Context: What to expect in 2020 (analysis conducted for USD fund, but same rational to apply to GBP and EUR fund)
Impact for the fund:Positive for the year with a base case for the USD fund of +9%, EUR fund of +8% and GBP fund of +9%
What to expect in 2020:
To understand what might happen in 2020, one has to look back at 2018-2019. Due to external shocks and starting from 1Q18 onwards, price of bonds held in the portfolio started to drop and ended in 2018 on average 14% lower (fund was down 8% during the year, having captured close to 6% income). Since that the price drop had not been driven by idiosyncratic events or credit deterioration from issuers held in the portfolio (by contrary, average rating year-on-year went up on notch higher to BBB+), we knew that 2019 would be a year of price recovery + income. We also mentioned that in theory, performance for the year could be +22% (price of the bonds had dropped 14% and due to the so-called pull-to-par, they would need to recover +16% to be break-even, then adding the 6% income = 22%) but that given political uncertainties related to Brexit and especially trade-war, our base case for the year would instead be “only” +12%. The fund outperformed this base case by 4% as we didn’t anticipate central banks to turn as dovish as they did during 2019.
It also means that despite the strong performance in 2019, price of the bonds that we own still trade at ca. 6% discount to where they should be trading at….
As we enter 2020, macro backdrop is very supportive. Central banks are highly accommodative/with a dovish bias, global growth has scope to start to surprise again to the upside/led by a cyclical recovery and interest rates have scope to remain low for longer. What it means for fixed income investors: a very supportive backdrop and 2020 has scope to look like 2017, or a vintage year for bond investors (fund was up 12.6%).
2020 Performance outlook
Base case for the USD fund of +9%
Base case for the EUR fund of +8%
Base case for the GBP fund of +9%
We feel that this is once again a conservative base case, as assuming ca. 2/3 of the performance stemming from income (5.5% gross contribution for USD fund & 4.5% for EUR fund) and only 1/3 stemming from capital gains (3.5% gross contribution). Given the supportive backdrop – contribution from capital gains could easily be 6% instead of 3.5%.
Furthermore, the USD fund has 35% exposure to grandfathered bonds i.e. bonds that have been issued for regulatory purposes under Solvency 1/Basel II and that don’t fully comply with new capital requirements set by Solvency 2/Basel III. In a nutshell, very expensive/inefficient bonds for issuers, but extraordinary investment opportunities for investors. For example, almost half of the grandfathered bonds that we own in the fund trade at an average price of 77%. As these will be tendered at a higher price or called at par, these should over the coming quarters generate close to 4% additional capital gains for the fund.