FUND MANAGER COMMENTARY ROYAL LONDON STERLING EXTRA YIELD BOND FUND DECEMBER 2015 Eric Holt HEAD OF CREDIT For professional investors only, not suitable for retail investors 1 P A G E
EXECUTIVE SUMMARY Shares in the Fund posted returns of -0.55%, -0.60%, -0.51% and -0.54% in December for the A, B, Y and Z class shares respectively. This brings the performance outturn for 2015 as a whole to 2.43%, 1.91%, 2.88% and 2.68% for these share classes. The decline in price in the month reflects subdued financial markets. Government, investment grade and subinvestment grade corporate bond indices generally posted negative returns in December, while equity markets weakened and commodity prices remained subdued. The oil price slumped to a ten year low. Rather than being a response to the widely anticipated first move up in US interest rates for almost ten years, this backdrop seems more likely to reflect concerns over the robustness of the global economy, with the outlook for China providing a particular focus. Distributions in respect of quarter four, payable at the end of February, are 1.74p, 1.58p, 1.63p and 1.62p for the A, B, Y and Z class shares respectively. These amounts are moderately lower than those paid in respect of quarter three, but above the amounts for quarter two. They bring total distributions in respect of 2015 to 7.28p, 6.59p, 6.79p and 6.72p respectively, compared to A, B, Y and Z class share prices of 1.10, 1.08, 0.97 and 0.98 at 31 December 2015. ECONOMIC DEVELOPMENTS The US Federal Reserve (Fed), as widely anticipated, raised interest rates for the first time since 2006, having maintained them close to zero since 2008. Oil prices continued to fall as stockpiles increased and the Organisation of Petroleum Exporting Countries failed (OPEC) to agree a production constraint. China s yuan weakened further after new currency arrangements, referencing the yuan to a basket of currencies, were introduced by the central bank. MARKET HIGHLIGHTS After being held near zero for seven years, the Fed raised the US federal funds rate 0.25%, the first hike in nearly a decade. The much-anticipated tightening of monetary policy was followed by a statement signalling more increases were to come in 2016. After initially declining on the news, core government bond yields ended the month higher. Gilts returned -1.03% over December. Sterling investment grade corporate bonds held up a little better, posting an index return of -0.91% in the month. Just two sectors posted positive returns on the month. Autos, up 0.28%, rebounded from earlier weakness related to the Volkswagen emissions debacle, while tier 1 bank bonds were up 0.33% in the month, reinforcing their prime position for 2015 as a whole, up 5.24%. In contrast the basic industry sector posted a -2.86% return in December, reflecting the weakness in commodity prices and the weighting of mining companies in this sector, bringing its out-turn for 2015 to -7.10%. The performance of high yield markets reflected the financial market and economic background. While in December there was little difference between the outturn for the Europe index (-2.37%) and that of the broader global index (-2.49%), for 2015 as a whole returns were 0.76% and -2.07% respectively, reflecting the substantial energy and emerging market components of the latter. Within Europe, BB bonds posted a -2.08% return in December compared to B rated bonds -3.05%, again reflecting the influence of deteriorating market sentiment. The picture of low returns prevailing in 2015 fairly universally across asset classes with high yield index returns shown above and gilts and sterling investment grade corporate bonds posting 0.47% and 0.72% returns respectively masked the heightened level of volatility seen over the year, itself reflecting the challenging market conditions and uncertain economic outlook. For the Fund, overall returns in 2015 effectively resulted wholly from income, which more than offset the modest declines in Fund share prices. Correspondingly the gross redemption yields of the A, B, Y and Z class shares moved up from 6.34%, 5.28%, 6.78% and 6.59% respectively at end 2014 to 7.16%, 6.10%, 7.59% and 7.41% at the end of 2015. 2 P A G E
COMPARATIVE PERFORMANCE ASSET MANAGEMENT Information about past performance is not a guide to future performance. The chart above shows total return (net of fees and net of tax) of the Fund against the following sectors: IA Sterling Corporate Bond, IA Sterling Strategic Bond and IA Sterling High Yield. PORTFOLIO COMMENTARY Against the background of challenging market conditions, most holdings in the Fund posted a moderate decline in price in the month, only partly offset by strong income generation. Within this there were a number of resilient stocks, including Ecclesiastical Insurance and Santander preference shares and Nationwide Building Society CCDS (core capital deferred shares), which benefitted from the relative buoyancy of the financial sectors and posted positive returns for the month. There were a few more esoteric positive influences in the month. TIZIR, the mineral sands producer and refiner were up 8% in the month on reaching terms with bondholders including a one-off 3% consent fee and additional capital injection from the owners to relax temporarily bond covenants to reflect the business s challenging markets. More recently the company announced the recommencement of titanium dioxide production at