Liontrust SF Corporate Bond Fund

Q2 2020 review

The Fund returned 9.4% over the quarter, outperforming the 9.0% return from the iBoxx Sterling Corporate All Maturities Index and the IA Sterling Corporate Bond sector average of 7.4%*.


Our overweight credit position was key to returns as corporate bonds rebounded strongly and outperformed government debt, benefitting from stronger risk appetite and favourable technical support. High yield performed particularly well, led by the European market, while investment grade was not far behind.

Stock selection was the principal driver, particularly within our favoured insurance and telecommunication sectors. These recovered strongly from a tumultuous first quarter, with our higher beta subordinated, longer spread duration and US dollar denominated bonds delivering positive contributions. Banks also saw a strong rally, as fears of a repeat of the financial crisis were dispelled over the period. All this far outweighed the drag on performance from our more defensive positions, such as our gilt allocation and short high yield, which suffered amid the risk-on tone in markets.

The strong rebound across these core stock and sector holdings reinforces our conviction in our high-quality portfolio, which we believe continues to be well positioned to withstand the significant impacts from the Covid-19 pandemic.

This was partially offset by underperformance from the fund’s short duration position, which was a detractor over the quarter. Despite the risk-on tone, government bonds held up remarkably well, demonstrating continued correlation with risk assets. UK 10-year gilt yields fell 18 basis points over Q2, closing June at 0.17%, driven by a combination of the Bank of England’s commitment to keeping government borrowing costs low, increased discussion around negative interest rates, and Brexit uncertainty resurfacing. While German 10-year bund and US 10-year Treasury yields were broadly unchanged over the quarter, this belies the underlying volatility, trading in ranges of 31bps and 43bps respectively.

We saw a huge contrast in Q2 compared with the first three months of the year, as central banks and governments responded swiftly and in coordinated fashion to the threat posed by Coronavirus. They provided enormous amounts of stimulus to support economies both domestic and global and the combination of slowing infection rates, easing lockdown measures and early signs of a rebound in economic data contributed to positive returns from financial markets.

That said, the impact of Covid-19 on economic activity has been significant: the UK saw a decline in GDP of -2%, whereas the fall was higher in the US at -4.8%. Unemployment rose sharply in the US to 15%, the highest level in post-war history, although the furlough scheme helped support the employment number in the UK. What these figures demonstrate is the huge impact the response to Covid-19 is having.

As stated, central banks have been quick to respond to prevent the economic situation evolving into a financial crisis, ensuring borrowing costs are kept low and liquidity is available, not just for large corporates but for small and medium-sized enterprises as well. In the US, the Federal Reserve response has been significant in both size and speed, committing to unlimited government bond purchases and increasing the size of its quantitative easing (QE) programme. This has been targeted at investment grade companies but, importantly, was expanded to include corporate debt rated investment grade prior to 23 March, helping alleviate fears over access to liquidity for companies downgraded to high yield. The Fed has committed to keeping rates low until it is confident economic activity is back on track towards full employment and inflation at the 2% target level.

In the UK, the Bank of England increased the size of its QE programme, helping keep borrowing costs low, and liquidity has been provided via the Covid Corporate Funding Facility (CCFF). The furlough scheme is estimated to be supporting 7.5m people, helping to reduce the impact of the lockdown on the workforce. As for the European Central Bank, it also continued QE and eased collateral requirements to help support small and medium-sized enterprises. European Commission president Ursula von der Leyen called for the power to borrow €750 billion for a recovery fund to support the worst-affected EU regions. This would be in addition to a €540 billion rescue package agreed in April. The European Central Bank also offered support, expanding its Pandemic Emergency Purchase Programme (PEPP) to €1.35 trillion.

In terms of corporate behaviour, companies have looked to ensure they have adequate liquidity to manage their way through this downturn. Access to the CCFF, use of the furlough scheme, equity raises and dividend cuts have all been regular features as companies focused on balance sheet strengthening. This resulted in record levels of new corporate bond issuance, but the combination of strong technical support and renewed investor sentiment has meant this supply has been well received by the market.

As expected, the impact of lockdown strategies and uncertain economic outlook has had a negative impact in terms of credit downgrades. Our portfolio has not been immune, but we have not seen any downgrades to sub-investment grade, reflecting the quality of the issuers held. While credit metrics across investment grade have been largely able to weather the storm due to strong pre-Covid starting points, earnings pressure has weighed heavily on already-weak metrics in the high yield space, leading to an acceleration in defaults. These have been predominantly US led, with the retail and energy sectors suffering the most.

Overall, the second quarter was dominated by positive sentiment as reductions in the infection rate allowed economies to restart and there were signs of promise in the early stages of vaccine development. This resulted in initial data releases suggesting the recovery may turn out to be sharper than widely believed, further boosting sentiment. However, the latter stages of the quarter saw renewed fears over a second wave, with new infections rising in the US and several emerging markets struggling to contain the virus. This serves as an important reminder that easing of lockdown measures must be carefully managed.

While significant uncertainty remains over the economic recovery, we will inevitably see attention turn back to political risks later in the year, with the US presidential election fast approaching, resurfacing US-China trade tensions and Brexit negotiations.

