The fund Berenberg Euro Financial Bond Selection focuses exclusively on financial sector bonds Photo: portishead1 Source: iStock

Pure play bank bonds

Author: Julian Krause and Timo Lüllau

There is nothing to suggest a meaningful trend reversal in the fixed income market over the next months. However the bond market does offer alternatives to government bonds. Julian Kruse, manager of the fund Berenberg Euro Financial Bond Selection (ISIN DE000A1C0UA9/DE000A1CZUK6), relies on euro denominated bank bonds because they make it easier to target specific risks within a company’s capital structure. He explains his approach in the interview with ChampionsNews.

Julian Kruse, portfolio manager Berenberg Source: Berenberg

ChampionsNews: Mr Kruse, one would think that generating reasonable fixed income returns is a significant challenge in the continuing low interest rate environment. What is your outlook on the euro zone’s fixed income market over the next six months? Is there a chance for a more significant interest rate reversal?

Kruse: Any sizeable interest rate trend reversal in the European fixed income market seems highly unlikely from a macro perspective in the next six months. The European Central Bank (ECB) indicated that it will not hike before December 2019. The economy and inflation across the euro zone appear robust and enable the ECB to reduce its bond purchases in the context of its purchasing program to zero. Development across the euro zone is not uniform, however. And external factors such as restrictions on free trade or unexpected shocks could affect the European economy. Overall, we expect interest rates to trend sideways in most European countries. Some countries, which warrant closer inspection, could experience higher interest rate fluctuations, though.

ChampionsNews: Your fund Berenberg Euro Financial Bond Selection relies on global corporate bonds. And you clearly overweight international financial sector bonds in your top holdings. What makes them such particularly attractive investments? Which criteria apply when you select bonds for the portfolio? Do you have other favourite sectors?

Kruse: The Berenberg Euro Financial Bond Selection focuses exclusively on financial sector bonds. Contrary to pure-play corporate bonds, financial sector bonds give us the opportunity to more selectively target certain risk buckets within a company’s capital structure. Different bonds of a bank have different risk/return profiles depending on their seniority. This characteristic is particularly useful for portfolio diversification. Our purely quantitative investment process does not stop at the fundamental analysis of each individual issuer’s general market environment but also considers the technical development of the risk premiums. And we also conduct legal and governance due diligence for equity-type bonds with a particularly high risk/return profile. Banks have significantly increased their equity buffers in recent years and are now generally more crisis-resilient. At the same time, they offer the opportunity to collect attractive coupon payments at relatively low durations in spite of the low interest rate environment - a clear advantage in what we expect to be a prolonged sideways rate market.

ChampionsNews: You exclusively select euro denominated bonds for the portfolio. Is this to protect the portfolio against currency risk? Are there currently are no alternatives to the euro?

There is never any foreign currency risk in the fund

Julian Kruse

Kruse: The Berenberg Euro Financial Bond Selection clearly focuses on euro-denominated bonds. However the fund may also invest in other currencies such as USD-denominated bonds and has also done so in the past. Any such exposures are immediately hedged via derivatives, though, which means that there is never any foreign currency risk in the fund. At the moment, however, the rise in US interest rates makes hedging so costly that USD-denominated bonds have lost their attraction for us.

ChampionsNews: Looking at your term structure, you favour bonds in the medium-term maturity range. Are there reasons for this?

Kruse: On average, financial sector bonds have shorter term structures than pure play corporate bonds. The majority of the available financial sector bonds in the euro market are in the three to five and the five to seven year buckets. The overall portfolio duration follows the duration of the underlying benchmark, which ranges between 3.5 and 4.5 years. For this reason, the rule-based investment process also favours these maturity buckets.

 

Author: Julian Krause and Timo Lüllau
Date of issue: 9/25/2018