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.
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.
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.