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Is there any point in investing in German sovereign bonds anymore?

It’s no secret what fans of equity investments think of bonds: they are “worthless”, and those who go and invest in sovereign bonds now are wasting their money and have nobody to blame but themselves.

It is true that yields on 10-year Bunds have risen around 25 basis points since the beginning of the year. Since the price of a bond falls as yield rises, investors in German sovereign bonds have effectively lost around 2% since the beginning of the year. That said, the amount of outstanding Bunds¹ in recent months has fallen even further and, according to Bloomberg, now stands at only 11%. So Bunds are still highly sought after. Thus, an increasingly small supply is being met with high demand, which in turn limits the upside potential of yields.

But who is buying German sovereign bonds anyway at their current yield level? It is mainly professional investors and public institutions who are still buying. For supervisory reasons, insurance companies and pension funds are obliged to hold a certain proportion of high-quality liquid assets in order to ensure the long-term serviceability of their pension and insurance payments. For that reason, they generally purchase long-dated bonds and then keep them until final maturity. Banks, on the other hand, hold Bunds for their liquidity reserve. If they need central bank money, they can deposit Bunds with the central bank as collateral in the form of repurchase agreements (repos). However, there are no longer sufficient Bunds to meet the high demand in the repo market.

This is because since the beginning of the coronavirus crisis, central banks are also increasingly buying them up in order to stimulate the eurozone economy. The Deutsche Bundesbank has bought almost a third of all outstanding German sovereign bonds on behalf of the ECB; the maximum that would be permitted under the ECB public sector purchase programme (PSPP) is 33%. This limit was first raised under the pandemic emergency purchase programme (PEPP). Then the German Finance Agency holds a further 11%. Thus the percentage of Bunds held by national institutions is well above 40%. To a certain extent, therefore, the strict regulatory requirements and the pandemic purchase programmes have created a distinct scarcity of supply and are now frustrating investors’ efforts to get their hands on some. At the same time, favourable financing conditions and rising public and corporate debt levels have led to a deterioration of credit profiles and a series of downgrades by rating agencies, meaning the universe of AAA securities available for investment has shrunk even further.

So, are Bunds only for professionals and central banks? No, a bond allocation still has a place in the average savings portfolio, at least so long as the investor sees sovereign bonds chiefly as an instrument for hedging against losses. Due to their low volatility and weak correlation with other asset classes, such as equities, sovereign bonds offer effective protection against market turbulence and, in extreme situations, their prices soar when all other assets are falling. This happened on Friday 26 November, for example, when concerns about the rapidly spreading Omicron variant caused prices in global equity markets to fall while Bunds made strong gains.

The ECB’s gradual exit from its ultra-accommodative monetary policy is expected to lead to a moderate rise in yields. Nevertheless, from a risk management perspective Bunds still have their raison d’être. The last few days of November, with the concerns about the Omicron variant, have borne this out once again to impressive effect.

¹ Defined as sovereign bonds held by price-sensitive private investors as a percentage of total outstanding bonds.

Portfolio Manager Update & Fund positioning

Ethna-DEFENSIV

Fresh concerns about Covid-19 left their mark on bond markets, too. Talk of lockdowns and the new Omicron variant caused uncertainty. As a result, in the euro investment grade segment in particular, spreads versus swaps widened significantly by 22 basis points to 1.09%. U.S. dollar spreads rose 12 basis points to 0.99%. In the high yield segment, credit spreads on bonds denominated in USD and EUR increased roughly to a similar extent, by almost 50 basis points.

Safe havens, on the other hand, were in strong demand; notably, the yields on U.S. Treasuries fell sharply by 15 basis points to 1.43%. Thus the trend towards higher yields of recent weeks reversed after 10-year Treasuries neared the 1.70% mark mid-November. 10-year Bunds also gained ground and are currently yielding -0.35% although the decline in yield was slightly less marked. Safe-haven currencies, such as the Swiss franc (+1.45%), the Japanese yen (2.75%) and the U.S. dollar (+1.75%) were also up sharply last month.

Concerns about rising and longer-term inflation faded further into the background somewhat, although figures were again above expectations. In Germany, inflation reached 5.2% in November, its highest level since 1992. After the Fed announced it was going to reduce its USD 120 billion per month asset purchase programme by USD 15 billion in November and December, the ECB could make a statement on the future of the PEPP programme at the coming December meeting. The PEPP is scheduled to end in March 2022. We think it quite likely that there will be a transition to the regular asset purchase programmes PSPP and CSPP with slightly relaxed terms. On the other hand, we consider it unnecessary to extend the PEPP in light of the favourable financing conditions.

Given that yields are expected to rise, we gradually reduced the duration risk in parts of the Ethna-DEFENSIV portfolio in recent weeks. In relation to bonds denominated in USD in particular, we still believe that the combination of improving economy, rising inflation and tightening monetary policy justifies higher yields. For that reason, we reduced the interest rate risk for our USD bond portfolio (almost 70% of the overall portfolio) to zero. In the eurozone, we are currently seeing little upside potential for yields, as the ECB is sticking with a very accommodative monetary policy and will raise interest rates a great deal later than the Fed. For that reason, we left the interest rate risk unhedged for bonds denominated in euro. Furthermore, we closed our 10% equity position, as we believe that most of the year-end rally has already played out and that risks slightly outweigh opportunities in the short term. The correction at the end of November has so far proved us right. In the medium to long term, however, in terms of performance, equities remain attractive, so we will probably reopen the position in the new year.

