Liontrust GF SF European Corporate Bond Fund

• Markets are now pricing in more central bank easing than earlier in the year, but mixed economic data has led to volatility across the bond market.
• The Fund delivered most of its outperformance from our duration management, white its credit positioning was mixed, with positive sector selection offset by security selection.
• We believe that current spreads offer sufficient compensation for fundamental risk, and investment-grade credit offering an attractive return profile given our outlook for both the asset class and the broader economy.

The Fund returned 3.7%* in euro terms over the quarter, compared with the 3.3% return from the Markit iBoxx Euro Corporates Index comparator benchmark.

Market review

We mentioned in our previous quarterly update that the path for financial markets would likely be a bumpy one, and that sentiment has certainly rung true over the last three months. While there has been a decisive shift towards markets pricing more central bank easing than earlier in the year, the progression of economic data has been less straightforward, resulting in volatility both within and across the bond landscape.

Europe, compared to the UK and US, has seen a more marked deterioration in economic data. The manufacturing sector, in particular in Germany, has looked under severe pressure, with some forecasters looking towards potential German recession in the coming quarters. German manufacturing has faced both weak demand from China and rising competition from its cheaper exports. In France, political uncertainty fell with no outright majority achieved in July. In September, President Macron appointed Michel Barnier as prime minister. Barnier sits centre-right, and has the task of tackling France’s growing deficit, with fiscal consolidation feeding into growth and then potentially the ECB’s rate of cuts. Speaking of which, the ECB cut by 25bps for a second time in September and, having initially reiterated its data dependence, that data is now suggesting further easing at the next meeting in October. The cut followed declining inflation over the period, with annual inflation printing from 2.6% in July to 1.8% in September. Yields in Europe fell, with 10-year German bunds falling from 2.50% to 2.12%.

The US has largely continued to lead the narrative in terms of the outright direction of yields among developed markets, with incoming data again providing competing narratives – with evidence of strong economic foundations alongside the suggestion of potential threats. The weakness has been largely concentrated in labour data, with the July labour market report (released in early August) galvanising a sustained rally across bond markets which had already performed well on the back of more benign US inflation data. This concern was then seen as validated by the Federal Reserve’s decision to reduce the funds rate by an initial 50 bps (basis points) in September, having held out for longer than many other developed market central banks.

While the market expected only a 25bps reduction, Chair Powell sought to reassure markets that the reason for the outsized move was not that the Fed was overly concerned about the underlying economy, but rather that this was an exercise in prudence: starting rates on a path to neutral and easing from a restrictive rate, having largely achieved the main tenets of its dual mandate. The incoming data will dictate the speed of further moves and ultimately the ‘terminal’ level of interest rates, but for now markets have largely bought into this narrative of a gradual cutting cycle, albeit having relinquished some of the gains given the scale of the moves. Having been as much as 80bps lower than where they started the quarter, 10-year US yields ended September around 3.75%, some 60bps below their opening level.

Watching UK bond markets has remained a somewhat frustrating activity, as they have retained their strong correlation with the US as yields rose but struggled to maintain that relationship during rallies. This is partly attributable to the mix of economic data outturns, which have shown firmer GDP growth (flattered by government spending), alongside some progress on services inflation and weakness in confidence measures. We remain convinced that UK yields should fall, as we believe the economic backdrop is not as strong as in the US, and, if anything, will prove more akin to the Euro area longer-term. The Bank of England (BoE) reduced rates by 25bps in August, but emphasised ongoing data dependence, striking a decidedly cautious tone. The ongoing uncertainty over the upcoming Budget has also done little to help the UK bond market of late, with fears of increased issuance and the risk of fiscal largesse fuelling hesitation among market participants. We remain sceptical that the government will be willing to risk its fiscal credibility to such an extent that it engenders further marked volatility, such as we saw in late 2022, though risks do remain.

Performance

Duration

The Fund delivered most of its outperformance from our duration management.

We started the quarter being 1-year overweight duration, which was expressed as 0.75 years to UK and 0.25 years to Germany. As gilt yields came down, we incrementally decreased the UK exposure by 0.50 years. This meant that we ended the quarter 0.50 years long duration, split equally between Germany and the UK.

