Brexit and US job report push bond yields to record low


Fund Commentary
19 Jul 2016


In June, Brexit led to a flight to quality towards US Treasuries and Bunds. At the same time, low quality debt such as high yield and deeply subordinated bank debt fell sharply, in line with equity markets. The other major event was the poor number of 38,000 jobs created in the US, the smallest number in five years.

As a result, market participants dramatically decreased the probability of a Fed rate hike in July, and after Brexit, they started to price in (up to a 20% chance) a possible rate cut in December! In Europe, as expected, the ECB started its CSPP program on 8th June. At the same time, peripheral banks (Spanish and Italian) became the biggest borrowers in the TLTRO program. Another rate cut by the ECB, as a result of Brexit, cannot be excluded in July.

In this context, the German yield curve experienced a bullish flattening, the 2y yield decreasing from -0.51% to -0.66% (-15bps), the 5y yield from -0.38% to -0.57% (-19bps) and the 10y Bund yield from +0.14% to -0.13% (-27bps). Italian and Spanish 10y yields also decreased from respectively 1.35% to 1.26% (-9bps) and from 1.47% to 1.16% (-31bps). Spanish bonds rallied in line with Germany after the victory of Mr Rajoy’s party in the last elections and, more importantly, the disappointing performance of Podemos just after Brexit. At the same time, Italian bonds were still lagging due to major issues around the solvency of its banking sector.

In the US, the 2y US Treasury yield decreased from 0.88% to 0.58% (-30bps), the 5y yield from 1.37% to 1.00% (-37bps), the 10y from 1.85% to 1.47% (-38bps) and the 30y long bond from 2.65% to 2.28% (-37bps). On the credit side, the European iTraxx Main widened from 73 bps to 85 bps (due to cyclical industrials and banks after Brexit and fears about Italian banks) while the US corporate CDX index remained unchanged at 77 bps. In Emerging Markets, the CDX 10y EM index spread tightened dramatically from 331 to 292 bps (-39 bps).



Following the strategy implemented in June 2015, the Investment Adviser continued to favour high quality and liquidity. He sold Enel 2026 (CSPP) and bought Valeo 2024. He also slightly decreased the weight of Nederlandse Gasunie 2022. Finally, he increased the duration overlay in order to decrease the overall modified duration of the Fund from 2.8 (close to the maximum authorized of 3) to 2.3 due to uncertainties around Brexit. In terms of portfolio diversification, the Fund held 41 issues from 39 different issuers.



As with the Euro Bond Fund, the Investment Adviser did not change the global strategy implemented in June 2015, favouring high quality and liquidity. He slightly decreased the weight of 30y US Treasuries (which had already been reduced in May) and added a position in EDP Finance 2021. The modified duration of the Fund, which had been decreased from 5.9 to 4.5 in May, stayed around 4.6. In terms of portfolio diversification, the Fund held 30 issues from 27 different issuers.



In June, the Investment Adviser sold African Export-Import Bank 2021 and partially switched Gazprom 2034 into Vnesheconombank 2025. He increased the weight of Export Credit Bank of Turkey 2019, Turkiye Garanti Bankasi 2022 and State Oil Co. of Azerbaijan 2023. In terms of geographical breakdown, the top 3 countries were Russia (18%), Turkey (18%) and Brazil (9%). The top 3 sectors were Government (32%), Energy (18%) and Basic Materials (13%). The rating allocation was 54% BB, 36% BBB and 3% A (and 7% cash). The modified duration reached 5.8 at month end. In terms of portfolio diversification, the Fund held 31 issues from 31 different issuers.



Regarding Europe, the Investment Adviser believes that the ECB will stay ultra-accommodative in the coming months, especially after Brexit. Mr Draghi will not hesitate to implement other non-conventional measures if needed. Economic conditions are slightly improving in the Eurozone but not enough to prompt the ECB to modify its policy and for Bund yields to climb substantially. The problem is still low inflation and, as the Portfolio Manager has already mentioned in previous reports, Mr Draghi announced a decrease of his inflation forecast in 2018 to 1.8%, still below the ECB target of 2%. It means that “Super Mario” admits implicitly that the ECB will not reach its goal during the two coming years. Regarding the Fed’s policy, the behaviour of the FOMC in 2016 is still unclear: inflation is low but will increase gradually (due to the base effect after the sharp decrease of oil prices in 2015), oil prices seem to be stabilizing around $45, international issues are unclear (Brexit today, but do not forget China) and the Fed is still expecting more rate hikes than the market. The Investment Adviser still believes that there will be no more than one rate hike this year and that the probability of a rate cut in December will increase gradually (simultaneously with the probability of a recession in 2017). He will stay overweight 30y US bonds (both Treasuries and TIPS) and will seize any opportunity to buy dips in order to increase the modified duration. Emerging Markets will stay volatile but the current environment, with low yields in US, Europe and Japan, higher commodities and oil prices, stabilisation of emerging currencies and a “not-too-hawkish” Fed leave room for further spread tightening. The huge rally after Brexit could probably lead to a more cautious stance, taking profit on some BB rated bonds and switching into A-BBB rated issuers with lower spreads but lower volatility and spread-widening risk.


The views and statements contained herein are those of the Eric Sturdza Private Banking Group in their capacity as Investment Advisers to the Funds as of 15/07/16 and are based on internal research and modelling.