For the month, bonds in the Ethna-DEFENSIV were in negative territory because, as described above, the risk premia widened and yields fell. Our currency position is well up, with the U.S. dollar and the Swiss franc in particular making a healthy contribution to performance and, together with the gains on the equity position (now closed), it more than made up for the loss on bonds. The Ethna-DEFENSIV is up 1.30% year-to-date (T class).

Ethna-AKTIV

The momentum in global equities based mainly on good quarterly results, as mentioned in last month’s commentary, slowed significantly after November got off to a good start. In addition, we saw a sharp decline in market breadth in the last uptrend. Although we essentially share the moderate optimism about growth prospects for 2022 now being published by almost all the research firms, this perception of consensus makes us think twice and we believe much of the good news has been priced in. Overall, the combination of a lack of catalysts, declining market technical factors and (admittedly) above-average participation in recent weeks prompted us to successively reduce the equity risk over the course of the month. Although Fed Chair Jerome Powell stands for continuity in monetary policy, the wind had gone from the sails of even the strongest U.S. indices by the time of his renomination, if not before. Then, when news broke of a possibly even more infectious coronavirus variant (Omicron), there was a Black Friday sale in equities during slack trading after Thanksgiving. The accompanying volatility that continued into December really tested investors that had so far this year been spoiled by good performance. In this environment, however, the multi-asset fund Ethna-AKTIV, with its flexible management style, demonstrated its strengths. On the one hand, its inherent diversification helped and, on the other, the volatility and the loss of value during this period was reduced by taking discretionary measures. The fund closed the month up despite the fact that equity and bond markets moved sideways overall, since almost the entire performance for the month was generated by the USD position, which is still over 40%. Given that the interest rate differential is expected to widen and, especially, flagging global economic growth – which always tends to go hand in hand with a stronger U.S. dollar – we will hold onto this positioning into the new year. As already indicated, going forward we are still cautiously optimistic about next year and will therefore sooner or later use the funds freed up by reducing exposure in order to position ourselves for the new year. However, it must be borne in mind that the low-hanging fruit of the post-pandemic recovery have already been picked and selecting the right individual stocks and sectors will be all the more important. It should also be clear that there is no getting around equities in order to generate performance. However, this road will be a little bumpier in 2022. With its balanced portfolio construction, the Ethna-AKTIV is well positioned to reduce these fluctuations so they don’t impact the portfolio.

Ethna-DYNAMISCH

As communicated in the past, the Ethna-DYNAMISCH is an Article 8 fund under the Sustainable Finance Disclosure Regulation. On principle, we are thus committed to take sustainability criteria into account – as well as the conventional triad of investment decisions – earnings potential, risk and liquidity. A good example of how difficult it is to integrate such criteria is game developer Activision Blizzard – one of our portfolio stocks.

Activision Blizzard recently received strong criticism for its workplace culture, which allegedly fostered harassment and discrimination. Purely from the ESG perspective, as an investor committed to sustainability, we are faced with the dilemma of what to do when negative events involve our holdings. One consequence that is easy to follow through with is divestment. Doing so puts pressure on the share and how the price reacts is a direct reflection of market dissatisfaction. On the other hand, divestment is a non-specific signal. Plus, as investors we deny ourselves the opportunity to have a positive influence on the company by exercising shareholders rights in the future.

We have therefore decided against divestment, first and foremost purely from the ESG perspective. Instead, through active engagement, we communicated our dissatisfaction and our demands for specific measures to the management of Activision Blizzard. We expect that Activision Blizzard will genuinely sort out its internal problems, going by the first few measures it has taken. By exercising our voting rights at the next general meeting, we will take a critical look at progress on the ESG front. We believe such active engagement is the more responsible, correct option in the specific case of Activision Blizzard, rather than direct divestment.

Besides, ESG criteria are an additional but – as mentioned above – not the sole basis for decision-making. While the claims against Activision Blizzard also have actual economic consequences, such as delaying the publication of new games due to increased staff turnover, we believe that the share is fundamentally undervalued after the sell-off in November. Activision Blizzard’s video games continue to be some of the biggest and most popular in the industry, and the company has previously demonstrated its ability to turn things around. For that reason, we believe that the opportunities currently outweigh the risks.

Single-stock risks – as in the case of Activision Blizzard – detracted from the performance of the Ethna-DYNAMISCH in November in the absence of any stand-out positives. Apart from the one-off market setback at the end of the month – triggered by the latest Omicron variant of the virus – the fluctuations in our portfolio holdings largely involved technical movements and market rotations. There was no significant change in the fundamentally positive picture painted by our investments, as can be seen from the persistently high gross equity allocation of 74%. However, taking hedging components into account, the net equity allocation has been falling since as far back as October and stood at 58% most recently. Other asset classes such as bonds and gold still play no major role in the current fund allocation.

