Liontrust GF SF European Corporate Bond Fund

Q3 2021 review

The Fund returned 0.2% in euro terms over the quarter, outperforming 0.1% from the Markit iBoxx Euro Corporates Index (which is the comparator benchmark)*.

 

Relative outperformance was primarily driven by the overweight credit position, as spreads proved resilient in the face of rising yields. Sector allocation was the main factor, with our overweight to financials, including banks and insurers, set to benefit from a rising interest rate environment. Elsewhere, our allocation to telecommunications also performed well.

Security selection was positive over Q3, particularly within insurance where some of our higher beta subordinated holdings in names such as Swiss Re, Axa and Phoenix Group added to returns. There was a similar trend in utilities, where our higher beta hybrid holdings in names including National Grid, TenneT and Orsted performed strongly. Other contributors included names continuing to benefit from economies reopening and pandemic restrictions easing, such as office landlords Canary Wharf and Aroundtown.

This more than offset the negative impact from our holding in HSBC, which was a detractor over the period given its significant Asian exposure as uncertainty escalated around the outlook for the Chinese economy in the wake of Evergrande and wider property sector struggles. We continue to believe the banks is well managed, however, and while there will likely be a hit to profitability near term, it remains well capitalised with more than sufficient buffers to weather potential impacts.

 

Our short duration position was neutral over Q3 as it was primarily expressed through the German and US markets where yields were largely unchanged. Ten-year US Treasury yields rose just 2 basis points to 1.49%, having dropped as low as 1.17% before rising sharply following the Federal Reserve’s hawkish rhetoric in September. It was a similar story in 10-year German Bunds, which were also largely unchanged at -0.2%, having reached a low of -0.5% before retracing in the latter stages of the quarter. In contrast, a hawkish turnaround from the Bank of England (BoE) saw a sharp spike higher in UK government bond yields, with 10-year Gilt yields rising more than 30bps to finish the quarter at 1.02%.

 

Overall, the third quarter saw recent momentum in risk assets grind to a halt across equity and credit markets. Concerns over a combination of rising inflation pressures, moderating economic growth and negative developments in China was enough to offset the continued strong rebound in corporate earnings and ongoing positive news on Covid-19.

 

Inflation pressures continue to defy central bank expectations that the underlying factors are largely transitory, with US and eurozone levels setting new post-Global Financial Crisis highs of 5.4% and 3.4% respectively, while the UK reached a nine-year peak of 3.2%. This saw the Fed and European Central Bank (ECB) raise inflation forecasts for the year, although both are prepared to tolerate transitory overshoots versus the 2% target. These pressures look unlikely to ease in the near term given ongoing supply chain disruption, growing consumer demand, labour shortages and, more recently, rapidly rising energy prices and fuel shortages. The Fed’s inflation forecast for 2021 is now 4.2% while the BoE is expecting levels to peak above 4% and the ECB raised its guidance to a modest overshoot of 2.2% this year. These concerns are putting immense pressure on central banks and the potential timing of policy response.

 

After holding its dovish stance for much of the quarter, the Fed pivoted to a more hawkish tone at its September meeting, seemingly confirming expectations that quantitative tightening is set to begin before the end of the year. This will be done through tapering its asset purchase program, which looks set to be reduced faster than anticipated, concluding in mid-2022. Meanwhile, it also looks poised to raise rates much earlier and quicker than forecast, with the dot plot indicating a 50:50 split among members on the prospect of a first hike as early as 2022 and the median indicating rates could reach as high as 1% in 2023 and 1.75% by end 2024.

 

Following suit, the BoE made a similarly sharp hawkish pivot at its September meeting. Interest rates again look set to rise far sooner than anticipated, with the market pricing in an initial hike before the end of the year, although timing remains dependent on impacts from the furlough scheme ending. In contrast to the US, asset purchases should remain at least until the end of the year, with a 7-2 vote to continue the current programme. Meanwhile, the ECB, despite also raising inflation forecasts, remains in the more dovish camp, electing for only a moderate slowdown in its Pandemic Emergency Purchase Programme (PEPP). ECB President Christine Lagarde was quick to point out this is not the start of tapering, reiterating the Bank’s stance that it will tolerate modest transitory overshoots relative to its 2% inflation target, with interest rate remaining at current lows.

 

Elsewhere, the wait goes on to discover Angela Merkel’s successor after the German election ended in stalemate and a three-party coalition the most likely outcome. The two largest parties, the SPD and CDU, performed poorly, although the former narrowly ‘won’ with around 25% of votes and both leaders claiming mandates to form a new government. While fragmented, this result should mean a more centrist government, with far left and far right also performing poorly and unlikely to be part of any coalition. This makes it difficult to envisage any material changes in policy to worry investors.

 

While developed markets grappled with inflation, emerging markets were rocked by fears around the Chinese economy. Headlines were dominated by reports that Evergrande, one of the country’s largest property developers, was on the brink of collapse, highlighting wider default risk across the country’s property sector. This has raised global concerns given the significant amount of debt obligations at risk and the sector’s sizeable contribution to the overall Chinese economy. This compounded developments around stricter regulations on the education and technology sectors, potentially inhibiting growth.

