March 2021

How we did in March: The fund returned between 0.1% and 0.4% across the different share classes, compared to SPX 4.4%, SX5E 7.9%, EUR BAML HY (HE00 Index) 0.6% US BAML HY (H0A0 Index) 0.2% and EM bonds (EMGB Index) -1.7%. Performance in March, gross of fees in EUR, was from: (i) Credit: 4bp, with 7bp from cash and -3bp from CDS; (ii) Rates: 33bp; (iii) FX: -4bp; (iv) Equity: 8bp, and (v) Other: -7bp.

In March, risk-asset prices were slightly higher despite higher treasury yields, as the US released fresh fiscal stimulus and an infrastructure-spending plan. The fund gained from this rise in treasury yields and maintained its low exposure to market beta, having entered the month 50% invested in credit bonds and with credit protection via CDS.

What we are doing now: The portfolio remains cautiously invested in credit and we have been adding credit protection, as spreads have gradually tightened despite a continued widening in rates and an uneven global reopening / recovery. Over the course of the year, we expect US treasury yields to move higher still given the risk of overshooting inflation in the coming months, an infrastructure bill passed in H2 and a gradually less dovish Fed. We also expect a gradual re-opening of domestic economies, but vaccination-rates have been slower than we anticipated outside the US and UK. Therefore, we expect hospitality and travel related companies focused in the US and UK could have a better summer than in 2020 vs those in Europe, even after assuming for a pick-up in European vaccination rates in Q2.

While this environment presents limited opportunity to add beta risk, it does present alpha opportunities through positioning for: a repricing in cyclical value sectors like energy and financials, higher global yields where inflation could rise further (US, Australia) and companies that benefit from domestic-reopening. We maintain a high allocation to convertible debt, especially in bonds with low delta and low credit risk, focusing on the alpha-sectors of cyclicals and re-opening. In the vanilla credit bonds, we focus on companies which offer a high coupon relative to their risks, in the cyclical (financial, energy e.g. like Pemex), re-opening (cruises, airlines e.g. CCL, FinnAir) and consumer (autos e.g. Aston Martin) sectors.

We expect volatility to rise in H2, potentially triggered by near-peak economic momentum, already-long positioning in credit and gradually less dovish central banks. We would use this opportunity to redeploy capital in beta-markets, including high yield debt and emerging market hard currency.

March rounded off one of the strongest quarters on record for financial markets across the globe. A vast majority of asset classes built on earlier year-to-date (YTD) gains, as governments and Central Banks (CBs) in main developed countries remain committed to do “whatever it takes” such that the economic malaise from the pandemic is rolled back as soon as feasibly possible. Meanwhile, sovereign rates continued to widen as reflation concerns gathered further momentum and the central banks’ narrative around inflation remained unflustered with all viewing higher prices as transitory.

Across the regions we are predominantly invested in, US and European bank equities rallied 6% in March, taking YTD performance to +24% and +19% respectively. This helped underpin credit spreads of European banks in March, with AT1 bonds on average +50c / 10bps tighter which was broadly in line with dated subordinated securities. In addition, it is worthwhile to note that capital securities of second tier institutions outperformed during 1Q21 as they had largely lagged over the past quarters.

One financial entity that underperformed significantly in March was Credit Suisse, after disclosing its association with a supply chain financing entity and a subsequent unrelated loss linked to a margin call in prime brokerage equity financing. Across its capital structure, AT1s retraced 3-5pts and equity fell 25%. We currently do not believe that there will be significant materiality from both events such that AT1 coupons could be jeopardised; there exist sufficient buffers in place to mitigate any reasonable losses that could be incurred and an additional line of defence from organic profit generation. However, the ramifications of these events in quick succession could lead to stricter regulatory oversight. This should in principle favour creditors given there is likely to be retention of earnings for capital buffer rebuild in the foreseeable future.

Away from Credit Suisse, it is perhaps noteworthy to flag a few “merger” developments in March: CaixaBank’s acquisition with Bankia has been completed; Credit Agricole has officially launched its takeover of Credito Valtellinese; and Santander is seeking to buyout the listed minorities of its Mexican subsidiary, in a deal that is value accretive for the Spanish banking group.

Issuance dynamics in March kept pace and trend with the other months so far this year. The bulk of new deals in March were concentrated in Senior – c85% of total EUR40bn issued amount, bringing the Senior total YTD to cEUR90bn out of EUR105bn – with again just a handful of dated and junior subordinated transactions from leading national champions. In AT1 space, March saw a double tranche from HSBC refinancing bonds up for call over the coming quarters, and both NWG and Sabadell filling out their regulatory buckets.

