Annual report: Period Ended 31 December 2012 - Invesco Perpetual

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6 City Merchants High Yield Trust Limited Manager’s Investment Report Market Background High yield bonds achieved very strong total returns in 2012, benefitting from capital appreciation as well as the high levels of yield they carried into the period. Throughout the year, investor risk appetite was boosted by actions and announcements of policymakers that were designed to address the debt problems in the Eurozone, support the banking system and stimulate economic growth. Under its new president, Mario Draghi, the European Central Bank (ECB) has offered much greater support for Eurozone member states’ sovereign bond markets and has also addressed funding concerns in the banking system, moving the bank closer to providing the single currency area with a lender of last resort. European political leaders have agreed plans for a single banking authority for the currency area. All of the major central banks have maintained very low interest rates, by historical comparison, and extended their various programmes of quantitative easing. In the corporate sector, fundamentals have remained solid and many companies have been able to take advantage of the strong conditions in the credit markets and the easy monetary conditions to reduce their cost of capital. Meanwhile, economic growth has been subdued. The US economy has continued to grow at a modest level and there are signs from the housing market and from consumer lending statistics to encourage belief in a sustained recovery. But in Europe the outlook has remained poor. Levels of business activity and sentiment are consistent with very low or negative growth while high unemployment and low earnings growth hold out little hope of a rapid expansion in consumption. According to data from Merrill Lynch, European non-financial high yield (non-investment grade) bonds had a total return for the year of 19.4% (all returns in sterling terms). The aggregate yield for the asset class fell 441 basis points, from 9.57% to 5.16%. This return compares to 15.8% for sterling investment grade corporate bonds, 2.8% for gilts and 1.5% for bunds. Within investment grade, financials strongly outperformed, reflecting the improved sentiment on the banking system. Sterling financials returned 23.4% compared to 10.2% for non-financials. Subordinated bank capital was the strongest part of the sterling financial sector, with Tier 1 debt returning 30.7% and Lower Tier 2 31.3%. The default rate in European high yield bonds remains low. According to Moody’s, the European trailing 12-month high yield default rate was 1.8% in December 2012, down from 3.3% a year before. The rate of corporate debt issuance was high. Barclays estimate there was a total of £46 billion in new high yield supply across European currencies, the highest annual total they have recorded. The contrast with 2011 is quite stark, with even peripheral Eurozone high yield issuers successfully tapping the market in 2012. For example, in recent months Portugal Telecom (BB+) issued a 2018 bond with a coupon of 5.875% and Rottapharm (BB–) issued a 2019 bond with a coupon of 6.125%. Both bonds closed the year priced above par. Investment grade issuance reached its highest level since 2009 at over £400 billion. Portfolio Strategy As mentioned in the Chairman’s Statement, the Company is the successor vehicle to City Merchants High Yield Trust plc (CMHYT plc) following its re-domicile to Jersey. It retains the same investment objectives, portfolio managers and investment portfolio. Consequently this report covers the 12 months to 31 December 2012, even though the re-domicile was enacted on 30 March 2012. Over the 12 months to 31 December 2012, and using the NAV of CMHYT plc at 31 December 2011, the NAV total return for the ordinary shares of the Company was 24.5% and the NAV rose by 25.73 pence to 171.29 pence. For the trading period 2 April to 31 December 2012, the NAV total return was 13.2%. A total dividend of 10 pence has been paid for the year to 31 December 2012, including the special dividend of 2.4 pence paid by CMHYT plc. After the poor market conditions of the latter months of 2011, the portfolio managers believed that there were very attractive opportunities across the high yield bond market as well as in areas of investment grade, especially financials. They were comfortable with increasing credit risk in the portfolio in order to lock in the value they saw. This strategy allowed the Company to benefit from the strong market rally seen over the course of the year.
City Merchants High Yield Trust Limited 7 Gearing was not employed during the period. The portfolio managers are not currently anxious to draw down on the Company’s loan facility but in a market correction they may get the opportunity to add value and help to build reserves by doing so. During the year, the portfolio managers trimmed positions into strength, selling bonds that had achieved strong capital returns, and bought in periods of relative weakness to capture yields they thought would be attractive additions to the portfolio. They added to holdings in convertible bonds as they were attracted to income opportunities available in this market. More investment in convertibles might be considered, and possibly some direct equity investment, over the course of 2013. The portfolio managers have continued to favour financials, subordinated capital in particular, despite the considerable falls in yield seen, and increased the portfolio’s exposure to banks over the period. While systemic concerns have been addressed by central bank action, the banks have also made more progress in strengthening their balance sheets, raising capital and increasing liquidity. Many banks have taken advantage of their stronger funding to restructure their liabilities, tendering to buy back uneconomic outstanding debt. This will help them satisfy changing regulatory requirements. These exercises have provided an extra support to the market in bank debt. Outlook Credit markets have been very strong over the last year and yields have fallen a long way from the levels they reached in 2011. The portfolio managers think that a lot of the market is quite fully valued at current yields, that large areas of the non-financial investment grade market are looking expensive and that a lot of the capital gain in high yield bonds is already priced-in. Default rates are predicted to remain low and there has been strong demand for the income high yield offers, with a lot of money entering the asset class in 2012. However, there are some signs of poorer quality issuance in the recent strong market conditions and the market could be susceptible to any macroeconomic deterioration. The portfolio managers expect financials to outperform the wider bond market again in 2013. They have believed for a long time that the process of capital structure and balance sheet repair by banks and other financials will be good for creditors. However, banks still face challenges. November’s Financial Stability Report, issued by the Bank of England, highlights the prospect that UK banks will have to raise additional capital and some are seeking to wind down or exit investment banking operations. While generally not good news for equity investors, these are positives for bondholders. Progress continues to be made on bank balance sheet repair. Tier 1 capital levels have risen across the European banking sector in 2012 and loan to deposit ratios have declined. The strong performance of this sector over the last year means that yields have fallen and credit spreads have tightened considerably. However, yields remain attractive, in the portfolio managers’ view, especially compared to the low yields available in high quality non-financial corporate bonds and in gilts. The portfolio managers do not expect core government bond yields to rise rapidly in coming quarters. They do expect that at some point in the next few years interest rates will normalise, but core government yields could rise 200 basis points and still be unattractive. It is likely that the portfolio managers will need to consider some strategies to hedge the risk such a move would pose to the capital value of the portfolio. Overall, the portfolio managers think that fixed interest returns in 2013 will probably be positive but unspectacular. They expect some parts of the corporate bond market to see even lower yield levels. While they can still see some opportunities for capital return, a lot of the market is not particularly attractive, in their opinion, and income is likely to be the dominant factor in total return. Invesco Asset Management Limited Manager Paul Read Paul Causer Portfolio Managers 28 March 2013
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Annual report: Period Ended 31 December 2012 - Invesco Perpetual

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