Liontrust GF SF European Corporate Bond Fund

Q3 2020 review

The Fund returned 1.6% in euro terms over the quarter, underperforming the iBoxx Euro Corporate All Maturities Index’s 2.0% (which is the comparator benchmark)*.


The Fund’s underperformance was almost entirely driven by the short duration position as it proved a volatile period for government bonds, despite yields remaining broadly unchanged by the end. In Europe, government bonds performed relatively well, supported by the unveiling of a €750 million pandemic recovery fund. As a result, German 10-year Bund yields fell 7 basis points over the quarter; they traded in a 15bps range, however, rising to -0.4% before falling again amid concerns around sharp rises in infection rates across the Continent.


Meanwhile the 10-year UK gilt yield finished the period 6bps higher at 0.23%, trading in a 25bps range as moves higher following positive Covid developments over summer reversed in the wake of higher infection levels, the return of Brexit uncertainty, and increasing potential of negative interest rates from the Bank of England. US 10-year Treasury yields were also broadly flat, moving just 3bps higher, as uncertainty around the Presidential election builds and accommodative monetary policy was offset by the failure to agree a further fiscal stimulus package.

Corporate bonds continued to recover over Q3, outperforming government bonds, as strong technicals, including low levels of issuance, ongoing central bank purchase programs and rising demand as investors search for yield, drove credit spreads tighter. As a result, the Fund benefitted from its core sector positions within banks and insurance, with a particularly strong stock selection contribution from subordinated holdings against a constructive backdrop for risk assets. However, this was largely offset by the drag on performance from our more defensive allocation to Bunds, combined with our underweight to autos, which continued to recover in a strengthening economic environment. This resulted in a broadly flat contribution from overall credit positioning.

Looking at the macro picture in more detail, we saw heightened optimism regarding Covid-19 over summer as infections/hospitalisations remained low despite the gradual reopening of economies and progress in vaccine trials. Fears of a second wave resurfaced towards the end of the quarter, however, as infection rates rose rapidly across a number of European countries. This resulted in the reintroduction of localised lockdowns and growing concerns over potentially higher death rates as we approach winter. Governments remain reluctant to enforce widespread lockdown measures given the detrimental impact on the economy, favouring stricter local restrictions in problem areas.

Overall, economic recovery has continued with corporate earnings in particular surprising to the upside, although there are concerns around the pace of recovery, which appears to be slowing. In Europe, fiscal support measures for workers have been extended into 2021, while the UK also continues to offer government funding, albeit on a reduced scale, through the job support scheme, which is helping to keep unemployment rates in check. As stated, the EU unveiled a €750 billion pandemic recovery fund, comprising a mixture of grants and loans available to member countries.

The recent deterioration in Covid developments coincided with rising political uncertainty as we build towards the election in the US, while Brexit negotiations also appear to have stalled.

On Brexit, issues surrounding state aid and fishing rights are thought to be two of the main areas of disagreement. Relations became further strained following the release of the UK government’s Internal Market Bill, which appears to override parts of the Brexit Withdrawal Agreement relating to trade between the UK and Northern Ireland. This prompted the EU to call for the UK to withdraw measures from the bill and has increased the probability of a hard Brexit or a ‘skinny’ deal.

In the US, despite Joe Biden maintaining a relatively healthy lead in the polls, uncertainty continues to build, particularly in key swing states. Control of the Senate also came to the forefront after it failed to pass additional fiscal stimulus, with Democrats and Republicans disagreeing on the size of the package required.

As mentioned earlier, credit market technicals remain supportive, none more so than monetary policy, which is very accommodative. In Europe, the ECB’s corporate purchasing programs continue to buy corporate bonds, which, combined with a relatively benign period for new issuance, proved positive for credit spreads. In the US, meanwhile, the Federal Reserve announced it is moving to an average inflation target, which will permit temporary overshoots of its 2% target to compensate for periods where the level is below that. As for the Fed’s dot plot, that currently suggests interest rates will remain at/near zero until 2023. Finally, the Bank of England continues to discuss the potential of negative interest rates, although governor Andrew Bailey sought to address concerns by ruling it out in the near term. 