Despite the widening path in sovereign rates globally which has yet to show any signs of topping out, investors’ appetite for financial credit remains undiminished given the attractive relative value pick-up vis-à-vis other sectors. That said, a differentiating pattern is starting to emerge between primary and secondary markets for financial transactions where the former struggle to outperform despite books being several times covered. Accordingly, we continue to adopt a prudent stance for the time being with respect to issuer selection, duration, and cash balances.

Global financials moved higher again in March, with the MSCI ACWI Financials index up nearly 4% in the month and 11.6% for the quarter. The rally has been driven by a continued rise in yields (US 10 yr up 34 bps and 82 bps on the month and YTD, respectively) as the reflation and reopening themes take hold. Banks stole the headlines this quarter with Japanese banks up almost 27% as a group, US banks up 23%, and European banks just over 20%. As the dust settles from the post-vaccine/blue wave rally, we continue to see strong risk-reward across the sector, and European banks and US life insurers in particular.

With rates being the key driver of the sector in recent months, we thought it would be useful to assess where we are in respect to global yields. The size and depth of the US Treasury market makes it the key benchmark for global interest rates, and the recent rise in US Treasury yields has made them particularly attractive for foreign investors for the first time in years. For example, today 10y US Treasuries provide a spread of 125bps over 10y German Bunds on an FX-hedged basis. Since the formation of the Euro, this spread has averaged 16bps and has rarely been higher than today. This suggests that a further rise in US Treasury yields is likely to pull rates higher in Europe, even if the European recovery does not take place at the same velocity as in the US. We see the same phenomenon in the UK, with the FX-hedged spread over 10y Gilts at 129bps, vs an average of 33bps over the same period. In Japan as well the FX-hedged spread over 10y JGBs has ticked up to 78bps – the highest level in the post-GFC period.

Real rates are still exceptionally low (negative) across the globe and inflation expectations are breaking higher, and with US fiscal stimulus enhancing growth rates across the world, we see the US Treasury as the leading indicator for global yields. A steepening of non-US curves over the next 12 months would be a key positive tailwind for banks from both a multiple and earnings perspective. Some of our more rate sensitive holdings in Europe have 40% (HSBC) to 100% (Commerzbank) upside to earnings from a lift in rates – and not simply dependent on ECB hikes, either. But even without help from rates, we find significant value across our European bank holdings, which continue to trade near multi-decade lows on an absolute and relative basis with earnings momentum accelerating and with forward yields in the 8-9% range for even high quality banks.

The vaccine rollout in Europe has been disappointingly slow, as has been well documented. However we see some light at the end of the tunnel as the distribution of doses is set to increase by over 4x in the second quarter to 360 million. This means the daily vaccination rate should jump from ~0.3% currently to ~0.8%, which will be sufficient to have >70% of the population vaccinated by the end of August. While slow relative to the UK and US, and perhaps too slow for some businesses in tourism-dependent countries, growth projections should not be meaningfully changed and the ECB, in our view, is still very much on track to allow for European banks to go back to business as usual with their capital return plans in the fourth quarter.

In the US insurance space, we saw two large takeover bids announced in March, with Chubb looking to buy Hartford (HIG) and Apollo buying Athene. HIG rejected Chubb’s initial $65 bid, which was clearly too low and we believe Hartford is unlikely to entertain any offer sub $80. The company has several valuable ancillary businesses, each of which could be sold off to the highest bidder; between its group benefits, asset management, and personal lines units, any buyer of HIG could likely recoup at least ~$12 bn of the initial purchase price. Assuming a $80 bid, that would suggest the buyer would be paying just ~10x for HIG’s crown jewel, their small commercial insurance business. This seems altogether too low. With potential other interested bidders (possibly Berkshire, Travelers or Allianz), there could be an auction here and if HIG refuses to negotiate their management will be under heavy pressure from activists to create value on a standalone basis, such as by selling off its high-multiple benefits arm. All in, the risk reward for HIG looks good with the stock in the $60s, and we suspect there could ultimately be secondary impacts too as other insurers are forced to chase scale – a new wave of M&A could beckon.

Also in March, long-term core holding Athene was taken out by Apollo, which already owned ~30% of Athene and which manages 100% of Athene’s investment portfolio. While we long thought this was the likely end-game for Athene, we were somewhat surprised by the premium paid (~15%, paying just 1x BV despite a mid-teens ROE) and the timing, given the steepening yield curve was a clear tailwind developing for Athene. As they are paying in shares for Athene, our ownership in ATH will be swapped into Apollo, which we owned for several years in the past and believe strongly in their business model. The deal is highly accretive for APO, leaving the stock on ~9x next year’s distributable earnings (versus 17x for KKR and 20x for Blackstone). This looks very attractive to us and while we locked in some of our substantial gains in Athene on the day of the announcement, we expect to continue to hold a position as long as the see-through valuation remains compelling.