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Quarterly Credit Commentary, Q4 2019

Please find below a summary of performance, activity and outlook from our fund managers.

Fraser Lundie Portfolio Manager

Market and Performance review

The Macroeconomic backdrop remains subdued, with a myriad of Brexit - related uncertainty and global trade tensions remaining unresolved. Global growth momentum continues to slowdown offset by supportive monetary policy. Data continues to disappoint versus expectations. Inflation expectations remain anchored, particularly in Europe.

With lacklustre global growth and increased policy uncertainty, the continued drop in government bond yields during Q3 encouraged gains across less risky bonds. Yields on 10-year Treasuries remained below those of 3-month Bills, keeping the yield curve inverted, signalling even weaker expectations relative to current conditions.

With, uninspiring earnings growth, credit metrics are slowly deteriorating in the corporate universe. Profitability in the banking sector is under pressure in this low interest rate environment while capital buffers built since the crisis are strong. The technical picture remains strong across credit markets. Large amounts of negative yielding assets are encouraging asset locators to look at spread products and we can see this in strong inflows across US, European, Emerging Market, High Yield and Investment Grade markets for the year-to-date. Only two markets are lagging, these are Emerging Market Local and US Leveraged Loans.

Sentiment has improved, post European Central Bank announcement of additional monetary stimulus, with Equity & Credit volatility near two-year lows.

The Fund’s positions in Banking, Basic Industry and Index Trades boosted its return the most over the quarter. Technology & Electronics, Consumer Goods and Real Estate detracted the most. At the individual holding level, DeutschePostbank (Banking), Dell (Technology) and Enbridge (Energy) contributed most to its performance.), Sprint (Telecommunications), Antero Resources and Rabobank (Banking) detracted the most.

From a ratings perspective, BB and BBB issues boosted the Fund’s return the most. At the regional level, performance was driven by holdings from North America, Western Europe and Latin America.

Activity

Cash bonds continued to lag single-name CDS over the quarter, encouraging us to switch from CDS into bonds as the relationship reached highs in some capital structures.

Uncertainty surrounding Brexit enabled us to switch into sterling denominated bonds at an attractive pick-up compared with Euro-denominated securities from the same issuers.

Large amounts of negative-yielding debt around the world are driving demand for issues at the front end of curves, keeping curves steep and increasing the importance of extending the duration to optimise the Fund’s roll-down return. Furthermore, the ten-year versus 30-year curve steepened over the quarter, leading us to extend our exposure in some investment-grade capital names.

Negative convexity remains an issue in the global high yield universe. Positioning in sectors that have better convexity, such as Energy, Basic Industry and Banking, is key to performance and as a result we reduced exposure to sectors with the worst convexity, such as Media.

On the back of the change of our internal score for ADT Inc, we sold the name from the Core Long bucket and opened a position in the company in the Core Short bucket. We initiated a new long CDS position in Macys in the Income bucket.

Outlook

A dovish tone from central banks across the globe and progress in trade wars and Brexit have led to improved investor confidence. Accommodative monetary policy is back on the major central banks’ agendas: this will increase the proportion of negative-yielding assets, but will act as a tailwind for spread products.

We see better risk-adjusted return potential in investment grade and the higher-rated segments of high-yield credit given the slowdown in the global economy. Overall, we favour bonds that are positioned to cope with macroeconomic weakness and have levers such as dividend cuts available to them. With credit curves currently steep, we favour lending for longer to stronger issuers, both in high yield and investment grade. CDS spreads are significantly lower than cash bond spreads at present, making cash bonds look more attractive than CDS in certain capital structures.

Fraser Lundie Portfolio Manager

Market and Performance review

Geopolitical risk that dominated much of 2019, faded in Q4, giving to a much improved macroeconomic back drop. The landslide general election victory for the Conservative Party, helped ease any Brexit-related uncertainty and improved optimism surrounding progress on the US China trade deal.

Amid the improved investor sentiment, the final quarter of 2019 was a strong period for global Credit returns, finishing what was a very strong year for the asset class as a whole as it benefitted from spread tightening, the rates rally and the return of quantitative easing in Europe.

Given the technical backdrop, there is still room for the Credit markets to rally further but that ability to perform on the upside, or convexity is not the same across different segments of the market. For example, there is stark difference between the European High Yield market and US High Yield market, where the former is at the highs of percentage of bonds trading above call while the latter only middle of the range. A high active share approach that combines both top down and bottom up elements will be key to performance in 2020.

From a ratings perspective, BB and BBB issues boosted the Fund’s relative return the most. At the regional level, holdings from North America, Latin America and Western Europe drove the Fund’s outperformance.

Activity

An increasingly large part of the market is trading above call, thus limiting the upside capture of many securities in the market. On the back of that we continued to monitor our portfolio for securities that offer poor upside/downside payoff profile to improve the overall convexity of the portfolio. New issue market offered multiple opportunities in Q4 to optimise the portfolio.