While we have maintained high conviction in our existing holdings throughout the crisis, there was moderate portfolio activity over the quarter, as the widespread market sell-off presented a number of opportunities. As mentioned, new issuance was a feature of the period as corporates sought to bolster near-term liquidity concerns and this was well absorbed by government purchasing and rising risk appetite. The portfolio took part in new issues from SSE, Severn Trent and RBS at attractive valuations.

We selectively added exposure to names where valuations have been heavily impacted by the pandemic over the near-term. These bonds were still trading close to the wides, having not participated in the ensuing rally, but we believe they have been oversold as their medium-long term outlook remains robust. One example was Unite Group, the UK’s largest purpose-built student accommodation provider. We topped up our existing position, with the company set to continue benefitting from favourable market dynamics such as a growing demand/supply imbalance and low reletting risk with 56% of the portfolio under nomination agreements. The company has proved more resilient to the pandemic than the market is pricing in, with reservations for 2020/21 at 81%, and following our decision to increase exposure, Unite also completed a £300m share placing to bolster near-term liquidity, demonstrating prudent management.

Other examples of names we added to included Intercontinental Hotels Group and Compass Group, increasing exposure to well-run businesses at attractive valuations as we feel they will prove more robust to Covid-19 impacts than the market is giving them credit for.

We also took advantage of the weakness to add new names Rothesay Life and Phoenix Group, which specialise in providing long-term pension security. Both companies participate in bulk annuity and pension buyouts that provide companies and beneficiaries certainty and stability, securing participants’ financial health and future. Rothesay actually improved its solvency over Q1, offering evidence of its quality, absence of exposure to Covid-19 and prudent investment exposure.

Against these investments, we reduced some of our exposure to subordinated financials that had performed particularly well during the rally, such as the Nationwide and Coventry Building Societies. Following an unsatisfactory engagement response, we also decided to exit our position on Notting Hill Housing Trust on sustainability grounds, with the company failing to deliver on its proposed ESG strategy and timeline. We reinvested the proceeds in industry-leading peers in terms of sustainability, Clarion Housing Group and Optivo, which were trading at similar valuations and offering a more attractive opportunity.

We took advantage of the underperformance in US dollar credit in the initial stages of the crisis, rotating out of some of our sterling-denominated telecommunications bonds into duration-matched USD equivalents. The spread and yield pick-up on offer had reached all-time wides in some cases, despite the same level of credit risk. Examples included Deutsche Telekom, Verizon and Telefonica.

We continue to believe high yield is more challenged as earnings pressure, rising cost of debt, liquidity constraints and ineligibility for central bank support leaves the market vulnerable to a sharp economic downturn. Early in the quarter, we added a -5% short position to the US high yield market, where the index has considerably more exposure to the most significantly impacted sectors, namely energy and retail, where we anticipate a sharp spike in defaults. The fund benefitted from this move with nine defaults in the index since early March, with an average recovery rate below 10 cents. While a sharp downturn is not our base case, the short position in this part of market provides protection against periods of renewed weakness.

 

In line with our previous guidance, we elected to reinstate the short duration position at 1.5 years short relative to the index, after 10-year UK gilt yields fell to near all-time lows, eventually finding a floor around the bottom end of the 0.2-0.8% range we had anticipated. This is currently fully expressed via the UK market.

Looking to the rest of the year and beyond, a near-term deterioration in credit fundamentals is inevitable given the significant disruption to corporate earnings but we remain positive on investment grade credit: it offers a rare source of yield and strong fundamentals give enough headroom to withstand much of the negative impact. As detailed earlier, this is combined with a high level of technical support fuelled by central bank purchases, alongside an expected reduction in new issuance following elevated levels in H1. Companies have ensured they had funding in place but their focus is now turning to balance sheet repair. With credit spreads above long- term average levels, there is scope for a gradual grind tighter in spreads. We remain committed to existing positions, which we believe are well set to withstand the economic impacts, and do not view any of our holdings as exposed to a credit event.

On the duration side, we continue to believe recently announced QE programs will limit any increase in gilt yields over the coming months, with the Bank of England explicitly saying it will extend QE if necessary to keep yields in check. On the other hand, any renewed bad news on the virus/hit to the economy will likely result in a government bond rally.

 

Given the above, we expect 10-year gilt yields will remain in a relatively tight trading range of between 0.2% and 0.8%, recently finding a base at the bottom end of this. As such, we feel there is now scope for yields to rise modestly as the magnitude of the fiscal impact on issuance hits the market, and we will look to increase duration in the portfolio as they trend towards the higher end of our expected range.


Longer term, we see an ongoing risk that gilt yields rise and/or the curve steepens, supporting our preference to retain a short position. Further to this, with government bonds yielding close to zero (or below in a number of countries), it is our belief that government bonds have limited ability to dampen portfolio volatility and actually provide meaningful downside risk during bouts of market weakness or volatility.

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

 

Jun-20

Jun-19

Jun-18

Jun-17

Jun-16

Liontrust Sustainable Future Corporate Bond
2 Inc

5.5

5.6

0.4

10.2

5.3

iBoxx Sterling Corporate All Maturities

6.5

6.8

0.4

6.8

9.1

IA Sterling Corporate Bond

5.8

5.6

0.6

6.4

6.1

Quartile

3

3

3

1

3

 

* Source: Financial Express, as at 30.06.20, primary share class, total return, net of fees and interest reinvested.

 

For a comprehensive list of common financial words and terms, see our glossary here.

 

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.

Thursday, July 16, 2020, 3:28 PM