Liontrust GF SF European Corporate Bond Fund

The Fund -0.3%* in euro terms over the quarter, compared with the 0.1% return from the Markit iBoxx Euro Corporates Index comparator benchmark.

Market review

In many ways the second quarter of 2024 could be viewed as similar to the first – yields moved higher, volatility remained elevated, and the incoming economic data charted an unpredictable course. Latterly however, developments in that data have provided encouragement that supports our strategic view, though the path will no doubt be a bumpy one.

The picture in Europe has diverged from US and UK counterparts, despite a similar narrative on the inflation side with services remaining stickier than many anticipated. Nevertheless, the European Central Bank delivered their first rate cut of the cycle, arguing that monetary policy remained restrictive. The cut itself was well telegraphed, while the resulting message was one of absolute data-dependency, with no pre-commitment to any particular course of action from here. Given the range of views on the Governing Council, this pragmatic approach seemed designed to achieve such a compromise, and we wouldn’t be surprised to see the Bank of England adopt a similar approach following their eventual first move. The end of the quarter saw euro markets’ attention shift to political risk, as the surprise calling of snap elections saw a blowout in French-German spreads as markets priced greater fiscal uncertainty amid the likelihood of a more extreme style of government. Although the Euro area benefitted from their first interest rate cut, the elections caused 10-year Bund yields to end the quarter around 20bps higher.

The narrative of a US ‘no-landing’ scenario was one which gathered both pace and credence early in the quarter, particularly as the March inflation report, released in April, provided the third upside surprise in a row to both headline and core CPI. Core services ex-shelter, one of the Federal Reserve’s (Fed) preferred measures, was particularly firm and showed signs that this strength might have been becoming entrenched. Alongside a fairly modest loosening in the labour market, the strength in both spot inflation and in some of the pricing components of the survey data, led yields to rise markedly in April, with the US 10-year spiking almost 50 basis points (bps) higher.

While some of the survey data seemed to soften, and measures of consumer health such as delinquency rates picked up meaningfully, the market has moved to push out the timing of the first rate cut. Indeed, at the Fed meeting in June, the ‘dot-plot’ suggested that the median voter saw only one rate cut in 2024, down from three at the previous projection. The May inflation report was more encouraging, however, and we think there are other tentative signs that the “US exceptionalism” narrative might diminish somewhat. Although marked by volatility,10-year yields ultimately fell over both May and June, ending the quarter a little over 20bps higher than they started.

UK rates markets have largely, and somewhat frustratingly, behaved almost in lockstep with their US counterparts, despite economic data generally seeming more subdued and having started on a less sure footing. While growth has been firmer than expected, the inflation backdrop has been more mixed. Headline inflation reached the Bank of England’s (BoE) 2% target in the May report, although services inflation has remained somewhat stickier than both we and the Bank would have hoped. Given the ongoing signals from the labour market that seem to suggest further loosening ahead, we would expect to see that persistence dissipate over time. While the strength in services inflation had put paid to any hopes of a June cut to Bank rate, the BoE did leave the door open to an August move.

Given the communications embargo due to the impending general election, the only tool available to the Monetary Policy Committee (MPC) was the published minutes of their meeting. Though the vote split remained at 7-2, they elected to use the minutes to guide the market on some key points: firstly, that a number of members had considered joining the two who had voted to reduce rates; secondly, broadening out their emphasis to a range of survey indicators which have shown weakness of late; and finally, highlighting the importance of the August Monetary Policy Report in outlining their views on the direction of travel. While the timing of the first cut and the minutiae of the MPC’s messaging are less important than the overall path for interest rates, this was nevertheless seen as an indication of the BoE’s willingness to begin to ease their pressure on the monetary policy brake.

Amid this backdrop corporates have remained resilient. Continued easing in inflation data and moderate US growth have kept the economic environment stable. Modest growth in Europe also supported spreads but these ticked up towards the end of the quarter over election concerns. Election uncertainty and expectations for rate cuts also caused issuers to postpone coming to market, with issuance numbers down compared to the previous quarter. Default rates did tick up over the quarter, as the effect of higher monetary policy continues to filter through the economy, but remains below long run averages.

Duration

We started the quarter 0.50 years overweight Europe and 0.50 years overweight the UK relative to the benchmark, totalling 1.00 year overweight overall. We maintained this level throughout the period. Although the overall duration position remained stable, we initiated a cross-market trade, taking a 0.25 year long position in 10-year UK Gilt futures versus a corresponding 0.25 year short position in 10-year German Bund futures. The rationale behind this position is our view that Gilt yields are relatively further away from our fair value target than Bund yields are, while UK markets have exhibited a higher beta to the US than their German counterparts, a relationship we think should reverse as UK economic data weakens. We also sought to challenge the difference in market pricing for cuts in both economies, where UK pricing was more akin to the US than the Eurozone.

