Poor liquidity and Draghi’s QE highlights the attractiveness of PSPP bonds


Fund Commentary
18 Sep 2015


In August, nervousness reached a peak due to uncertainties driven by Greece, commodity prices, emerging markets, and first and foremost China and the Federal Reserve (Fed). Equity markets tumbled after the People’s Bank of China (PBoC) announced a devaluation of the yuan. Consequently, doubts about the pace of the Chinese growth arose to a level that could force the Fed to postpone its first rate hike from September to December.

In the US, economic statistics were dominated by the publication of the GDP figures for Q2 (annualised) at +3.7%, revised from +2.3%. The unemployment rate stayed at 5.3% while inflation was still low, with a CPI at +0.1%, PPI at +0.2% and average hourly earnings at +0.2%. The publication of the minutes of the July FOMC showed that the Fed seems likely to raise its interest rate soon but the timing of lift-off is less important than the subsequent pace of increases which would be gradual. The Fed’s monetary policy will most likely remain highly accommodative for quite some time. 

In Europe, mixed French and German data were offset by the Spanish recovery, led by housing and retail sales. The European Central Bank (ECB) announced that it is ready to expand or extend its QE program if needed. Its inflation target is threatened by the drop of commodity prices, the deflationary effects of the Chinese slowdown and the PBoC monetary policy.

In this context, government bond yields have been dominated by flows. Against all odds, during equity markets turbulences, US Treasuries (and Bunds to a lesser extend) did not rally significantly as the PBoC sold huge amounts of bonds. In addition, some emerging markets Central banks were also forced to sell Treasuries as they needed US dollars to stop the collapse of their currencies. As a consequence, despite rumours of a probable increase of the ECB’s QE, European government bonds were also hit by these Central banks sales and the 2y German yield climbed from -0.23% to -0.20% (+3 bps), the 5y yield from 0.05% to 0.13% (+8 bps) and the 10y Bund yield from 0.64% to 0.80% (+16 bps). On the credit side, corporate spreads behaved similarly on both sides of the Atlantic: the US corporate CDX index widened from 71 to 82 bps and the European iTraxx Main from 62 to 71 bps. More importantly, liquidity decreased sharply in the low quality universe (BBB, crossover, high yield, subordinated debt and hybrid bonds) and this was not due to the fact that traditionally, in August, volumes are low.

In August, following the strategy implemented in June and July, the Investment Adviser paid more attention to liquidity, issuer quality and the correlation between the behaviour of the stock markets and the Fund (through its investments in corporate spreads) in order to align (more than in the past) the Strategic Euro Bond Fund as a natural hedge against European equities.

i)    Higher liquidity: purchase of European government bonds and PSPP (ECB’s Public Sector Purchase Program) bonds. The Investment Adviser bought five government bonds maturing in 2020: Belgium, Netherlands, France, Ireland and Finland, as well as buying two PSPP issuers, the Austrian Asfinag and the Italian Enel.
ii)    Higher credit quality / lower correlation to stock markets: significant decrease of exposure to BBB issuers, purchase of high-quality corporates and government-owned corporates that may be included by the ECB to its PSPP list. The Investment Adviser bought the Dutch Enexis (Aa3/A+), Tennet (100% owned by Netherlands), EDF-RTE (85% owned by France), Sagess (100% owned by France) and Engie (ex-GDF Suez, 34% owned by France). The Investment Adviser also sold the following BBB names: Wendel, Imerys, Edenred, Adecco, Mondelez, Wolters Kluwer, WPP, RCI Banque and Telekom Austria. Finally, Wal Mart 2026 was sold given its duration; the Investment Adviser believes a 2026 maturity is too long in the current environment.
iii)    Lower exposure to Asia/Pacific: the Hong Kong conglomerate Hutchison Whampoa was sold, the exposure to Korea has been decreased (sale of KDB and Export-import bank of Korea) and the weight of the Australian mining Company BHP Billiton has been reduced due to the falling prices of iron ore and other commodities, the exposure of BHP to China and the increasing risk of recession in Australia. 

The consequence of the intense trading is that, at month end, the exposure of the Fund to Eurozone Government bonds reached 7%, the exposure to PSPP reached 7.5% ( i.e. 14.5% belong to the ECB’s QE). The exposure to government-owned corporates was above 20% and the exposure to BBB (excluding Irish, Spanish and Italian governments and PSPP) has been reduced to 3.5%. The exposure to Asia ex-Japan has been reduced to less than 0.5%.

Liquidity has always been a key factor in the Investment Adviser’s bond selection process. Consequently, in the current environment, dominated by poor liquidity, it has not been difficult to sell 9 BBB rated issuers. As a result the “liquidity” component of the investment process is robust when markets turn unfavourable. The Investment Adviser will continue to monitor very closely and carefully this key parameter.

The Modified Duration of the Fund has been held around 2.5-2.7 and the duration overlay policy has not been very active. At month end, the Fund held 59 issues from 58 different issuers.  

The Investment Adviser believes that the ECB will stay very accommodative and that Mr Draghi will continue his “whatever it takes” policy. The Central Bank is ready to intervene to prevent a major drawdown of markets. The liquidity of the bond market is a major issue and the Investment Adviser will continue to be invested in liquid assets such as PSPP bonds. Depending on developments in the markets, the Investment Adviser may maintain the duration risk of the Fund between 2.2 and 2.7. Peripheral corporate spreads (excluding PSPP) will not be considered as a buying opportunity. The average quality of the portfolio has been dramatically improved in July and August: the S&P score decreased from 82.5 (end of June) to 77.2 points (July) and 59.5 in August. In addition, this already low level, below 60 points, does not reflect exactly this improvement because some Irish, Spanish and Italian governments and PSPP are rated BBB but offer much higher quality and liquidity than BBB corporates.

The Investment Adviser will maintain the current strategy in the coming weeks and still believe that positive returns will be achievable as a result of the carry of PSPP bonds and high-quality corporates, their spread tightening potential, credit selection and active management of duration and yield curve.

The views and statements contained herein are those of Sturdza Private Banking Group in their capacity as Investment Adviser to the Fund as of 15/09/15.