January 2020

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  • 1. Why is there a difference in performance between the EUR and USD Funds

    Context: Different Interest rates levels and valuations of EUR vs USD sub debt result in an outperformance of the USD fund over the EUR fund

    Impact for the fund:The USD fund outperforming EUR fund by 1.5% – 2% per annuum

    The difference in performance between EUR and USD fund is mainly due to two key drivers: difference in income & valuations

    • Difference in income – broadly 1.5%-2% per annum is due to interest rate levels
    • Valuations, as prices of subordinated debt in EUR have not recovered to the same extent as in USD (see chart below)


    What catalyst could make spreads for EUR securities converge toward USD one (i.e. which would mean EUR fund outperforming USD fund)? We feel that with Trade war concerns receded (Phase 1 deal signed) – economic activity is likely to pick up and PMIs (especially that of export-oriented economies such as Germany) are poised to improved, indicating a cyclical recovery for the Eurozone. In our view this would lead to EUR-denominated subordinated debt outperforming.



    As an example, in 2017 – the EUR fund outperformed the USD fund (see chart below) despite lower income yields in EUR, reflecting the outperformance of EUR-denominated sub debt.
    This was driven by an improving macro picture – with a strong improvement in manufacturing PMIs and GDP growth rising to 2.5%.



  • 2. Client is asking what is the investment team credit risk policies concerning derivatives?

    Context:The usage of derivatives is bearing some counterparty risk; how does we evaluate that?

    Impact for the fund:No impact

    The fund uses derivatives for currency hedging purposes only, with no use of derivatives for interest rate or credit risk hedging purposes. For currency hedging – we use a panel of top-tier banks (US G-SIBs) to enter into forward contracts, including State Street – our custodian. For each FX forward trades, collateral is posted which significantly reduces the counterparty credit risk. For forward contracts entered into with State Street, no collateral is exchanged as they are our custodian.

    In any case, credit risk of derivatives counterparties is mitigated by the collateral received as well as the high quality of the counterparties. Furthermore, all derivatives counterparties are covered by analysts as part of the investment process and therefore their fundamental credit risk is closely monitored by the investment team which further mitigates the credit risk.

    As with the issuers we own in the fund, if there were to be a deterioration of credit quality of our derivatives counterparties, appropriate action would be taken to reduce exposure to these – following our investment process.

  • 3. Clients are asking details on the investment process we follow and if we apply an initial screen based on yield.

    Context:Understanding the four steps investment process and how we evaluate the holdings we invest in

    Impact for the fund:The investment philosophy of Atlanticomnium in the process leading to the investment decisions

    When analyzing potential investment ideas, we conduct a detailed process to ensure that the potential bond fits our strict criteria

    This starts with detailed analysis of the issuer (analysis of financial statements, meeting with senior management, etc.) to identify conviction issuers that are consistent with our investment philosophy of capturing high income from bonds of very high-quality issuers. Once we have identified high-quality issuers that fit our criteria, we analyze the instrument itself (understanding the capital structure, term and conditions of the bonds, regulation etc.) to understand the potential upside and downside risk and the attractiveness of the bond structure. When we have identified the attractive bond(s) of high conviction issuers, we then look at valuations to ensure that the bonds add value to the portfolio. We look at a range of indicators such as yields, spreads, potential for price appreciation, volatility. We do not have a pre-defined yield or spread level under which we do not invest, as this depends on market conditions (level of interest rates, spread levels in the market, etc.). However, we will only make investments that make sense in our portfolio context, following the investment philosophy of capturing high income in high quality issuers.

    Finally, we constantly review the portfolio, adding issues that complement the existing holdings, based on relative value and on a risk-adjusted basis. We consider the management of credit risk to be of prime importance. The rigorous bottom-up approach to choosing companies and issues in which to invest embodies very careful consideration of both the return potential and risk of each credit investment throughout the investment process. To this end, the fund managers closely monitor daily changes in:

