Quarterly Fund Commentary USD

MARKET BACKDROP

During the second quarter the fund enjoyed both income and capital gains of approximately 4.3% in aggregate while the 10-year US treasury bond yield went from 2.39% to 2.30%. There were gains in all our categories of fixed-rate bonds, fixed to floated securities and floating rate notes. During the quarter we invested in a wide range of bond opportunities including additions to holdings of Glencore, QBE and Trafigura which all give bond yields above 5%. We invested in two new issues, 4.625% Demeter/Swiss Re with an interest reset after 5 years and 5.25% Louis Dreyfus 2023. We also added to the better quality contingent capital securities of Barclays, Credit Suisse, HSBC, Standard Chartered and UBS. We believe that despite the junior status of these bonds, the yields are attractive and would highlight that HSBC securities which have a call and a reset in 2023 and 2024 yield approximately 5.5% to call with an investment grade rating. Our view remains that changes in regulations are favourable for the best names which continue to strengthen their capital bases. Indeed, the take-over by banco Santander of the weakened Banco Popular showed that the levels of risk for the strongest institutions are improving over time and there is a consolidation of the banking sector.

PERFORMANCE

The fund gained 4.38% over the quarter, versus the Barclays US Aggregate Corporate Total Return index, which gained 2.54%.

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 5.60%. On a quarterly basis, this is not necessarily the predominant feature, but it should not be underestimated. In particular, due to our 7.48% 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.

Performance contributors

The top three contributors for the fund included our holding in Rabobank undated securities where the price increased from 112.8% to 118.5%, 6.375% HSBC contingent capital securities where the price increased from 102.1% to 106.3% and 7.875% Société Générale contingent capital securities where the price rose from 101.0% to 110.5%. This was the result of the greater clarity as discussed above. 

Performance detractors

There were no significant performance detractors during the quarter. 

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 5.60% compared with 3.20% of the benchmark. This is despite significant 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, 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 74.60%. 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.

OUTLOOK

While the 10-year US treasury rate actually declined over the quarter, we remain focussed on the probability and expectation of higher interest rates. Indeed, over the quarter two year interest rates increased from 1.25% to 1.38% 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 mitigate for the coming 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 provide benefits and this is demonstrated by higher share prices for the major US banks. Within Europe a normalisation of interest rates should also strengthen financial companies and act as a positive catalyst for junior debt of the good institutions. We will continue to maintain a good balance between fixed rates, fixed to floating and floating rate securities in order to achieve a steady high income and capital gains.

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