Report - Nikko AM Asia Limited

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Subsequently, the Fund modestly underperformed the benchmark during 2Q 2013, which was a very difficult period for active fixed income investing. The primary detractor was an overweight to the emerging market debt (EMD) sector and an overweight to Mexican rates and currency. Other detractors included an overweight to German and UK rates and an underweight to EUR. These negatives were largely offset by exposure to non-agency mortgages; underweights to the US, French and Japanese sovereign rates; and underweights to the Australian Dollar as well as the New Zealand Dollar. On 9 April 2013, the Fund’s capabilities were enhanced by introducing an absolute return strategy (i.e. The Russell Absolute Return Bond Fund) that reduces interest rate risk but does not sacrifice yield. Our allocation was additive over the quarter as it reduced overall duration prior to the surge in interest rates. During the third quarter, the Fund posted positive absolute returns but underperformed its benchmark. Performance was held back primarily by currency positioning, notably underweights to the Australian Dollar, the New Zealand Dollar and the Euro. Mitigating this to certain degree were currency positives in the form of overweights to the Polish Zloty and Sterling and an underweight to the Indonesian Rupiah. Rates positioning was mixed, with negatives from overweights in Germany and New Zealand offset by positives from overweights in Australia and Ireland. Sector positioning dragged primarily due to an overweight to local currency emerging markets (overweight to Mexico and Brazil and an underweight to Czech Republic). An underweight to investment grade credit was secondary detractor. The Fund finished ahead of the benchmark over the fourth quarter, gaining from its duration underweight as yields inched higher over the period as well as its country, sector and currency positioning. An overweight to Irish rates, while being underweight to the UK and the US had a positive impact. In terms of sector selection, an overweight to high-yield and non-agency mortgages contributed, but exposure to local EMD detracted. Currency underweights to the Japanese Yen and the Australian Dollar and an overweight to the Polish Zloty further enhanced gains. Market Review Global fixed income markets remained dominated by policy and politics during the first quarter of 2013, impacted by speculation and outcomes in notable events as the US sequester and debt ceiling, the inconclusive Italian election, the botched Cypriot bank resolution as well as the European Central Bank (ECB) and the US Federal Reserve’s (Fed) comments/minutes. The Bank of Japan’s (BoJ) loose monetary policy (whose actual size surprised the market in early 2Q 2013) evolved along with other central banks, who took efforts to ‘jaw bone’ their currencies down (ECB, Norway and New Zealand). Most economic and market trends broadly continued, including positive US growth (despite the 2% payroll tax increase) and housing market, declining European economy and moderating global inflation. In USD unhedged terms, the Barclays Global Aggregate Index returned -2.1% over the quarter, with the negative total return driven by the sell-offs in EUR (on Draghi statements, Cyprus), GBP (on Bank of England indicating it might tolerate higher inflation) and JPY (on the US asset purchases expectations). 10-year US treasury (UST) yields increased modestly over the period, rising 10 basis points (bps). Investment grade corporate credit outperformed governments on a duration-adjusted basis. This was led by financials, whose yields are now back down to their traditional position below that of industrials. The US financial spreads have tightened due to the improving asset quality of their loan books and increasing capitalization. High-yield corporates did very well and outperformed most other sectors, given their attractive yield levels, strong credit fundamentals and continuing low default rates. Agency mortgage and commercial mortgage-backed securities spreads widened a bit and underperformed governments due to investor preference for riskier sectors. Non-agency mortgages continued to stand out with exceptionally strong performance, given the sector’s supply constraints and the positive fundamental backdrop of the US housing market. Though it struggled over the period, emerging markets hard currency outperformed the unhedged Global Aggregate index. Falling commodity prices, continued high issuance and devaluing emerging market currencies against the USD contributed to the pressure on EMD. Global fixed income markets performed poorly in 2Q 2013, closing out their worst first-half since 1994. The Barclays Global Aggregate Bond Index posted negative returns of - 2.79% for the quarter and -4.83% during 2H 2013. The key driver was a surge in the US interest rates, fuelled by the US Fed Chairman Ben Bernanke’s Congressional testimony on 22 May 2013 (and reiterated at the Federal Open Meeting Committee (FOMC) meeting on 19 June 2013) that the Fed could “taper” its stimulative bond-buying program before year-end if the economy continued to improve. For the quarter, the 10-year USTs rose 63bps to 2.48%, nearly a two-year high. While rising US rates caused German and the UK governments to post negative total returns, peripheral European treasuries bucked the trend with declining rates and positive returns. These bonds saw firm demand due to comments from ECB President Mario Draghi that the central bank “stands ready to act when needed”. Japanese government rates were also pulled up by rising US rates, despite the BoJ embarking on a large quantitative easing (QE) effort of its own. Over the quarter, virtually all spread 9
