Quarterly Fund Commentary (USD)

MARKET BACKDROP

During the first quarter the fund enjoyed both income and capital gains of approximately 4.4% in aggregate while the 10 year US Treasury yield decreased from 2.44% to 2.39%. There were significant gains in many of our floating rate notes and lesser gains in our fixed rate holdings. An example was the floating rate notes of Ageas which were highlighted in the December report which increased from 48% to 57%. During the quarter we took advantage of new issues of good quality companies yielding 5% or more, including 5.125% Axa 2047, 5% EFG 2027, 5.25% Legal and General 2047 and 5.875% La Mondiale 2047, which all have interest rate refixes within 5 and 10 years. We also increased holdings in the better quality fixed to floating contingent capital securities including 6.25% Credit Suisse, 6.25% HSBC and 6.875% UBS in the secondary market, with yields to the first call, within 4 to 8 years, of above 6%. Our view remains that small changes in regulations are favourable for the best names which are strengthening their capital bases. In non-financial names we added to our holdings in Glencore senior debt and participated in the new issue of 6.875% Trafigura undated securities. We continue to believe that ongoing regulatory changes are supportive of our holdings as they force the financial sector to further strengthen their capital bases.

PERFORMANCE

The fund gained 4.4% over the quarter, versus the Barclays US Aggregate Corporate Total Return index, which gained 1.22%.

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 5.67%. On a quarterly basis, this is not necessarily the predominant feature, but it should not be underestimated. In particular, due to our 8.82% 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 performance contributors added in aggregate over 0.5% to the value of the fund. The largest contributor was 13% Lloyds securities where the price increased from 177% to 182.5%. 5.5% Pershing Square holdings 2022 increased from 99.9% to 102.8% and 7.875% Old Mutual increased from 111.3% to 118.2%. 

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 5.67% compared with 3.33% 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 between 63% and 83%, 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 73.47%. 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

Markets remain focused on the prospect for higher US Treasury yields and rising interest rates as Donald Trump plans for higher fiscal expenditures. However, as we reported in the December review, a rise in the US dollar and US interest rates has already taken place and the divergence between US interest rates and rates elsewhere remain large. Global growth remains low and some deflationary factors persist, particularly when it comes to cost-cutting and the continued disruption created by new technologies. Within the fund we continue to target yields of 5%, 6% or above for our fixed rate securities, most of which are issued by investment grade companies. So while we expect and will monitor rising rates under the Donald Trump administration, we feel well protected by interest on investment grade fixed rate securities of 6% or more. We also benefit in a rising rate environment from our floating rate note securities. For our financial companies the 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. 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 selective capital gains.

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