Liontrust GF SF European Corporate Bond Fund

Q4 2018 review

Having launched on 29 May, the Fund’s first seven months have come against an increasingly challenging backdrop, with a risk-off tone gripping markets in the fourth quarter as volatility returned to the fore.

Driven by fears over slowing growth plus the well-worn trio of trade wars, Brexit and tightening monetary policy, the quarter proved difficult for broader risk assets and corporate bonds were no exception. The ensuing flight to safety saw Government bonds outperform as investors flocked to safe haven assets, leading to a sharp drop in yields across developed markets. This resulted in underperformance from the portfolio’s underweight position to interest rate risk.

Our overweight position to credit also contributed negatively, as corporate spreads widened significantly across investment grade and high yield, even in traditionally defensive sectors such as utilities. This weakness was amplified by new issuance, as large premiums were on offer to tempt investors back to the market. This repriced the secondary curves in individual names and sectors however, compounding moves wider in spreads.

Due to widespread weakness, the portfolio’s core overweights to sectors such as banks, insurance and telecommunications underperformed, with financials particularly struggling. Some of this weakness was offset by the allocation to Bunds however, given the outperformance of government bonds over the period.

We have consistently held a 10% allocation to Bunds since launch and this position was unchanged throughout Q4, reflecting our short-term defensive bias as we continue to exercise prudence ahead of key events like the Brexit vote on 15 January. In addition, with heavy new issuance expected in Q1 2019, we are well positioned to take advantage of either a technical-led cheapening in the secondary market or new deals that become available with large concessions to the market.

The portfolio also benefitted from structural underweights to the utilities, oil and gas, and industrials sectors due to our SRI analysis coupled with an unfavourable risk/reward profile. A combination of increased supply and weakening demand, exacerbated by concerns around global economic growth, saw a sharp downturn in oil prices over the period.

Looking into some of the macro reasons behind this difficult quarter, fears of a “no deal” Brexit scenario grew as political turmoil engulfed the UK. Prime Minister Theresa May’s proposed EU Withdrawal Agreement was met with fierce criticism and several senior ministers resigned, including Brexit Secretary Dominic Raab. On failing to win enough support for the deal, the Prime Minister postponed the Parliamentary vote scheduled for mid-December until January.

This decision saw a further loss of support, triggering a vote of no confidence in her leadership of the Conservative Party. Despite going on to win 63% of the votes to retain her position, the significant lack of support from her party does not bode well for the pending vote on the Withdrawal Agreement.

Europe has had its own share of political uncertainty, with Italy having several budget proposals rejected by the European Commission as they failed to meet required fiscal targets. As a result, Moody’s downgraded Italy’s sovereign debt one notch: critically however, it remains investment grade. Despite the EU accepting a much revised budget proposal from Italy in December, concerns over the country’s financial health have not abated.

In the US, midterm elections turned out as anticipated, with the Democrats gaining a majority in the House of Representatives but the Republicans retaining a majority in the Senate. This will make it more difficult for the Trump administration to provide additional fiscal stimulus through further tax cuts.

Economic data has been mixed over the quarter, as political pressures weigh on the outlook for global growth and increase fears of a slowdown. These concerns intensified when several large-cap companies, notably Apple, warned of a slowdown in earnings growth.

As promised, the European Central Bank confirmed the end of its quantitative easing programme in December; with data indicating a slowdown in growth however, they also reiterated previous guidance that interest rates will remain on hold until at least summer 2019.

December also saw the US Federal Reserve raise interest rates as expected. This was the fourth hike in 2018 although associated commentary was dovish, lowering expectations for rate hikes in 2019 from three to two. Despite this, there remains a disconnect between the market and the Fed’s expectations over the path of interest rates, with the former continuing to price in no hikes in the US for 2019 and even possible rate cuts further out.

The Bank of England kept rates on hold amid mixed data and pending further Brexit developments.

In terms of portfolio activity in Q4, the focus was on repatriating some of our US dollar holdings back into euro or sterling equivalents, driven by a number of factors. Rising hedging costs have resulted in a need for higher spread pick-ups to compensate, while the incremental pick-ups on offer have also been compressing and are now inside longer-term averages.

This is combined with increased risk of a no deal Brexit, which would likely see foreign creditors of European and UK-based companies be first to take flight and US dollar-denominated debt in these names underperforming against the euro or sterling equivalents as a result. This was the primary driver behind relative value switches within names such as Orange, Telecom Italia, and Zurich (Demeter Investments and Cloverie).

We also sold our holding in Valeo over the period. While the company has strong exposure to the growth in safety and emission control technologies, we have grown increasingly concerned about the automotive sector, which came under further pressure from escalations in trade tariffs. We also saw a reduction in our exposure to RBS following the company’s decision to exercise its call option on the 5.5% perpetual bonds we owned. 

Elsewhere, the fund’s short duration position was increased to two years short relative to its benchmark. This is expressed solely through the German market where we favour the lower yields, which provide less downside potential in the event of a no deal Brexit scenario while retaining the upside potential attached to a favourable resolution.

As we enter 2019, we continue to believe government bonds are overvalued and expect yields to rise as concerns over a no deal Brexit and global trade wars abate. Indeed, in the event that we avoid a no deal situation, it is possible the correction in yields could be sharp, on the basis much of the downside is priced in. As such, we retain a significant underweight position to interest rate risk.

We still believe the macro backdrop for credit markets remains solid, supported by positive economic growth, low default rates, loose monetary policy and robust trends in corporate earnings. Moreover, corporate bond valuations now appear attractive, helped by the significant repricing that occurred in 2018 due to technical and sentiment factors mentioned above. Looking forward, we expect that, as these issues subside, the market focus will shift back to the relatively strong underlying fundamentals and attractive valuations.

Our core sector preferences within insurance and telecoms are supported by attractive valuations and higher credit quality and, although somewhat tempered by supply concerns, remain unchanged over the longer term.

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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. The majority of the Liontrust Sustainable Future Funds have holdings which are denominated in currencies other than Sterling and may be affected by movements in exchange rates. Some of these funds invest in emerging markets which may involve a higher element of risk due to less well regulated markets and political and economic instability. Consequently the value of an investment may rise or fall in line with the exchange rates. Liontrust UK Ethical Fund, Liontrust SF European Growth Fund and Liontrust SF UK Growth Fund invest geographically in a narrow range and has a concentrated portfolio of securities, there is an increased risk of volatility which may result in frequent rises and falls in the Fund’s share price. Liontrust SF Managed Fund, Liontrust SF Corporate Bond Fund, Liontrust SF Cautious Managed Fund, Liontrust SF Defensive Managed Fund and Liontrust Monthly Income Bond Fund invest in bonds and other fixed-interest securities - fluctuations in interest rates are likely to affect the value of these financial instruments. If long-term interest rates rise, the value of your shares is likely to fall. If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds. Mentioned above five funds can also invest in derivatives. Derivatives are used to protect against currencies, credit and interests rates move or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions.

 

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.

Monday, February 4, 2019, 11:44 AM