Dynamic Bond Trust - February 2012 update

Markets

The ECB is offering European banks unlimited loans out to three years called three year Long-Term Refinancing Operation (LTROs) which has been viewed as a game-changer for banks, not least because the jump-to-default risk for banks is much reduced – at least temporarily. This has meant that interbank borrowing rates (Libor/Euribor) have come down as banks are more willing to lend to each other and credit spreads have narrowed, led by financials.

The US Federal Reserve has also effectively eased monetary policy, announcing its intention to keep rates on hold until at least the end of 2014 (an 18 month extension to its previous guidance). They remain ready with additional quantitative easing (QE) should it be needed.

This easing of monetary policy increases demand for assets which offer a yield above cash while the LTROs, if not the ‘big bazooka’, appear to have been interpreted as offering some hope that the worst of the European debt crisis is behind us. Both these are likely to be behind January’s rally in riskier assets.

So is the rally sustainable? In Dickie’s view, the reason that central banks are easing policy is because there is no growth. Banks and governments need to keep deleveraging which remains a headwind to economic growth. LGIM expects subdued global growth this year with mild recessions in the UK and Europe and the risk of another soft patch in the US.

Fund positioning

• Dickie has therefore been using the stronger market and demand for riskier assets to reduce the fund’s beta (credit risk), in particular selling financials opportunistically, eg, when he gets a bid at a price greater than August lows, and moving up in credit quality.
• We continue to participate fully in tenders/exchanges for subordinated bank debt (including Bank of America, Unicredit, Credit Agricole and Citi) which also helps reduce exposure to this sector of the market.
• We continue to move up in quality (a theme over the last six to seven months), Dickie has been buying senior secured bonds issued by stronger, well-capitalised banks (eg, HSBC senior and lower tier 2 bonds) as well as covered bonds (Barclays, RBS). Covered bonds haven’t rallied as much as senior bonds in recent weeks so these look more attractive on valuation grounds.
• Dickie is adding subordinated financials that are callable in 2012-14, while selling those with first call dates further out, when he receives a strong bid.
• Added to holding in Legal & General High Income Trust and participated in new issues coming cheap to secondary market, including Danish energy company, Dong, and Brazilian energy company Petrobras. Corporate non-financials have generally lagged financials in this rally, presenting good opportunities.
• In some cases, new issues are rallying so strongly in the secondary market that we’re reaching profit targets quicker than expected. In such instances, Dickie is taking profits and reinvesting in bonds with more potential upside.

Legal & General Investment Management - February 2012