    – Average credit rating across each fund
    – Individual credit ratings and how they influence investor behavior
    – Prices of both the bonds and their related stocks
    – Relative positions between similar instruments and ratings
    – Liquidity across each fund and of individual positions
    We maintain a strong focus on liquidity throughout the investment process, with the majority of
    holdings within the portfolio typically classified as very liquid or liquid. Liquidity risk is further mitigated by diversification across a large number of positions of different types such as fixed, fixed to floating, floating
    senior, junior, higher coupon and lower coupon bonds which each behave differently from one another
    with the aim to always own some holdings that will be attractive to buyers at different times and in different market environments. Furthermore, the investment team monitors daily liquidity changes closely across the funds as a whole and of the individual underlying positions.
  • 4. We have been asked our view on potential and timing for CET1 easing going towards 2020 and if yes what might be the implication for the funds

    Context:Regulatory changes are on-going and Pillar 2 Requirement that for European Banks must be met only with equity (i.e. CET1), will going forward be met with CET1, AT1 cocos and Tier 2. While this creates a on-off capital relief for European banks of ca. 90bps, this doesn’t change the trend of more capital and further de-levering, which is very supportive for subordinated debt holders.

    Impact for the fund:No impact as this would be more an equity story

    If related to Pillar 2 Requirement (P2R): Yes, this creates a capital relief Andrea Enria of the ECB Banking Supervision or SSM has been very clear on that:
    “When considering the impact of Basel III, we should also consider recent legislative changes that will lead to more lenient requirements. For instance, the Capital Requirements Directive V contains new rules on the quality of capital for Pillar 2 requirements, which will impose a change in the policy the ECB has pursued until now – that of focusing only on Common Equity Tier 1, or CET1 for short. When this change was being negotiated, ECB Banking Supervision and the European Parliament voiced their concern about this change, warning that high quality capital was essential. According to our calculations, the change will generate an average reduction in CET1 requirements of 90 basis points, as banks will be able to rely on lower quality additional Tier 1 and Tier 2 capital, which is now available at favourable conditions.”

    What is the SSM saying: Pillar 2 Requirement (P2R) that until now had to bet met only with equity or CET1 can, with the upcoming redefinition of P2R under Capital Requirement Directive 5 (CRD5), be met with a split of equity and sub-debt i.e. 56% CET1, 19% AT1 and 25% T2. This will create a capital easing of ca. 90bps or ca. EUR 30-40bn.

    Timing should be around JAN22, earliest.

    Looking at the bigger picture: this is not really an easing. Namely, implementation of revised-Basel III (so-called Basel IV) should start to kick in in 2022 too, which will lead to a gradual increase in risk-weighted-assets, offsetting this one off and up-front boost in excess capital. Another element to take into account is that banks will not be able to double count their CET1 between P2R and P2G (Pillar 2 Guidance).

    If so, what is the potential implication for AT1/ T2 performance, and in turn, their fund performance

    This is more an equity story (on margin positive) and is neutral for bond holders. We expect the performance of the fund to be strong, independent of impact of the revision of P2R, as indicated by our base case of +9% for the year. Additional info can be found in the Jan Spotlight that will be attached to the monthly comment

  • 5. We have been asked by a journalist from Bloomberg our view on the current strength of the AT1 coco market

    Context:During 2019 and beginning of 2020 many subordinated bonds from financials, among others, AT1s bonds have reported strong rallies

    Impact for the fund:Strong performance from capital gains which we expect to continue going forward

    Clearly the tone in markets has been very strong in 2019 and into 2020 with positive sentiment driving the rally in AT1s – and as there was a significant re-pricing to call, bonds with lower reset spreads benefitted greatly from the move. However, there is also a rates component in the AT1 rally, for example the UBS 5% is still trading more than 100bps wider (in spread terms) than when issued (factually – not expressing any view on the bond itself), even though prices have recovered towards par.

    On the AT1 market, we remain very bullish, as valuations remains highly attractive in a very low rates environment, while the macro environment has turned more supportive vs. 2018 (geopolitical issues have receded, well positioned to see a cyclical recovery in the EuroZone economy). For example, in EUR AT1s we are capturing spreads above 320bps – more than 100bps pick-up compared to BB high yield.

    That being said, we remain highly selective, both in terms of bond structure (i.e. avoiding new issues with very low reset spreads that will be more vulnerable to volatility) and issuer – where we think best value remains in the very high-quality national champions. As the market has been very strong this has paved the way for weaker issuers to come to the market at favorable conditions. Despite the relatively high yields, the downside risk of investing into lower quality issuers can be significant – especially those with asset quality issues, as we have seen in the past with Banco Popular, where AT1 CoCos and Tier 2s were written down to 0.

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