During the quarter we added risk in the Steel sector in the US, where valuations have not fully reflected the early signs of the underlying fundamental improvement as restocking started and steel producers were able to implement price hikes helped by the overall improving global macro picture.

In majority of capital structures bonds continue to trade cheap versus CDS and this continued to offer an opportunity to switch from CDS into bonds.

On the back of significant repricing within the energy sector we have slightly reallocate capital from names that outperformed into better value propositions in other parts of the market.

As consensus turned more positive on Russia for 2020 the valuation in Russian corporates has become increasingly challenging, resulting in us selling a number of names and reducing our overall exposure to the country. On the other side, opportunities opened up in the paper space in South Africa, where we added risk.

The curves remain cheap in certain parts of the market, for example the 10 versus 30 year investment grade, where we extended in certain capital structures, particularly in the cyclical sectors.

Outlook

A dovish tone from Central Banks across the globe, indications of macroeconomic stability, progress in trade wars, and a near-term resolution of Brexit have all led to improved investor confidence. Accommodative monetary policy is back on the major Central Banks’ agendas and should act as a tailwind for spread products given that 20% of outstanding bonds in the market are still providing a negative yield.

Overall, we favour companies that are positioned to cope with macroeconomic weakness and have levers, such as dividend cuts, to preserve their balance sheets available to them. As such, even though lower-quality Credit rallied in December thanks to the supportive factors we mentioned above, we see little reason to chase equity-like Credit risk at this stage. We continue to prefer higher-quality Credit and to remove convexity risk from the Strategy using primary market issuance from companies in which we are invested. Finally, Credit curves are still steep, so we favour lending for longer to High Yield issuers.

Fraser Lundie Portfolio Manager

Market and Performance review

The Macroeconomic backdrop remains subdued, with a myriad of Brexit - related uncertainty and global trade tensions remaining unresolved. Global growth momentum continues to slowdown offset by supportive monetary policy. Data continues to disappoint versus expectations. Inflation expectations remain anchored, particularly in Europe.

With lacklustre global growth and increased policy uncertainty, the continued drop in government bond yields during Q3 encouraged gains across less risky bonds. Yields on 10-year Treasuries remained below those of 3-month Bills, keeping the yield curve inverted, signalling even weaker expectations relative to current conditions.

With, uninspiring earnings growth, credit metrics are slowly deteriorating in the corporate universe. Profitability in the banking sector is under pressure in this low interest rate environment while capital buffers built since the crisis are strong. The technical picture remains strong across credit markets. Large amounts of negative yielding assets are encouraging asset locators to look at spread products and we can see this in strong inflows across US, European, Emerging Market, High Yield and Investment Grade markets for the year-todate. Only two markets are lagging, these are Emerging Market Local and US Leveraged Loans.

Sentiment has improved, post European Central Bank announcement of additional monetary stimulus, with Equity & Credit volatility near two-year lows.

The Fund’s positions in the Basic Industry, Banking and Energy sectors boosted its return the most. Index trades detracted the most. At the individual holding level, Deutsche Postbank (Banking), Ardagh Packaging (Capital Goods) and Allergan (Health Care) boosted its return the most. Range Resources, Antero Resources (both Energy) and EnLink Midstream Partners detracted the most.

From a ratings perspective, BB and BBB issues drove the Fund’s performance. At the regional level, holdings from North America, Western Europe and Latin America boosted the Fund’s return the most.

Activity

Cash bonds continued to lag single-name CDS over the quarter, encouraging us to switch from CDS into bonds as the relationship reached highs in some capital structures.

Uncertainty surrounding Brexit enabled us to switch into sterling-denominated bonds at an attractive pick-up compared with Euro-denominated securities from the same issuers.

Large amounts of negative-yielding debt around the world are driving demand for issues at the front end of curves, keeping curves steep and increasing the importance of extending duration to optimise the Fund’s roll-down return. Furthermore, the longer end of high yield (15+ years) is looking particularly attractive from a historical perspective.

The Energy sector is trading two standard deviations cheaper than the High Yield index over the past ten years, creating good opportunities for singlename selection within the sector. We added to mid-quality Energy issuers that are well positioned to withstand macroeconomic volatility.

Negative convexity remains an issue in the global high yield universe. Positioning in sectors that have better convexity, such as Energy, Basic Industry and Banking, is key to performance and as a result we reduced exposure to sectors with the worst convexity, such as Media.

On the back of the worsening global macroeconomic backdrop and our change in view on the name, we initiated a short in Ineos Group in our Outright Short bucket.

We added the new IQVIA Euro loan and NXP Semiconductors front-end cash bonds to the Income bucket.