Bund yields outperformed over the quarter, tightening by 38bps compared to gilt yields tightening by 17bps.

Credit

The Fund’s credit positioning was mixed, with positive sector selection offset by security selection. In general, credit performed strongly, with euro investment grade spreads ending the quarter marginally lower. The overall level of index spreads however remains at its tightest level compared to historic records, showing its resilience for yet another quarter.

Within our portfolio, positive sector performance came from banks, real estate and autos. Banks continued their strong performance this quarter due to improved and strong fundamentals. Supply dynamics in senior paper have been particularly strong in September, although less so in tier-2 securities, which supported technicals within the subordinated sector. This has helped our overweight position and contributed to performance. We remain constructive on T2 bonds and hence we maintain our current positioning. Real estate fared well over the quarter as the prospect of rate cuts gave confidence to investors over stabilised capital values and the reopening of transaction markets. Our slight overweight position to the sector contributed positively to performance; however, that was offset by negative stock selection. Our exposure is in more defensive names with fewer governance issues, which led to underperformance in security selection, as higher beta names led the tightening in sector spreads.

While our overweight position to utilities provided positive attribution, as the sector’s spreads tightened over the quarter, we had negative attribution from security selection. This came from the unwinding of tightness within names that had previously outperformed. In telecommunications, our overweight position underperformed, as sector spreads marginally widened over the quarter. Security selection was also negative, due to our overweight spread duration positioning. Also, our lack of exposure to the automobile sector helped support credit performance. Multiple issues such as slower electric vehicle growth, Chinese market pressure and Chinese supply hitting Europe all contributed to widening spreads.

Trading activity

Trading activity was higher throughout the quarter, as we added a number of names to the portfolio. Fewer issuers came to market in the first half of the quarter, although issuance activity saw a surprise uptick as the quarter progressed.

In insurance, we reinitiated a position in AXA, following its disposal in 2023. We also performed a relative value switch in Generali and sold our position in Phoenix. In banks, we added new names, including Caixabank and KBC Group. We also performed relative value switches between bonds in Credit Agricole, BPCE and NatWest.

Outside of financials, we added a number of new names. This included Smurfit Westrock, the largest European card box manufacturer that benefits the move away from plastic packaging. We added Roche, a pharmaceutical that focuses on the development and manufacturing of lifesaving medicine. We also started a new position in Verbund, a utility focussing on renewable hydropower that diversified our renewables exposure, and Orange, a telecommunications company we sold out of in 2021. Elsewhere, we added Siemens, Sika and Suez to the portfolio.

As they approached their call date, and came closer to being fully valued, we took the opportunity to reduce hybrid exposure in the Fund, disposing of hybrid securities from TenneT, SSE and National Grid.

We made some disposals in non-financials as well, selling out of Intercontinental Hotels as our position was through shorter dated paper. We also sold out of Experian and used some of the proceeds to participate in a new issue from Bunzl, which came at an attractive valuation.

Outlook

Our thesis on developed markets remains largely unchanged from earlier in the year. While the initial part of the year showcased the strength of the US economy, recent developments indicate a shift in market pricing. As a result, the Fed’s rate cut, and ECB’s cautious approach reflect a broader trend of easing monetary policy.

Having moved earlier, the ECB has now reduced rates twice (albeit in smaller 25bp increments), while also advocating a distinctly data-dependent approach. While the growth and inflation path may remain subject to volatility, many measures of economic activity are suggesting a drop off in momentum, in particular in the manufacturing sectors of Germany. The fiscal outlook is also challenged, with many governments, like in France, now facing Excessive Deficit Procedures and a need to rein in deficit spending over time.

European corporates are still in a strong position, characterised by low leverage and ample liquidity. We believe these companies are well positioned, especially as we enter a phase of monetary easing.

Credit spreads remained stable this quarter, largely due to supportive fundamentals underpinning corporates. Although the potential for further spread tightening is limited given current levels, progress on inflation and lower interest rates should continue to provide a supportive backdrop to corporate credit. Supply dynamics saw a significant uptick in September, which was an unexpected development in both Sterling and European markets.

We believe that current spreads offer sufficient compensation for fundamental risk, with all-in yields hovering around 3.50%, 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 30.09.24, 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