yields. Among more significant transactions, during the quarter the fund participated in the new issue of the litigation finance company 5% Burford 2026 and added to 6.375% Coventry Building Society contingent capital securities, which have a company call and reset in 2019, at a little above par. The fundamental results for our companies, both the banks and the insurance companies, continue to show progress in the multiyear process of capital strengthening. This reinforces their value in the context of historically wide interest spreads, up to 3% - 4% or more for investment grade companies.

PERFORMANCE

The fund gained 4.27% in the first quarter, versus the Barclays Sterling Aggregate Corporate Total Return index, which gained 0.55%.

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 yield to maturity of 4.89%. 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, the fixed-rate bonds provide a large part of this income 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, with limited turnover, this component of returns is largely the result of prices being marked up and down.

Performance contributors

The major gainers in the fund were 13% Lloyds where the price increased from 182.5% to 188.75%, 5.7% Prudential 2036 where the price increased from 106.6% to 114.5% and 8.875% General Accident (Aviva) where the price increased from 151% to 159%.

Performance detractors

There were no performance detractors of the fund 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 4.89% compared with 2.41% 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. 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 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 77.07%. 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 variety of names which have issued sterling denominated bonds.

OUTLOOK

During the quarter the 10-year gilt yield increased from 1.14% to 1.26% and we are mindful of the prospect for further increases in the interest rates. However, there are wide interest spreads on our bonds, which mainly represent investment grade companies, with interest coupons often above 5% - 6% accruing on a daily basis. Most of our long dated securities yield over 5.5% and we have recently reduced some of the holdings with lower yields than this. In addition, we have many high coupon bonds with likely calls in the next several years, fixed to floating bonds (where holdings have been increased) and some discounted floating rate notes. Fundamentally the results of our financial companies continue to show significant capital strengthening and we believe the current wide interest spreads should continue to compress over time. Although we can expect rising rates due to inflation and there may be unexpected twists and turns in Brexit negotiations, they are likely to remain limited in absolute terms as growth remains weak and structural deflationary forces due to cost-cutting and technology remain in place. So our current high yields should continue to be beneficial when returns elsewhere remain low.

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