Outlook

A dovish tone from central banks across the globe and progress in trade wars and Brexit have led to improved investor confidence. Accommodative monetary policy is back on the major central banks’ agendas: this will increase the proportion of negative-yielding assets, but will act as a tailwind for spread products.

We see better risk-adjusted return potential in investment grade and the higher-rated segments of high-yield credit given the slowdown in the global economy. Overall, we favour bonds that are positioned to cope with macroeconomic weakness and have levers such as dividend cuts available to them. With credit curves currently steep, we favour lending for longer to stronger Issuers, both in high yield and investment grade. CDS spreads are significantly lower than cash bond spreads at present, making cash bonds look more attractive than CDS in certain capital structures.

Fraser Lundie Portfolio Manager

Market and Performance review

The Macroeconomic backdrop remains subdued, with a myriad of Brexit - related uncertainty and global trade tensions remaining unresolved. Global growth momentum continues to slowdown offset by supportive monetary policy. Data continues to disappoint versus expectations. Inflation expectations remain anchored, particularly in Europe.

With lacklustre global growth and increased policy uncertainty, the continued drop in government bond yields during Q3 encouraged gains across less risky bonds. Yields on 10-year Treasuries remained below those of 3-month Bills, keeping the yield curve inverted, signalling even weaker expectations relative to current conditions.

With, uninspiring earnings growth, credit metrics are slowly deteriorating in the corporate universe. Profitability in the banking sector is under pressure in this low interest rate environment while capital buffers built since the crisis are strong. The technical picture remains strong across credit markets. Large amounts of negative yielding assets are encouraging asset locators to look at spread products and we can see this in strong inflows across US, European, Emerging Market, High Yield and Investment Grade markets for the year-todate. Only two markets are lagging, these are Emerging Market Local and US Leveraged Loans.

Sentiment has improved, post European Central Bank announcement of additional monetary stimulus, with Equity & Credit volatility near two-year lows.

The Fund’s holdings in the Basic Industry, Energy and Banking sectors boosted its return the most. Index trades detracted the most. The individual holdings that contributed most were Enbridge, Enterprise Products (both Energy) and Allergan (Healthcare). Range Resources, Antero Resources and EnLink Midstream (all Energy) detracted. From a ratings perspective, BB and BBB issues boosted the Fund’s return the most. At the regional level, North America, Western Europe and Latin America drove performance.

Activity

Cash bonds continued to lag single-name CDS over the quarter, encouraging us to switch from CDS into bonds as this relationship reached highs in some capital structures.

Uncertainty surrounding Brexit enabled us to switch into Sterling-denominated bonds at an attractive pick-up compared with Euro-denominated securities from the same issuers.

Large amounts of negative-yielding debt around the world are driving demand for issues at the front end of curves, keeping curves steep and increasing the importance of extending the duration to optimise the Fund’s roll-down return. Furthermore, the longer end of high yield (15+ years) is looking particularly attractive from a historical perspective.

The Energy sector is trading two standard deviations cheaper than the high yield index over the past ten years, creating good opportunities for single-name selection within the sector. We added to mid-quality Energy issuers that are well positioned to withstand macroeconomic volatility.

Negative convexity remains an issue in the global high yield universe. Positioning in sectors that have better convexity, such as Energy, Basic Industry and Banking, is key to performance and as a result we reduced exposure to sectors with the worst convexity, such as Media.

There are opportunities in high-quality loans, including the new IQVIA Euro loan, which we added to our Loans pocket.

Within Emerging Markets we added to the Sovereign pocket as corporates outperformed sovereigns. We reduced exposure to high yield due to worsening convexity.

Ahead of the expected rebound in primary markets in Q4 we reduced our exposure to ABS, particularly in the UK. We increased the size of our options overlay and rolled the options’ maturity from September to November and
December.

Outlook

A dovish tone from central banks across the globe and progress in trade wars and Brexit have led to improved investor confidence. Accommodative monetary policy is back on the major central banks’ agendas: this will increase the proportion of negative-yielding assets but will act as a tailwind for spread products.

We see better risk-adjusted return potential in investment grade and the higher-rated segments of high-yield credit given the slowdown in the global economy. Overall, we favour bonds that are positioned to cope with macroeconomic weakness and have levers such as dividend cuts available to them. With credit curves currently steep, we favour lending for longer to stronger issuers, both in high yield and investment grade. CDS spreads are significantly lower than cash bond spreads at present, making cash bonds look more attractive than CDS in certain capital structures. Within Emerging Markets we added to the Sovereign pocket as corporates outperformed sovereigns. We reduced exposure to high yield due to worsening convexity. Ahead of the expected rebound in primary markets in Q4 we reduced our exposure to ABS, particularly in the UK. We increased the size of our options overlay and rolled the options’ maturity from September to November and December.

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other communications, strategies or products.

Past performance is not a reliable indicator of future performance. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. It should be noted that any investments overseas may be affected by currency exchange rates.


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