Liontrust SF Corporate Bond Fund

Q3 2020 review

The Fund returned 2.0% over the quarter, outperforming the 1.6% return from both the iBoxx Sterling Corporate All Maturities Index and the IA Sterling Corporate Bond sector average (both of which are comparator benchmarks)*.


While global equities delivered more mixed performance over Q3, credit markets continued their recovery, supported by a strong technical backdrop and ongoing economic improvement. Credit also remained remarkably resilient towards the end of the period despite being faced with a combination of rising political uncertainty and infection rates. Those strong technicals, including low levels of issuance (in Europe), ongoing central bank purchase programs and rising demand as investors continue to search for yield, drove a risk-on tone in corporate bonds, and the Fund’s outperformance was almost entirely driven by the overweight credit position.

 

Stock selection again proved strong, especially within our favoured banks, insurance and telecommunications sectors, where higher-beta subordinated and cross-market US dollar-denominated holdings continued to recover against a constructive backdrop for risk assets. This was supported by a positive contribution from sector allocation, notably our overweight to financials but also underweights to cyclical non-financials including industrials and consumer discretionary, which continued to suffer as a result of ramifications from Covid-19. This far outweighed the drag from our more defensive allocation to gilts and the short position to high yield.

Meanwhile, performance from our short duration position was virtually flat over the period, as government bond yields were broadly unchanged despite intra-quarter volatility. The 10-year UK gilt yield finished Q3 just 6 basis points up at 0.23%, although it traded in a 25bps range as moves higher following positive Covid developments over summer reversed in the wake of rising infection levels, the return of Brexit uncertainty, and increasing potential of negative interest rates from the Bank of England. Elsewhere, German 10-year Bund yields fell 7bps over the three months, amid rising infection rates on the Continent and the unveiling of a €750 million pandemic recovery fund. US 10-year Treasury yields were broadly flat, moving just 3bps higher, as uncertainty around the Presidential election builds and continued accommodative monetary policy was offset by the failure to agree a further fiscal stimulus package.

Coming back to the macro picture in more detail, we saw 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 across a number of European countries. This resulted in the reintroduction of localised lockdowns and concerns over potentially higher death rates as we approach winter. Governments remain reluctant to enforce widespread lockdown measures given the 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. 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 the latter, issues surrounding state aid and fishing rights are thought to be 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 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 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 terms of portfolio activity, new issuance has been relatively subdued over the summer months, in contrast to record levels during the second quarter. As a result, activity predominantly revolved around adding exposure at the margin across a number of our preferred names, particularly within our favoured insurance, telecommunications and banks sectors following strong portfolio inflows. We also disposed of our holding in Investec, which appeared fully valued following a significant recovery from Covid lows and offered limited upside. It is also potentially exposed to a higher level of non-performing loans relative to more diversified peers given the high concentration to SME lending in the UK and South Africa. We reduced our exposure to Lloyds through the disposal of two holdings we also believe were fully valued and offering limited upside potential.

The proceeds from these transactions were reinvested across a number of preferred holdings in the banks space, including HSBC, Nationwide Building Society and Coventry Building Society, all of which demonstrate high social impact through their significant exposure to SME and mortgage lending.

Elsewhere, there were also a couple of relative value switches during the period. We rotated within Tier 2 holdings in Natwest, switching into a slightly longer-dated bond with low extension risk for a significant pick-up in spread and yield. We also moved up the capital structure in Swiss Re, rotating out of holding company subordinated bonds into operating company subordinated bonds for only a modest reduction in spread.

Although not expected to peak until early 2021, the pace of acceleration in high yield defaults has slowed after doubling from pre-Covid levels, given better-than-expected corporate earnings and the number of weaker companies that have already defaulted, with the US contributing approximately two-thirds of 166 global defaults year to date. Further to this, we believe surviving companies are likely to fare better in a recovering market, with a short position likely to be a drag on returns. As such, we elected to close our short position to US high yield during the period, in line with our favourable disposition towards credit at present.

While we maintained the portfolio’s duration short at 1.5 years relative to its benchmark in Q3, we opted to rotate 0.5 years of the position out of the UK and into the German market. This was primarily because there is less political risk in Europe at present, whereas the UK is subject to Brexit uncertainty and volatility in the US is expected to pick up as we build towards the election. We will continue to actively manage this allocation where we see relative value opportunities.

Looking into 2021, we are constructive on investment grade debt, 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 being 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.

We continue to expect 10-year gilt yields to remain in a relatively tight trading range of between 0.2% and 0.8%, as the Bank of England uses quantitative easing to limit any rises in yields and remains reluctant to introduce negative rates in the near-term. Given 10-year yields are currently languishing towards the lower end of this range, we believe there is scope for them to rise modestly as the magnitude of fiscal impact on gilt issuance hits the market, and we will look to increase duration as they trend towards the higher end of our range. Longer term, we feel there is a risk gilt yields rise and/or the curve steepens, supporting our preference to retain a short position.

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

 

Sep-20

Sep-19

Sep-18

Sep-17

Sep-16

Liontrust Sustainable Future Corporate Bond
2 Inc

4.0

8.7

0.4

2.8

13.2

iBoxx Sterling Corporate All Maturities

4.3

11.0

0.0

0.3

15.9

IA Sterling Corporate Bond

4.2

9.0

0.1

0.6

12.2

Quartile

2

3

2

1

2

 

* Source: Financial Express, as at 30.09.20, 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.

Monday, October 19, 2020, 1:11 PM