In October, the spread of the ICE BofA High Yield Composite Index (Q964) tightened by 54 basis points to a level of 350 basis points over the swap curve. This is equivalent to approximately 411 basis points over the government bond curve. The index earned a total return of +2.44%. German 10-year government bond yields closed October at +2.14%, representing an increase of 3.5 bps basis points compared to the end of September 2022.

Contrary to the investment grade credit market, high yield credits performed strongly in October. This is a bit perplexing as non-investment grade companies will be more affected by the economic downturn that is developing. There were several possible explanations for the market strength. First of all, Q3 earnings published were in general better than expected which helped sentiment. Secondly, Autostrade, the Italian toll road company that is a big index constituent was upgraded to investment grade status at the end of the month. Thirdly, there was again very little new issue activity in the high yield market. As the average duration of the index is approximately 1.2 years shorter than the IG index, a bigger share of the index gets repaid every quarter and the continued lack of issuance activity is slowly making bonds ‘scarce’. Lastly, again the hope increased for a FED ‘pivot’. Loosely defined, with the FED pivot market participants envision that the FED will slow or stop and even reverse its interest rate hiking campaign. The pivot proponents find that the FED has hiked enough or even too much and with that it is making a mistake that will hurt the economy. A lot of the investors in this corner belonged to the now ill-famous camp transitory that believed that the 2021 inflation spike would be temporary and disappear out of itself in 2022. We strongly disagreed with this in 2021 and we are also not a big fan of some of the claims of the pivot thinkers. Inflation is still too high and so far has not reacted to central bank tightening. Economic activity in the US remains supportive. Rates in Europe are still very accommodative vs the level of inflation. Several studies have shown the historic stickiness that inflation exhibits when it tops the 5% level. We do agree that the FED can slow its hiking campaign as its short term rate is now close to the inflation rate. However we find it highly unlikely that the FED will cut rates in the next two years. As said before, inflation that has topped the 5% level in general takes years to get back to former trends. The FED wants to be very sure that inflation will be on a sustained downward path. They want to avoid making the same mistake as the 1970s FED that lowered rates when inflation seemed to cool but had to reverse this when it picked up again. As a result we remain cautious on the market but try to capture the various opportunities that volatility and dispersion provide us.

On a positive note, the political situation in the UK quickly stabilised in October. Investors displayed trust in the new Prime Minister Rishi Sunak and the new Chancellor of the Exchequer Jeremy Hunt. Also, with hindsight, it is clear that the BoE played its cards well by first offering liquidity to pension funds that needed to sell gilts to increase their collateral positions but also by urging them expedite this in order to avoid creating moral hazard. Furthermore they are now in a better position to start quantitative tightening which they had to postpone at the height of the crisis. The economic situation in the UK remains dire however.

Most of the economic data published last month, such as the JPM Global Composite Purchasing Managers’ Index (PMI), which dropped to 49 in October, continued to illustrate the slowing of the global economy. In the US, higher rates are especially causing the housing market to slow down. This also affects certain related sectors. The economy overall remains relatively strong however with a very low unemployment rate and employers still struggling to find enough workers. This did not change in October.

In Europe the economic situation looks bleaker than in the US but the expected sharp downward contraction keeps being pushed out. The German GDP print came in much stronger than expected at +0.3% quarter-on-quarter, supported by private spending, despite cost of living pressures and economic uncertainty. The energy crisis remains the key risk for Europe with the unusually warm weather in October leading to lower gas prices. Winter gas prices are down by about 60% since the peak in August, they however remain higher than the 2021 average. Europe announced new plans to tackle the energy crisis that included a first version of a price cap and a common purchases system. These measures, together with several new fiscal stimulus support plans, should help both households and businesses. The eurozone PMI surveys reached levels that are consistent with a recession. October’s flash composite PMI declined to 47.1, with the manufacturing index at 44.2 and services at 48.2. Inflation in the single currency bloc rose to 10.7% y/y, and core inflation at 5% y/y.

We continue to maintain an underweight risk position from a beta perspective. During the month we kept our beta positioning largely unchanged. Wider spreads and increasing dispersion continue to present interesting relative value opportunities. On the flip side, earnings warnings are punished harder than in the past, especially in the lower quality spectrum of the market.

Primary activity in EUR high yield remained very light in October, with €1.6bn of issuance. The deals that came were covered well and performed decently.

Flows in EUR HY in October were negative at €429m, although ETFs saw slightly positive flows. Total cumulative outflows stands at €12.6bn, 15.3% of AUM. Interesting to mention is that US HY saw large inflows in the last weeks of the month. The inflow for October is $5.2bn compared to a $6.8bn outflow in September in US HY. While a large part of these inflows are from ETFs, also active HY funds saw inflows.

The portfolio delivered a return of +2.40% (gross). This was 4 basis points below the benchmark return of +2.44%. During the month, the portfolio’s sensitivity to market trends varied between 93% and 96% in beta terms. The portfolio’s conservative positioning in cash and govvies subtracted from relative performance due to the spread rally. Our positioning in travel & leisure, retail and technology had a positive contribution, while banks and industrial goods & services contributed negatively this month. On an individual issuer level the strategy saw a positive contribution from our overweights in IAG and Lufthansa and our underweights in Atos, MPW and Valeo. Our overweights in Kennedy Wilson, Tritax and Ericsson had a negative impact on performance.

In October, the Fund did not participate in primary activity.

Outlook
Although credit spreads have strengthened again, we remain on the cautious side. We see more risks on the horizon, including a prolonged Russian invasion, uncertainty regarding European energy supply and security, weaker global growth and stubbornly high inflation. We are still moderately bearish and think spreads could widen due to the weaker macro-economic environment, expectations for continued hiking by central banks and impact over time of Quantitative Tightening globally. Q3 2022 company results were solid but we fear that higher rates and a potential recession in both Europe and the US over the next 18 months are not adequately reflected in earnings and profit guidance at present. Spreads are too low to fully compensate for the risks that we have identified. The technical backdrop is not supportive with supply that needs to pay substantial NIPs to be able to print. For 2022, we expect spreads between rating categories to decompress. We are underweight the BB- segment as a result and have compensated this partly with an overweight position in IG rated subordinated paper. Lastly we are also underweight the longer end of the credit curve due to the expected impact of rising rates on longer dated maturities.