Although headline inflation has fell throughout the quarter, services inflation, a metric closely followed by the European Central Bank, has fallen less than expected. This led to volatility in yields over the quarter, which was only partially offset by the central bank’s inaugural rate cut, and followed by politically driven rising yields into the end of the quarter. As a result, European sovereign yields widened over the quarter, which detracted from performance given our overweight duration positioning. Gilt yields also rose by 24bps, on sticky services inflation, similarly detracting.

Credit performance

The Fund’s credit performance was positive over the period. The European corporate index remained flat for most of the quarter, rising around 10bps towards the end of June.

Within our portfolio, sector selection was positive, driven primarily from our overweight position to the banking sector, which fared well over the quarter, and supported by our overweight position to REITs, which saw spread tightening.  However, our allocation to Bunds detracted slightly from performance, as government yields delivered a negative return. 

Generally, riskier assets outperformed over the quarter. In the US, strong earnings growth across the Magnificent Seven, a group of influential and leading technology stocks, drove market strength, and economic data for the Euro area surprised to the upside. This led to lower rated bonds outperforming on a total return basis.

In terms of security selection, we delivered positive performance from insurance. This was offset by negative stock selection from banks, as our longer duration French holdings fell. These have subsequently recovered after the quarter end following the election results with the lack of a clear majority. We also had underperformance from the utilities security selection, as our position in TenneT fell following the announcement that the German and Dutch governments had ended discussions for a portion of the business to be sold. This reduced the upside from a potential Liability Management Exercise or Change of Control Call that was priced in and the spreads have now returned to trading at previous levels.

Regarding favoured sectors, we have not made any material changes to positioning. We continue to see intrinsic value in financials and hence remain overweight in banks and insurance. We have also retained our overweight in Telecoms, as we like the sector from both a fundamental perspective and their ability to pass on costs to consumers. Our maintained overweight in utilities reflects our more cautious view on the valuations of the industrials and chemical sectors relative to the index, as well as their sustainability risks. Similarly, we remain underweight consumers, as we believe they will face a more challenging outlook due to higher policy rates constricting disposable incomes.

Trades

Trading activity rose compared to the first quarter of the year. However, fewer issuers came to market towards the latter half of the quarter as political uncertainty grew, following a snap election being called in France, and UK and US elections gathering momentum.

We sold some shorter dated bonds in the Fund as we believed that spreads had become fully valued. In Scottish and Southern Energy, we sold two shorter dated senior bonds, extending them into one longer senior note and one hybrid from the same issuer.

Another shorter dated holding we sold was GlaxoSmithKline. Given tight valuations within healthcare, we elected to reinvest proceeds into Motability. We also extended our shorter dated, existing Motability paper into a longer issue.

In financials, we sold out of our position in Aviva. We reinvested the proceeds into Experian at an attractive pickup in spread. We also reduced our position to BNP discount bonds (discos). Following HSBC’s redemption of their last legacy bond it has significantly outperformed other financials on expectations it will be called too.

We also performed relative value trades between bonds of the same issuer in a few other names, including Logicor and Annington. We also topped up in favoured names, like Veralto.

Outlook

European corporates remain in a strong position with continued low leverage and ample liquidity. Interest coverage has fallen from its high, as the cost of funding has trended higher but remains well above its long-term average. We believe corporates  are well positioned as we approach the period where monetary policy should be relaxed from its current restrictive levels. Considering how resilient corporates have been to rates at 3%, we would expect this to remain the case, even if rates were to be held at current levels for a prolonged period, which is not our base case scenario.

Although elevated services inflation has been a common theme across many developed market economies, we broadly expect those inflationary pressures to reduce in the coming months. Labour market loosening should aide this process, while the ‘long and variable lags’ of monetary policy transmission continue to work their way through the respective economies. Indeed, we are seeing ongoing signs of moderation in several economic indicators.

In Europe, survey indicators have pointed to a slowdown in recovery, with surveys suggesting weaker manufacturing and services activity. In the US, inflation has been moderating after a series of strong prints, while measures of consumer delinquencies have risen sharply, and in the UK, survey indicators have suggested falling inflation and wage expectations, while mortgage arrears have continued to tick up to levels not seen since 2016. Nonetheless, this moderation is occurring against a backdrop of fairly healthy economic fundamentals, and as such we are not anticipating a dramatic economic slowdown, but rather a gradual cooling which should allow central banks to ease policy.

Credit spreads have tightened over the first half of 2024, primarily due to supportive fundamentals and technical factors which have supported markets so far this year.  Although further spread tightening  potential is more limited at these levels, progress on inflation and a lowering of rates should provide ongoing support for corporate credit.

We therefore believe that current spreads offer sufficient compensation for fundamental risk, with all-in yields above 4.0%, and investment-grade credit offering an attractive return profile given our outlook for both the asset class and the broader economy.

Discrete years' performance (%) to previous quarter-end:

*Source: FE Analytics, as at 30.06.24, A5 share class, in euros, total return (net of fees and income reinvested). Discrete data is not available for 10 full 12-month periods due to the launch date of the portfolio.

Key Features of the Liontrust GF SF European Corporate Bond Fund