Fund Overview
This Fund seeks total return through current income and capital appreciation. The Fund invests in securities across a variety of fixed income sectors including international investment grade corporate and government debt, international high yield debt, emerging market debt, US government and corporate debt. The Fund may also invest in dividend-paying international equities. The Fund is managed by John Pattullo and Jenna Barnard.
Quarterly Commentary
The failure of Lehman Brothers in September led to a reassessment of market risk while the publicity surrounding the event has had a marked impact on the real economy. The realization that large banks could be allowed to fail brought a policy response, effectively admitting that the decision processes around the Lehman failure caused a policy mistake. The Federal Reserve and the Treasury believed they had averted a broad recession by cutting rates to 2.0% and embarking on a fiscal expansion. However, the raft of press headlines and the loss of confidence in the financial system has caused a business and consumer reaction. Consumers will curtail spending and struggle to raise finance while business will cut capital expenditure and jobs. The US has limited room to cut interest rates because the starting point of 2.0% is low compared to Europe or the UK.
Fund performance
Over the period, the Fund underperformed the benchmark, Lehman Brothers Global Aggregate Bond (ex-US MBS) Index. Disappointing performance was led by holdings in bank preferred and ordinary equity shares. Top performers over the period were high-yield holdings: Colt Telecom and paper company, M-real. Both holdings are very short-term bonds with maturities in 2009 and 2010.
The Fund held two defaulted* securities, Belvedere and Lehman Brothers. Lehman Brothers ended the period valued at zero, while Belvedere has been restructuring its debt and has issued plans to sell some businesses under court supervision and intends to pay the deferred coupon.
Investment activity
The Fund maintained a moderate cash reserve, after having trimmed the Fund's exposure to high-dividend stocks. We continue to believe the yield available from depressed bond markets offers equity-like return prospects but with a potential for reduced vulnerability to lower earnings.
As of the end of the period, the high yield sector weighting rose to 55.2% following selective purchases and remained one of our preferred sources of high income, bank andinsurance company holdings fell to 24.5% due to the difficult market conditions in the Financial sector and emerging market government bond exposure was reduced to 9.4% following the sales of Turkey, El Salvador and Uruguay. We have reduced our previously favoredemerging market exposure because the financing crisis may impact more heavily on some of the countries in the sector.
Outlook
The UK and Europe have strong exchange rates that, we believe, are likely to weaken (due to a higher dollar). The authorities have provided large amounts of liquidity to the banks that remain critical to the economy and provide most of the finance for households and businesses.
The cumulative default rate is extremely low, although it is from one of the organizations once regarded the least likely to fail. Credit defaults are concentrated in the Financial sector and include banks (Lehman, WAMU, Northern Rock), insurance (AIG) and mortgage guarantors (Fannie and Freddie). While some high yield bond sectors are at high risk of default, namely auto companies, auto parts and airlines, most companies have few debt maturities and are likely to defer amortization* of loan services where possible. We believe, the depth and persistence of the recession will determine the default rate but the market discount has heavily anticipated this outcome.
*A defaulted security is the failure to pay interest or principal when due. A default occurs when the debtor is unable to meet the legal obligation of debt repayment. Amortization: paying off regular debt over a series of time.