sectors (including investment grade and high-yield corporate credit) posted negative total returns and underperformed equivalent-duration treasuries as concern over the Fed ending its accommodative money policy induced technical selling. EMD was especially hard hit, with pressure exacerbated by news of slowing growth in China. Non-agency mortgages also declined despite the continued support of an improving US housing market and declining delinquency and foreclosure rates. In the currency space, the USD outperformed most currencies on the prospects of rising US rates and an improving US economy. Harder hit currencies included the BRL and ZAR, given Brazil and South Africa’s slowing growth and renewed inflation concerns. Australia and New Zealand also sold off materially versus the USD as the Royal Bank of Australia cut interest rates and the Bank of New Zealand made comments that it would intervene to manage down the overvalued kiwi. The EUR appreciated modestly against the USD on the back of expected ECB support. The JPY continued selling off due to the BoJ’s effort to weaken the currency. During the third quarter, the Barclays Global Aggregate Bond Index advanced 2.8% USD unhedged and 0.8% USD hedged. The period’s volatility, which was a continuation of that seen in 2Q 2013, was driven by mixed central bank messaging, the crisis in Syria, speculation over the next FOMC governor, German and Italian politics, and confounded expectations of a September Fed taper. After rising 50bps and peaking near 3% in early September, 10-year UST yields rallied 10bps on the news that Larry Summers withdrew from consideration for the Fed’s governorship, and then rallied another 15bps following the Fed’s surprise decision in September to maintain its monthly USD 85bn QE program. Although, the 10-year note ended the quarter higher at 2.61%, a potential government shutdown in Washington and the looming debt ceiling added to the post Fed-decision momentum as investors turned more cautious. The UK also saw a rise in rates, as 10-years gilts yields increased 28bps to 2.72%. The rise was fuelled by speculation the Bank of England may raise interest rate earlier than it has forecast, following positive macroeconomic updates. Elsewhere, peripheral European bonds continued to outperform for a second consecutive quarter, as Spanish and Italian yields fell 30bps and 11bps respectively on the back of stronger Purchasing Managers Index. On the other hand, gains on Italian debts were eroded by the rising political tension. In Japan, the 10-year government yields declined 17bps. A rebound in Chinese economic data along with an incrementally improving outlook for global growth contributed to a modest rebound in hard currency EMD. However, local EMD continued to underperform, delivering a negative total return for the sector. Local EMD was dragged down by currencies such as the Indonesian Rupiah, Turkish Lira, Indian Rupee and Mexican Peso. EM currencies that performed well were those less reliant on external financing, such as Korean Won, or benefited from EUR strength, including Polish Zloty and Czech Koruna. In developed market (DM) currencies, the British Pound and New Zealand Dollar rallied on better economic news, while the Euro defined gravity due to the implied support of the ECB. The Japanese Yen appreciated modestly against the USD during the period. The Barclays Global Aggregate Bond Index returned a modest 0.22% (USD hedged) over the fourth quarter, bringing the full year return to -0.14%. DM safe haven government yields declined in October, led by USTs which rallied on congress kicking the government shutdown and debt ceiling ‘cans’ down the road into the first quarter of 2014. However, DM rates rose during the remainder of the quarter on stronger US and UK economic data. This included German rates, which increased despite a surprise November ECB rate cut. Key 10-year rates that increased over the quarter included the US (+42bps to 3.03%), the UK (+30bps to 3.02%), Germany (+15bps to 1.93%) and Japan (+5bps to 0.74%). Notable DM rates defying this trend were those in the European periphery (Italy -30bps and Spain -15bps), which performed strongly on the back of improving growth and sentiment, and the continuing expectation of an ECB backstop. Italy also benefited from improved government stability and reduced risk of snap elections. The quarter ended with the Fed somewhat surprising the markets by announcing the start of its QE program tapering, reducing its monthly purchases of treasuries and mortgages from USD 85bn to USD 75bn. This had very little impact on the market, given the material increase in rates earlier in the year and the Fed’s accompanying statement that it would maintain short term interest rates “well past the time that the unemployment rate declines below 6.5%”. In the wake of rising DM yields, hard currency and corporate EMD showed their resilience, while local EMD was dragged down by pressure on EM currencies of countries with current account deficits such as Brazil, Indonesia, South Africa and Turkey. Currencies of EM countries in better fiscal position fared well, including the Polish Zloty, the Hungarian Forint and the South Korean Won. Among DM currencies, EUR continued to confound investors and strengthened against the USD. On the other hand, the Japanese Yen, sold off against the greenback. This was due in part to signs that Abe’s policies were working and BoJ comments that inflation would have to be maintained at 2%, signalling the central bank’s commitment to QE. 10
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