The outperformance of lower-quality bonds has been a consistent theme in our commentary since the summer months. In Q4, particularly November and December, this dynamic has been turbo-charged; the compression of yields has been driven ever lower since the results of the US election and the excellent efficacy of the various major vaccine trials.
Since the end of October, CCCs have returned a whopping 12% in US dollar terms. The market has returned 6.1%, with 5.3% from BBs 5.3% and 5.8% from Bs. Over the same period, the difference between BB and CCC spread has contracted from around 800 basis points to around 570bps. For context, 800bps was below the five-year average for this differential; the ten-year average is around 750bps. Of course, energy has played a major role in this. As we have written before, energy is a large component of the market, and particularly so within higher-yielding bonds. Indeed, thematic cyclical sectors in general are heavily represented. Since the end of October, the energy sector has produced a return of 14%.
We don’t spend a lot of time thinking about peers, but it has been an interesting year and one where it has been easy to assess how funds have been positioned by looking at returns. In mid-March, in the midst of the crisis, only the very defensively positioned funds stood out because just about every bond fell significantly, almost regardless of
quality. For example, broadband companies and the likes of Netflix, which, from a business perspective, were clearly going to have a ‘good’ crisis, were a source of liquidity to meet redemptions. This may even have concentrated certain funds in the highest-risk bonds they held and price action later in the year would suggest that to be the case.
By mid to late April, the liquid, quality stuff had bounced back and so too had the funds sharing these characteristics. Meanwhile, funds holding less quality, likely more thematically cyclical, bonds were noticeably lagging. As monetary support trickled through the market, CCC outperformance, as previously described, kicked in and we saw a compression of bond prices and of peer fund performance. Since early November, higher risk has gone like the proverbial train. Given our process, it is likely not possible for us to produce the returns seen by some funds in our market over this late-year period. Indeed, we have a mandated limit of 20% in CCCs, not that we have been near that ceiling.
Over the quarter, the Liontrust GF High Yield Bond Fund (A1, accumulation class, total return in euros) produced a return of 5.5% versus the ICE BAML Global High Yield index’s (euro hedged) 6.2%*. Given the big skew in returns in favour of parts of the market where we have little exposure, we are pleased with performance in Q4. The two energy bonds we hold, Enquest and Neptune, have done well. One of our CCC holdings, Howden, an industrial gases business, saw its bonds go materially higher, which was backed up by good Q3 results, where the impact of Covid, particularly on cash flow, has been fairly modest.
We believe M&A will be a strong theme in 2021 as management teams look to build empires with cheap capital. Even in the last few weeks, we have had two holdings acquired by investment grade-rated peers, namely Norbord and MTS Systems, with both seeing capital appreciation in their bonds, which led us to sell on valuation grounds.
The Fund participated in a number of new issues, with a mix of existing and debut issuers. For example, we purchased a debut bond from Italian (but with a global footprint) packaging machine manufacturer IMA. It is a business with a reasonable growth outlook but with cost and cashflow flexibility. We also purchased bonds from Adevinta, the listed Norwegian company that acquired eBay’s classified ads business (but where eBay retained a stake).
We have sold out of a number of our smaller holdings, largely on valuation grounds, including auto parts business Gestamp, Vodafone hybrid bonds, building materials company James Hardie, and aircraft leasing company Avolon.
In our view, the growth outlook for the second half of 2021 looks good. This is down to the herd immunity that will likely be achieved in major developed economies by April and into the summer. In Fund positioning, we are not betting against central banks or the logistical effort to get people vaccinated. However, we do not want to bet on companies or, more accurately, capital structures that might not be intact without central bank support or unprecedented success in rolling out a vaccine in such a short space of time.
To reach down the risk spectrum in any meaningful way, in our view, typically means managers must accept large accumulations of thematic risk; and as you know, we prefer idiosyncratic risk. Referring to the BB/CCC relationship described earlier, we may well see further yield compression and therefore outperformance of lower quality bonds. As mentioned, now at around 570bps, the ten-year low in the spread is 407bps. If we get to this level, CCCs could outperform BBs by another 3-4%.
Meanwhile, our Fund offers investors a gross redemption yield in euro terms of around 3.5%. For the level of default risk within the Fund, despite the long way yields have travelled since late March, we still believe this represents decent value versus other parts of the fixed income spectrum, where you likely have to marry lower yields with more interest rate sensitivity, or higher yields with less liquidity.
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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