HESPER FUND - Global Solutions (*)

Following a strong October, equity markets were generally mixed in November. On the one hand, third-quarter earnings were better than expected for most large-cap companies, and stocks almost reached their record highs. On the other hand, the persistence of pandemic-related imbalances, the increase in energy prices, and the improvement in the labour market provided the major central banks with sufficient evidence that it was time to start signalling an upcoming policy normalisation. While equity markets were digesting the central banks’ forward guidance that they would gradually reduce the extraordinary stimulus programmes (tapering), news about the new, highly-mutated Omicron variant of the Covid-19 virus stunned global markets and caused the steepest drop in equities since September. As such, the month ended with a high degree of uncertainty about the future path of inflation and monetary policy, and with concerns about the economic risks posed by the new Omicron strain.

At the time of writing, the new Covid-19 variant has been rattling markets since Friday 26 November. We have seen a sharp reversal in a number of trends and volatility has spiked. Oil prices plunged by 10%, yields collapsed, and the strength of the US dollar suffered an abrupt setback. Although researchers have yet to determine whether the Omicron variant is more contagious or deadly than previous ones, markets have entered reset mode and only time will tell us if it was an excessive reaction.

In November, the major US stock indices fluctuated, for the most part closing the month lower, but still not far from their highs. For the month, the S&P 500 decreased by 0.8%, the Dow Jones Industrial Average (DIJA) plunged by 3.7% and small-caps, as measured by the Russell 2000 Index, fell by 4.3%. Conversely, the technology-weighted Nasdaq Composite edged up by 0.3%, closing at 3.2% below its all-time high set on November 19 2021.

In Europe, stock markets suffered the most. The Euro Stoxx 50 Index lost 4.4% (a decrease of 6.3% when calculated in USD) while in the UK, the FTSE 100 plunged 2.5% (-5.4% in USD). Despite a strong Swiss franc, the Swiss Market Index performed relatively well, increasing by 0.4% (almost unchanged in dollar terms) over the month.

Asian markets receded, with the Shanghai Shenzhen CSI 300 Index losing 1.6% (-1% in USD terms). The Hang Seng Index in Hong Kong, where Omicron has also been detected, fell by 7.5%. In Japan, the blue-chip Nikkei 225 lost 3.7% (-2.6% in USD terms).

We are currently reviewing the macroeconomic scenario for the HESPER FUND – Global Solutions, due to the current extremely uncertain situation - where we are seeing a combination of higher inflation, lower growth, and the emergence of a new Covid-19 variant - that appears to be seriously challenging policymakers. We are assessing the macroeconomic assumptions of economic policy divergence and growth expectations in the major economic zones. For the moment, we are taking note of the shift in sentiment, due to the spread of Omicron and are moving to both reduce exposure in most risk assets and set tighter stop limits. The fund performed very well during the first three weeks of November, in particular profiting from a strengthening of the US dollar against the euro and the British pound, and a strong Swiss franc. Unfortunately, following the increased volatility of the past few days, the fund lost some of its performance gains in what would have been otherwise an excellent month.

As volatility rose, we reduced the fund’s long equity exposure significantly, and this now totals 30%. We also reduced the fund’s exposure to commodities and the US dollar. As always, exposure to the various asset classes is monitored and calibrated on an ongoing basis to adapt to market sentiment and changes in the macroeconomic baseline scenario.
As noted in the previous Market Commentary, the fund has been very active on the currency front, trading in favour of the US dollar and against the British pound. This stance paid off during the month. The fund took partial profits and significantly reduced its USD from 85% to 59%. We have retained the long Swiss franc position of 13%.
In November, the HESPER FUND - Global Solutions EUR T-6 rose by 2.93%. Year-to-date performance was 10.18%. Over the last 12 months, the fund has gained 12.17%. Volatility rose slightly but remained low at 6.9%, retaining an interesting risk/reward profile.

*The HESPER FUND – Global Solutions is currently only authorised for distribution in Germany, Luxembourg, Italy, France, and Switzerland.

Figure 1: Portfolio structure* of the Ethna-DEFENSIV

Figure 2: Portfolio structure* of the Ethna-AKTIV

Figure 3: Portfolio structure* of the Ethna-DYNAMISCH

Figure 4: Portfolio composition of the Ethna-DEFENSIV by currency

Figure 5: Portfolio composition of the Ethna-AKTIV by currency

Figure 6: Portfolio composition of the Ethna-DYNAMISCH by currency

Figure 7: Portfolio composition of the Ethna-DEFENSIV by country

Figure 8: Portfolio composition of the Ethna-AKTIV by country

Figure 9: Portfolio composition of the Ethna-DYNAMISCH by country

Figure 10: Portfolio composition of the Ethna-DEFENSIV by issuer sector

Figure 11: Portfolio composition of the Ethna-AKTIV by issuer sector

Figure 12: Portfolio composition of the Ethna-DYNAMISCH by issuer sector

* “Cash” comprises term deposits, call money and current accounts/other accounts. “Equities net” comprises direct investments and exposure resulting from equity derivatives.

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