Fraser Lundie Portfolio Manager
Market and Performance review
There were a few interesting developments in the global macro environment in the second quarter of 2019. Markets have been supported by increasingly accommodative Central Banks and the hope of progress in trade tensions. The Federal Reserve decided not to cut interest rates at its June meeting but indicated there may be rate cuts ahead. ECB President Draghi hinted at further monetary policy easing if inflation outlooks fails to improve. UK securities performed well over the quarter despite Brexit related uncertainty and the resignation of Theresa May.
The technical picture remained strong even though net supply turned positive for the first time since the start of 2018 as the weaker loan market led to issuers tapping the bond market instead. This positive supply was well digested by the market given the tailwind from strong inflows into the asset class as credit is again in strong demand.
Credit markets drew support from the growing stock of negative yielding assets. Higher quality performed better than lower quality on the back of demand for credits that have means to withstand macro volatility. Emerging Market bonds also had a positive quarter benefitting from a more supportive monetary policy backdrop.
The main sources of absolute performance were Basic Industry, Energy and Banking. The main detractor over the quarter was from the Index trades and the options overlay. Individual names that contributed to the Fund’s positive performance over the period included Basic Industry name Toll Brothers, Financial Services name AerCap and Energy name Enterprise Products. Individual names that detracted included Energy names Range Resources, Antero Resources and Petroleos Mexicanos.
From a ratings perspective BB and BBB names contributed the most to overall absolute performance. Geographically, absolute performance was driven from North America, Western Europe, the UK and Latin America.
During the quarter, we continued to reallocate some of our High Yield exposure towards Investment Grade corporates and Financials. As the convexity of the High Yield market deteriorated further, we reduced our exposure to securities trading above their call price, such as IQVIA, CSC Holdings and LKQ. With credit curves remaining steep, especially in investment-grade, we continued to rotate into longer dated securities where possible, such as in WPX Energy, Suzano and HCA Healthcare.
The persisting negative basis is a prevalent theme in the market at present. In order to manage it, we switched CDS positions into cash bonds to benefit from their better risk return profile in names such as Toll Brothers, Avis and Telecom Italia.
Given the very tight spreads on synthetic bonds, we initiated a short position on the iTraxx Crossover as part of the Fund’s hedge bucket. We also added some short dated out of the money options on the CDX HY to improve the Fund’s convexity profile.
A dovish tone from the Central Banks across the globe and supportive comments from G-20 meeting improved investor confidence. Accommodative monetary policy is back on the agenda of the major central banks, this will increase the share of negative yielding assets, and will remain a tailwind for spread products. Better risk-adjusted return potential in Investment Grade and the higher-rated segment of High Yield credit given the slowdown in global economy.
Overall, we favour credits that are well positioned for macroeconomic weakness and have levers such as dividend cuts available to them.
With credit curves currently steep, we favour lending for longer over to stronger lenders. This is true in both High Yield and Investment Grade. Negative basis is at the very wides making cash more attractive than CDS in certain capital structures.
The convexity of the High Yield market worsened on the back of stronger performance in an environment of stable fundamentals and a supportive technical backdrop. For High Yield portfolios, it is becoming increasingly important to maximise the convexity by re-allocating capital away from negatively convex securities.