Liontrust GF High Yield Bond Fund

Q4 2018 review

The global high yield market produced a total return (in US dollar terms) of -3.4% in Q4, with both US and European high yield falling in similar fashion. This is the worst quarterly return since the oil price-impacted Q3 2015. Within the total return, average prices dropped close to 5.0%, with the income typically associated with owning high yield bonds cushioning the blow. The US dollar return for 2018 was -1.9%, with the drop in average prices 8.1% and, again, income cushioning the majority of this blow. I believe the income generating nature of high yield and the resilience it provides really shines in years like 2018. Historically, high yield has never had two negative total return years in a row.

 

Alongside fears over the growth-choking impact of both higher interest rates and increased protectionism (US v China, Brexit and Italy), oil prices are back on investors’ radar and have contributed to this period of higher volatility and lower high yield bond prices.

 

Followers of the high yield market will know the last period of material volatility (2015/2016) was catalysed by a drop in the oil price. Therefore, unsurprisingly, the c.35% drop in the oil price during the quarter had a significant impact on sentiment. It’s worth noting that cost profiles in the industry have improved in recent years affording companies a little more resilience to deal with lower oil prices.

 

Without material exposure to energy or bonds rated CCC or lower, the European high yield market was notable during the quarter for idiosyncratic moves based on disappointing earnings. During company earnings season, it felt like there was a new headline every few hours with certain bonds’ prices routinely dropping multiple percentage points (e.g. restaurant chain Pizza Express, travel agent Thomas Cook, food producer Boparan, lottery and gaming service provider Intralot, and metal producer Nyrstar to name but a few). Thankfully, however, in general, the earnings season showed company earnings remain in good condition.

 

Fund

The Liontrust GF High Yield Bond Fund had one holding in the oil & gas sector at the start of October – Enquest. We are index agnostic and own Enquest bonds because we like them, not because our index tells us to own something in the sector. We like Enquest based on management’s priority to reduce debt and the improvement in company fundamentals since its Kraken field started producing in 2018, making it a completely different prospect to what it was in 2015. Yet, judging by the movement in its bond prices compared to other energy companies, the market isn’t giving it much credit for this. Its bonds yield in excess of 15% and we believe this is enough compensation to bear the risk that its production needs Brent oil above US$50 a barrel to be viable in the long term.

 

The Fund has avoided most of the ‘minefield’ European high yield credits in Q4. During the quarter, we purchased wind turbine manufacturer, Senvion, and lottery and gaming company, Intralot, after the bonds had fallen in price, though admittedly we did not call the intra-quarter bottom in either bond’s price. Both are high risk ideas yielding in excess of 15% that occupy below average position sizes in the Fund.

 

In November we added Neptune Energy, a decent quality gas producer with a USD bond yielding around 7.5%. Gas prices in the North Sea have been very stable compared to oil and Neptune employs a hedging strategy. We see this as a low risk investment in the oil and gas sector.

 

We purchased relatively lower risk opportunities in the form of United Rentals, Colfax and Arqiva. United Rentals is a cyclical US company but its structure allows it to generate cash during tougher periods. Colfax is also cyclical, however we purchased bonds after the announcement it is to buy a business involved in Orthopedics, thereby reducing the group’s cyclicality. We are also fans of Colfax’s main Founder shareholders and the governance culture they have entrenched in the company. Lastly, Arqiva has plenty of debt, though we believe its UK broadcasting infrastructure assets and long-term contracts allow it to service high levels of debt. 

 

Outlook

At the start of 2018 the global high yield market was expensive with a yield of 5.2%. This included an additional premium for default risk, or ‘spread’, of 3.5%, implying underlying government bonds offered a yield of 1.7%.

 

At the end of 2018, after a difficult year, the global high yield market has moved to a yield of 7.5%, which consists of spread of 5% and underlying government bond yield of circa 2.1%. In a year where high yield, thanks to income generation, has produced only a small negative return, the market has transitioned to a valuation which we now view to be attractive and as a team have been adding high yield risk in recent weeks.

 

I have mentioned the word volatility a few times. To provide some context, a well-known equity market measure of volatility which can be used as a proxy for high yield – the VIX index – doubled by mid-October 2018 since the beginning of the month. Undoubtedly, Q4 was more volatile than what we’ve been used to recently, yet the average volatility in the quarter, as measured by VIX, matched the average for the history of the data series, which goes back to 1990.

 

We think volatility levels comparable to the long-term history are here to stay and the lower levels witnessed in much of the last five-to-eight years were the anomaly. Our response to this is to maintain a portfolio of companies with the right combination of assets, growth prospects, pricing power and access to capital. This leads us away from the lower quality parts of the market, e.g. CCC and lower represents only 2% of the Fund.

 

Our discipline is based on the fact the default rate is the crucial determinant of value in high yield over the long term. By focussing on our investment and decision-making process, we believe we can minimise defaults and keep a calm head during periods of weaker sentiment. In the meantime, a starting point of yield of 7.5% is enough to justify an increased allocation to high yield in 2019 and beyond.

 

The Liontrust GF High Yield Bond Fund was launched in June 2018. As its track record is less than one year, regulatory restrictions prevent presentation of performance data in this review.

 

*source: UBS Delta, Liontrust.

 

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

 

Disclaimer

 

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, January 15, 2019, 4:31 PM