Bonds behaviour driven by uncertainty (US presidential election, Fed hike and ECB tapering)


Fund Commentary
18 Nov 2016


In October, markets were driven by the US presidential election, the probable Fed rate hike in December and the incredible rumour of tapering in Europe. Macroeconomic data was stronger in the US, led by consumer spending, the labour market (both employment and wage growth), industrial production and residential real estate. In Europe, two major economic data points gave the impression that the situation is improving: the Spanish unemployment rate decreased below 20% for the first time in six years and the German Ifo Business Climate index reached a two-year high.

Consequently, the Fed is expected to raise its Fed funds rate on 14th December even though there is a FOMC meeting on 2nd November (as this is considered to be too close to the Presidential election). In Europe, an incredible rumour affected the bond market that the ECB could consider a tapering of its QE. Some ECB members contradicted this rumour which led to a jump in the Euro and Bund yields. The official line from the ECB remains that they are open to further stimulus. In the meantime, they took advantage of this correction to purchase short term bonds which had climbed above the deposit rate.

In this context, the German yield curve experienced a huge bearish steepening, the 2y yield increasing from -0.68% to -0.62% (+6bps), the 5y yield from -0.58% to -0.40% (+18bps) and the 10y Bund yield from -0.12% to +0.16% (+28bps). At the same time, the Italian 10y yield increased from 1.19% to 1.66% (+47bp) while the Spanish 10y bond yield “only” rose from 0.88% to 1.20% (+32bp). The European periphery stayed under pressure, the difference between Italy and Spain reflecting improvement in the Spanish economic data and uncertainty about the outcome of the referendum in Italy on 4th December.

In the US, the US Treasury curve steepened substantially as well, the 2y US Treasury yield increased from 0.76% to 0.84% (+8bps), the 5y yield from 1.15% to 1.31% (+16bps), the 10y from 1.59% to 1.83% (+24bps) and the 30y long bond from 2.32% to 2.58% (+26bps). On the credit side, the European iTraxx Main did not move, staying at 72bps and the US corporate CDX index increased slightly, from 75 to79bps. In Emerging Markets, the CDX 10y EM index widened from 283 to 290 (+7bps).



During the month, the Investment Adviser implemented a new strategy. Since Q2 2012, the strategy of the Strategic Euro Bond Fund was to be partially invested in mediumterm corporate bonds (7-10y) with most of their duration hedged with short positions in the Futures market (both the 5y Bobl and 10y Bund). Due to the behaviour of the market recently and the increasing probability of tensions in the inter-bank market, the Investment Adviser decided to abandon this policy in favour of investments in Floating Rate corporates (non-Financials), i.e. bonds with low duration (between 0 and 0.3) and coupons indexed on the 3 month Euribor. As a result, all bonds maturing above Q3 2022 were sold (Proximus 2024, Valeo 2024, Aéroports de Paris 2023, RTE-EDF 2023, Nederlandse Gasunie 2022, Sagess 2023). At the same time short Bunds and Bobls were bought back. Almost 16% of the Fund has been invested in FRNs issued by Anheuser Busch Inbev, Honda, Coca Cola, Total, 3M and General Electric. Total 2021 was sold in order to increase the weight of the FRNs and Terna 2019 has been sold, switched against FCE 2019. Earlier in the month, issuers whose weight was too close to 5% were reduced (Enexis 2020, TenneT 2020, Nederlandse WaterschapsBank 2019 and Würth 2018). The duration has been slightly increased to 2.5, with portfolio duration decreased from 3.8 to 2.5 and the duration overlay increased from -1.5 to 0.0. In terms of portfolio diversification, the Fund held 36 issues from 35 different issuers.



The Investment Adviser did not change the global strategy of the Fund, favouring high quality and liquidity. He increased the weight of TIPS 2043 (an Inflation-linked US Treasury) and US Treasury 2046 when the US curve steepened and sold the remaining position in a US Treasury maturing in December 2016. He also implemented a switch, selling Korea Resources 2021 (Government-owned but in a challenging sector, coal) and buying Tesco November 2017 (1y maturity yielding above 2%), a British fallen angel (BB+ rated) in a recovery phase. The modified duration increased from 5.4 to 6.0. In terms of portfolio diversification, the Fund held 36 issues from 32 different issuers.



In October, the assets under management of the Fund climbed from $55 to $57 million. The Investment Adviser increased the weight of the following holdings: Sberbank 2019, Mol 2019, Tencent 2020, Romania 2024, Codelco 2025, Namibia 2025 and Gazprom 2034. He also added a new name into the portfolio: BRF 2024, a Ba1/BBB rated Brazilian food producer (mainly meat, poultry and pork but also pizza, pasta and frozen vegetables). In terms of geographical breakdown, the top 3 countries were Russia (18.3%), Brazil (10.0%) and India (7.6%). The rating allocation was 46.9% Investment Grade and 49.9% Crossover (BB+ and BB). The breakdown of the portfolio in terms of market allocation was 92.4% Emerging Markets, 4.4% Developed Markets (US Treasuries) and 3.2% cash. In terms of sector allocation, the Investment Adviser favoured Governments (37.6%) followed by Materials (16.6%) and Energy (15.9%). The modified duration remained around 6.4 during the month. In terms of portfolio diversification, the Fund held 39 issues from 37 different issuers.



Many risks can still materialize in the coming weeks and before year end: the outcome of the presidential election in the US, the referendum in Italy in December, oil prices, China, a free fall of the GBP post-Brexit, a liquidity stress in Europe due to fears of insolvency of an Italian or German bank. As a result, the Investment Adviser is strongly convinced that Central banks will continue to manage financial stability and market volatility. He believes that the ECB will stay ultra-accommodative in the coming quarters. Regarding the US, the Fed will probably raise the Fed funds rates only once in December 2016 and Ms Yellen will probably stay dovish during the press conference in order to reassure investors. The Investment Adviser still believes that the Fed needs to raise rates, not because the US economy is performing well but because the US Central bankers are scared by a possible slowdown in 12- 18 months while their toolbox is empty. The main reason why they should vote for a rate hike is because sooner or later in 2017 they will be obliged to ease their monetary policy, regardless of the outcome of the Presidential election. Emerging Markets will stay volatile but technical factors such as low net issuance, the negative or low yield environment in most Developed Markets, higher commodity and oil prices, stabilisation of emerging currencies and a “not-too-hawkish” Fed suggest that the environment will remain supportive for further spread tightening. Any correction would be a buying opportunity.


The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 14/11/16 and are based on internal research and modelling.