In contrast to the record levels during the second quarter, new issuance has been relatively subdued over the summer months and as a result, it was a quiet period in terms of portfolio activity. We did participate in a new issue from TenneT, which owns and operates high-voltage electricity transmission networks in the Netherlands and Germany. The company supports the efficient distribution of power, carrying electricity over large distances and minimising energy losses by transporting it at high voltages. The recent hybrid issuance was a certified green bond, with proceeds helping to finance its green project portfolio, and offered attractive yield and spread pick-up relative to outstanding senior bonds.

We disposed of our holding in Energias de Portugal (EDP) on sustainability grounds after a number of significant environmental and human rights concerns were reported regarding widespread habitat transformation and impacts on local communities in Brazil. The concerns specifically relate to its 33% stake in the Empresa de Energia São Manoel (EESM) consortium that owns the 700 MW São Manoel hydropower plant project, coming after the company had stated it was moving away from building large-scale dams in emerging markets. The proceeds were reinvested across several our preferred utilities holdings including Orsted, SSE and Iberdrola.

 

Further to this, we disposed of our holdings in Veolia; this was one of the largest contributors to the Fund’s carbon intensity, as measured by MSCI, and we also believe the bonds were fully valued, offering limited upside potential relative to peers. The proceeds were again reinvested across several names within our preferred, telecommunications, insurance and utilities sectors such a Vodafone, Axa and Suez. There was also a relative value switch within ING bonds, extending into a slightly longer-dated subordinated issue for an attractive yield and spread pick-up. The company remains one of our preferred banks holdings from a sustainability perspective, given its predominantly retail focus.


As highlighted in the last quarterly commentary, we elected to close the short position to the European high yield market, where the default environment has proved far more benign than in the US. The latter has seen a doubling of its pre-Covid high yield default rate, contributing two-thirds of global defaults year to date in contrast to less than 13% from the European market. We also believe the asset class should benefit from an ongoing recovery in credit markets, while further benefitting indirectly from the EU recovery fund.

Over Q3, we extended the Fund’s short duration position from two to 2.5 years relative to its benchmark, currently expressed solely through the German market following a further drop in Bund yields. Initially, the additional 0.5 year short was expressed through the US, which we viewed as having the greatest potential for rising yields. However, we anticipate rising volatility as we build towards the election and subsequently rotated this back into the German market, which we view as less exposed to political uncertainty.

Looking into 2021, we remain constructive on investment grade credit, with technicals set to remain supportive, and also expect companies’ focus to shift towards improving credit fundamentals. As expected, corporate fundamentals have deteriorated, fuelled by the collapse in earnings combined with growing debt issuance; in investment grade, however, issuance has predominantly been defensive in nature to bolster liquidity buffers. This is reflected in high levels of cash on company balance sheets, keeping net leverage levels broadly flat.

While further deterioration is likely in the near term as more periods of depressed earnings are factored into leverage calculations, we expect that, having weathered the initial storm, focus will shift towards creditor-friendly debt reduction and balance sheet repair supported by a rebound in corporate earnings.

We remain committed to our high-quality portfolio, which we believe is well positioned to withstand the economic impacts as a result of the pandemic, and do not view any of our holdings as exposed to a credit event. From a sector perspective, we continue to favour insurance, telecoms and banks, with cyclical non-financials generally over-owned, expensive and/or more heavily exposed to ongoing Covid-related uncertainty.

Our outlook regarding interest rates also remains relatively unchanged, with government bonds still vulnerable to unprecedented supply and reflation risks. Moreover, with government bond yields close to zero (or below in a number of countries, including Germany), they offer limited ability to dampen portfolio volatility and actually provide meaningful downside risk during bouts of market weakness, supporting our short duration position.

Discrete years' performance* (%), to previous quarter-end:

 

 

Sep-20

Sep-19

Liontrust GF Sustainable Future European Corporate Bond A5 Acc

-0.5

4.9

iBoxx Euro Corporate All Maturities Index

0.2

6.2

 

*Source: Financial Express, as at 30.09.2020, in euros, total return (net of fees and income reinvested). Discrete data is not available for five full 12-month periods due to the launch date of the portfolio


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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, October 19, 2020, 1:11 PM