We would use the word ‘resilient’ to describe the high yield market in Q3. Resilient in the face of the equity market volatility we’ve seen towards the end of the quarter, and resilient in the face of rising government bond yields. As we’ve mentioned in previous reports, some of the resilience being shown by the lower-quality end of the market is indeed down to the spectre of inflation and rising government bond yields, with many seeing CCCs as a ‘haven’ if you’re worried about duration risk.
The global market produced a return of 0.2%; however, the global index includes Chinese real estate, where there are well publicised issues. US CCCs returned 1.0% and EUR CCCs 1.5%. Similarly, US and Euro Bs were resilient, returning 0.7% and 1.0%, respectively. US BBs returned 1.1% and European 0.7%.
Over the quarter, the Liontrust GF High Yield Bond Fund (A1, accumulation class, total return in euros) produced a return of 0.4% versus the ICE BAML Global High Yield index’s (euro hedged) 0.0%*.
There were very few bonds that contributed or detracted any more than a few basis points during the quarter. The best performing holding was a capital providing bond issued by agricultural co-op bank, Rabobank. This was mainly driven by a leading investment bank publishing a positive view on what is something of a niche bond. The note clearly put the bond on the radar of a few more investors and the price jumped around 5%.
Bonds issued by Altice International, a telecom company generating the vast majority of its revenues in Portugal, have been a modest drag on performance. We own 2028 and 2029 maturity, euro denominated bonds, which are longer duration than average. We find Altice an interesting opportunity as, in our view, the bonds seem to be a tool for investment banks to ‘play’ periods of modest volatility, like we have seen around the turn of Q4. Whenever there is a slight turn in sentiment, one of the first comments you see from investment bank dealers is “calling Altice bonds lower”. This is technical rather than fundamental and if we were to see sustained, material volatility, other bonds would soon catch up. In the meantime, because of these technicals, Altice trades at a perennial discount, i.e., higher yield than would be suggested by the stability of telecom assets and indeed its credit rating. Rather than trade in and out of Altice on sentiment (and boost trading desk commissions), we are happy to accept this volatility in an average sized position and earn the extra yield that comes with the bond over the long term.
On an index relative basis, not owning anything related to the Chinese real estate sector was a strong contributor to performance. During a quarter when individual bond returns were in a tight range, two new holdings from the German real estate sector were detractors. We have taken a small position in bonds issued by Adler Real Estate, an operating subsidiary within Adler Group. There are various issues faced by Adler Group including political risks and, indeed, its own financial transparency. On the latter, prior to our investment the company had improved disclosure. We purchased bonds at a price of around 92.5, with the bonds having traded as high as 105 as recently as June. Ultimately, we believe Adler has enough asset value to navigate the current stormy waters. Towards the end of the quarter, on no additional news, the bonds dropped a further 6-7% - hence the cost to Fund returns. In the early days of October, the bonds have moved back closer to our average entry level.
The other new real estate holding is a company called Vivion which owns office assets in Germany and hotel assets in UK. It has been dragged down by general sentiment towards real estate rather than any fundamental issues specific to its credit worthiness.
During the quarter, portfolio activity has been relatively modest. We took small holdings in a couple of investment grade bonds, both of which offer BB-type spread. The first was a hybrid bond issued by US utility Southern at a spread close to 2.5%. The second was an investment company (structured as a trust) called Pershing Square at a spread close to 2.0%.
As mentioned, we purchased two German real estate holdings. In addition, we purchased bonds issued by an office-focussed Swedish real estate offering a spread of almost 4%. Note that we reduced holdings in CPI Property, a Czech/German real estate company and completely exited from the holding in Aroundtown Property.
Lastly, we purchased a US-based medical equipment distributor called AdaptHealth. We view the main risks in this sector as pricing pressure and risks around who’s paying (no national health service); we believe these are mitigated by AdaptHealth’s diversity. We purchased these bonds with a yield of 5.125%, when the market in general had a yield of around 4.25%.
Back to resilience. Due to our expectations for very low underlying defaults, we think the Fund’s current yield is a reliable guide to returns for the medium to long-long term investor. However, the path returns will take is obviously unpredictable. If rates continue to rise, it feels as if the equity market could see further declines as analysts start to use higher discount rates in their models and investors in general come to terms with less central bank manipulation of asset prices. In our view, such volatility would impact high yield bonds, but to a much smaller degree than equities.
We continue to mainly avoid the lower-quality parts of the market. As we’ve said before, we view the notion of CCCs being a haven in any market environment as fundamentally flawed. There is little upside and the reward of merely potentially outperforming more duration-exposed bonds is not enough to mitigate the risks of investing in an area where economic shocks can be so damaging. You’d be better off in equities. We’re sticking with higher-quality high yield, where we think the overall investment proposition remains relatively attractive.
Meanwhile, we continue to run with a short duration compared to the high yield index and we continue to run with a limited exposure to longer-dated bonds.
Liontrust Key risks & Disclaimers:
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 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 GF High Yield Bond 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. Bond markets may be subject to reduced liquidity. The Fund may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.
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