 

There was concern around accelerating Covid-19 cases early in the quarter but this eased as vaccine and booster programmes remain effective in limiting hospitalisations and deaths. Vaccination rollouts continue and are now being administered to school children, with more than 85% of the UK population fully vaccinated and major European nations not far behind at between 75% and 90% and the US just below 70%.

 

There was modest Fund activity over the period. While new issuance was relatively muted over summer, we did participate in deals from Medical Properties Trust, Vonovia, Santander and Annington, which came at attractive levels relative to existing secondary market securities.

 

Medical Properties Trust is a new name within the Fund, with this US-based healthcare REIT the second-largest owner of hospital beds in the US. The company falls under our Building better cities theme, as the owner of 425 properties including hospitals, rehabilitation, surgical and other medical facilities. It is rated high yield at BB+, with its acquisitive business model resulting in high leverage alongside a relatively concentrated tenant base. Its credit fundamentals are strong, however, owing to a resilient business model and lease structure, with high levels of cashflow visibility allowing the company to operate at higher levels of leverage. Furthermore, its acquisition strategy is reducing tenant concentration, and as such, we believe it is a prospective upgrade candidate to investment grade, which is not reflected in relative valuations.

 

Vonovia was another name added over the period, a leading European private residential landlord helping to address the housing shortage in the countries where it operates. It demonstrates robust credit fundamentals and low levels of cyclicality, as demonstrated via solid performance throughout the pandemic. Spreads had widened on the back of the proposed Deutsche Wohnen acquisition, offering an attractive entry point to a high-quality defensive issuer.

 

Against these additions, we exited positions in some shorter-dated bonds that have performed well and look fully valued, including ThermoFisher Scientific and Compass Group, while reducing our exposure to BNP Paribas.

 

Once again, we have continued to be active from a duration standpoint, with several relative value trades during the period. Having started Q3 with an overall duration short of three years, split 1.5 years to the German market, one year to the US and 0.5 years to the UK, we sought to take advantage following the move lower in Bund and Treasury yields early in the period. We increased our short to the German market by 0.25 years as 10-year Bunds drifted back down to -0.5%. We also rotated our short to the UK into the US on relative value grounds, after US Treasuries outperformed gilts over the initial part of the quarter, despite the significant inflationary pressures and the US’s stronger growth outlook. The Fund ended the quarter 3.15 years short in total, expressed through 1.75 years to the German market and 1.4 years to the US, which we continue to believe remains particularly vulnerable to inflation risks.

 

Looking ahead to the end of the year, sentiment continues to be dominated by the inflation debate, and the extent to which current pressures will prove transitory. Central banks and the wider market appear to be coming round to the realisation inflation will be higher for longer than anticipated but we continue to believe it will prove even ‘stickier’ than these revised expectations and above the 2% targets for longer than projected. This is supported by ongoing supply chain disruptions, labour shortages, rising energy prices and fuel shortages, in an environment where consumer demand continues to rise.

 

Even if inflation does ease back to the 2% area, if we do not see a further rise in nominal yields, then real yields will remain negative. We therefore continue to retain our short duration, with government bonds still vulnerable to unprecedented supply and reflation risks. As outlined, our position is split between the UK and US, where we see greater inflation pressures than in Europe and anticipate tighter monetary policy earlier than forecast.

 

While a rising rate environment undoubtedly presents risks for credit markets overall, we remain constructive on investment grade. We believe tighter monetary policy has been well communicated and will be introduced in a gradual and orderly manner, with central banks having learnt their lesson from the taper tantrum of 2013. Meanwhile, it is important to remember the reason we are entering into a rising rate environment is due to the strength of the underlying economy, which is ultimately supportive of credit and broader risk assets.

Corporate spreads remain resilient, supported by robust underlying fundamentals and technicals. Already-strong fundamentals should continue to improve as recovery continues and more periods of weak earnings drop out of calculations, further supporting spreads. As conditions improve, we expect companies’ focus to remain on enhancing fundamentals, including creditor-friendly debt reduction and balance sheet repair, and technicals should also remain supportive, as demand for corporate bonds persists as a rare source of yield.

We remain committed to our existing high-quality positions and believe they are well set to continue to perform as the market benefits from measures taken by central banks (quantitative easing and relaxed capital requirements), national governments (fiscal stimulus and SME guarantee programs), and the improving outlook.

Traditional short-dated bonds remain expensive, both from an all-in yield perspective as well as on a spread basis, with low expected returns, wide bid/offer spreads and shorter spread duration. Instead, we see ongoing value in the medium part of the credit curve, with steepening offering attractive longer spread duration opportunities. From a sector perspective, we continue to favour insurance, telecoms and banks, with cyclical non-financials generally over-owned and expensive.

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

 

 

Sep-21

Sep-20

Sep-19

Liontrust GF Sustainable Future European Corporate
Bond A5 Acc

2.8

-0.5

4.9

Markit iBoxx Euro Corporates Index

1.6

0.2

6.2

 

*Source: FE Analytics, as at 30.09.21, primary share class, 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.

 

Key Risks

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in the Fund 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. The Distribution Yield is also the Underlying Yield for this fund.


Disclaimer

This information 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. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust. Always research your own investments and if you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances.

Friday, October 15, 2021, 1:52 PM