The European government bond yields fell to all-time lows in November

By Eric Vanraes and Pascal Perrone

Fund Commentary
31 Dec 2014

By Eric Vanraes and Pascal Perrone

In November, the European government bond yields fell to all-time lows fuelled by speculation that the European Central Bank (ECB) will extend its asset purchases to sovereign debt. In addition, as OPEC (Organisation of the Petroleum Exporting Countries) members kept their output target unchanged, oil prices dropped to their lowest level in over two years. In the US, economic data continued to deliver a mixed picture: yoy GDP growth was revised from 3.5% to 3.9% as a result of a significant acceleration in consumer spending, while Thanksgiving sales (“black Friday”) showed an alarming -11% decrease, provoking fears of a weak start to the holiday season. Several Federal Reserve (Fed) members were concerned about a possible decrease in inflation expectations. Despite strong earnings published by US corporates, economic growth remained unclear and has led the Fed to publish a mixed outlook further to the conclusion of its latest statement:

“If incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated”.

The ECB confirmed its intention to increase the size of its balance sheet to EUR 3 trillion.

In Europe, business indicators rose as a result of more positive trends in economic data (with the exception of Italy). Consumption data were also stronger, new car sales in particular. The ECB confirmed its intention to increase the size of its balance sheet to EUR 3 trillion and has already started to buy ABS. Deflation fears have continued to increase and Mr Draghi said: “we will do what we must to raise inflation and inflation expectations, as fast as possible, as our price stability mandate requires”.

The 2y US Treasury yield decreased from 0.49% to 0.47% (-2bps), the 5y from 1.61% to 1.48% (-13bps), the 10y from 2.34% to 2.16% (-18 bps) and the 30y from 3.07% to 2.89% (-18 bps). As a consequence, the spread 5-30y (strategy implemented in the Fund at 151 bps) tightened from 146 to 141 bps. On the Credit side, the US corporate CDX Index did not move significantly, from 64 to 62 bps, whilst the European iTraxx main Index dropped from 65 bps to 58 bps, as European corporates could be included in the ECB asset purchases program.

Assets have not changed significantly, increasing by USD 400k to 113.4 million. The Investment Adviser amended asset allocation where the Fund’s exposure to Russian issuers was completely sold, (from 4%, including Vnesheconombank, Sberbank, Gazprom and Lukoil, to 0%). Exposure to the tobacco sector was reduced with the sale of Imperial Tobacco. The proceeds were reinvested by increasing positions in Lafarge, EDP Finance, China Uranium, Temasek and the 30y US Treasury. At month end, the Fund held 43 issues and 40 issuers.

The duration overlay policy was active in November. Corporate bond trades increased the modified duration of the portfolio from 6.2 to 6.4 and at the same time, the Investment Adviser decreased the modified duration of the Fund from 5.1 to 4.7. Consequently, the short positions in 10y & 5y T-notes have been increased.

US economic forecasts are still expected to be contradictory, better unemployment figures being offset by declining consumption data and lower inflation. The sharp drop in oil prices is not only good news: a barrel below USD 60 could lead to a huge recession in the US shale gas industry causing massive job cuts and defaults in the High-Yield Oil & Gas Sector. In terms of portfolio strategy, the Investment Adviser will adopt a more cautious stance and will continue to decrease the duration risk of the Fund before year end. On the Credit side, corporate bond selection will be driven by valuation opportunities in both primary and secondary markets. As a consequence, positive returns will be achievable thanks to the carry of corporates, their spread tightening potential, credit selection and active management of duration and yield curve.

Commentary provided by Banque Eric Sturdza in their capacity as Investment Advisers to the Fund as of 12 December 2014