its refurbished and upgraded plant. Within a generally still subdued offshore oil sector there were some individual positive developments. Deep Drilling bonds were up 10% on news of agreement on the terms for the extension of a part of the its short dated bond issue, repaying half the issue at its par value. Oro Negro bonds were up on 9% on news of a new long-term contract with Mexico s national oil company Pemex. In each case these bonds were secured by a first claim on operating assets. Meanwhile Noreco, the North Sea oil and gas production company, initiated a repurchase tender at a level almost a third above their subdued market price prevailing prior to the announcement, which was accepted in respect of the Fund s holding in the stock. In generally resilient financials sectors, the Fund s holding of Lloyds ECNs (enhanced capital notes), which represent some 0.3% of total Fund assets, were down 6% on news that the court of appeal have reversed the earlier judgement that the company did not have the right to call the bonds at the par value because under present regulations their capital efficiency was reduced. This new judgement seems in turn destined to go to appeal at the 3 P A G E
Supreme Court, a potentially lengthy process. Meanwhile, the very strong income accrual on the bonds has ensured a positive return from purchase in June 2014 even if the bonds were to be promptly redeemed at par. Turnover in markets ahead of the holiday season was relatively low and was reflected in the level of activity in the Fund. Notably, Amadeo Air Four issued a further tranche of shares, their 8.25% expected income yield supported by long-term contracts for the lease of Airbus A380 aircraft to the Emirates airline. Secured bonds of European transport business West Atlantic were purchased at issue, offering a 6.5% return for their four year term. Meanwhile, part of the proceeds of the Noreco bond repurchase tender mentioned above were reinvested in bonds of specialist offshore oil sector service provider DOF Subsea, offering a near 14% yield. The large holding of short-dated bonds in Principality Building Society was reduced slightly, while conversely, investment in secured and structured bonds of Tesco Property was increased. BB rated and amortising progressively through their term, these offered a 7% yield to their 2033 average life. INVESTMENT OUTLOOK We expect global economic conditions to be challenging over the medium term. In the UK, we expect economic progress to be more subdued than in the recent past, despite the support of loose monetary policy, especially in the context of the public spending cuts envisaged to be implemented over the course of the next three years. Meanwhile, we expect inflation to remain benign, even after allowing for the flattering effect of the lower price of oil. From their current level, which is well below our assessment of fair value, we expect a moderate move up in gilt yields over the medium term. Volatility in the asset class seems likely to remain high, although not necessarily as extreme as that during recent months. We believe that the present pricing of corporate bonds is still very attractive over the medium term, while their level of income generation is also appealing with the prospect of short-term interest rates staying low. Economic conditions in the UK seem likely to remain challenging and, in these circumstances, we believe bond characteristics which mitigate risk structural enhancements or a claim on assets or cashflows are an especially important aspect underlying investment performance over the medium term. 4 P A G E
CONTACT DETAILS Intermediaries Matt Jones Third Party Distribution Business Development Manager 020 7506 6739 Matt.Jones@rlam.co.uk Ian Furtado Business Development Manager 020 7506 6697 Ian.Furtado@rlam.co.uk David Billyard Business Development Manager 020 7506 6559 David.Billyard@rlam.co.uk Russell Evans Business Development Manager 01663 741 340 Russell.Evans@rlam.co.uk Institutional John Burke Head of Institutional 020 7506 6768 John.Burke@rlam.co.uk Alan Bunce Head of Institutional Business Development Direct Sales 020 7506 6570 Alan.Bunce@rlam.co.uk Kate Parker Institutional Business Development Manager 020 7015 2502 Kate.Parker@rlam.co.uk Emmanuel Archampong Institutional Business Development Manager 020 7015 2519 Emmanuel.Archampong@rlam.co.uk Philip Clifford Sales Director 07919 170 247 Philip.Clifford@rlam.co.uk Vathani Waran Consultant Relations Manager 0207 506 6558 Vathani.Waran@rlam.co.uk Chris Mills Consultant Relations Executive 020 7506 6655 Christopher.Mills@rlam.co.uk Business Development Support RLAM Business Development Support 020 7506 6754 BDSupport@rlam.co.uk This article is for professional customers only. The views expressed are the author s own and do not constitute investment advice. Information about past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount they originally invested. Issued by Royal London Asset Management January 2016. Information correct at that date unless otherwise stated. Royal London Asset Management Limited, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, registered in England and Wales number 2372439. RLUM Limited, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London, EC3V 0RL. The marketing brand also includes Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson s Quay, Dublin 2, Ireland. Our reference: 000-PRO-01/2016-HC 5 P A G E