FUND COMMENTARY THREADNEEDLE (LUX) EUROPEAN HIGH YIELD BOND FUND

COVERING SEPTEMBER 2020

                          FUND COMMENTARY
                          THREADNEEDLE (LUX) EUROPEAN HIGH YIELD
                          BOND FUND

                          Summary
                           September brought an end to recent gains in European high yield (EHY)
                            bonds, with the market recording a modest -0.6% decline.
                           The fund trailed its benchmark by 29 basis points (bps), gross of fees.
                           The overweight in services and underweight in energy detracted.
                           In the primary market, the fund participated in new issues from Virgin Media
                            O2, PPF Telecom and Center Parcs.
Roman Gaiser               We opened a position in pub operator Stonegate.
Joint Fund Manager
                           We added exposure to Valeo, Atlantia and Banca Monte Dei Paschi di Siena.

                          Market Background
                          Risk assets finally broke their winning run in September. Global equities posted
                          their first monthly decline since March, as profit-taking in large-cap US
                          technology stocks triggered broad-based selling across sectors and regions.
                          Concerns about the economic impact of the resurgent coronavirus pandemic,
                          political uncertainty in the US and related delays to fiscal stimulus spurred
                          investors to lock in gains. Commodities were down for the first month since April
                          as oil prices slumped on demand concerns. A stronger dollar weighed on gold
Gareth Simmons            and silver, but copper was supported by strong Chinese economic data. In fixed-
Joint Fund Manager        income markets, core bond yields fell in aggregate though US Treasuries were
                          little changed. Credit spreads widened modestly amid dwindling risk appetite and
                          the elevated supply of new issues.

                          Much of the economic data released during the month suggested that the global
                          recovery was still on track, but there were some reminders of its fragility.
                          September’s estimated composite PMI for the eurozone, for example, implied
                          that growth in business activity was close to stalling amid a renewed push to
                          contain the pandemic. Infection rates continued to surge across Europe, bringing
                          localised restrictions on movement, and they also began to rebound in the US.
                          More positively, hopes for a vaccine increased following encouraging news on
                          late-stage trials from frontrunners Pfizer and AstraZeneca.

                          In the political sphere, the US House of Representatives again failed to agree on
                          a new pandemic relief package. Hopes faded for a deal before the presidential
                          election after the death of Supreme Court Justice Ginsburg, as Republican efforts
                          to rush through a conservative replacement for the liberal judge are likely to take
                          precedence. The prospect of a larger conservative majority on the Supreme
                          Court also stoked fears that President Trump would be more likely to challenge
                          the election result should he lose. On the international stage, tensions continued
                          to simmer as the US imposed sanctions on China’s largest semiconductor
                          manufacturer. In Europe, fears of a no-deal Brexit intensified as the UK proposed
                          legislation that would override parts of its withdrawal agreement with the EU.

                          Accordingly, the MSCI AC World equity index was down 2.7% in local-currency
                          terms The industrials sector fared best, while energy fell heavily. Developed Asia
                          ex Japan was the biggest faller among the regions, followed by the UK, whose

FOR INVESTMENT PROFESSIONAL USE ONLY                  1                          Issued September 2020 | Valid to end December 2020

FUND COMMENTARY | AUGUST 2020

relative weakness was due to currency moves. The US also underperformed, despite a stronger dollar
flattering sterling returns: large-cap tech-related stocks that had driven the prior rally were notably weak. The
best performers were emerging markets (EMs) and Japan. Equities in Japan rose in anticipation that the
current loose fiscal and monetary regime would continue under the newly installed prime minister.

In fixed income, the 10-year US Treasury yield fell just 2 basis points (bps) while the German and UK
equivalents fell 13 bps and 8 bps respectively. Credit spreads widened by 8 bps, 4 bps and 4 bps
respectively in the dollar, euro and sterling investment-grade (IG) markets. In high yield (HY), US dollar
bonds also underperformed those in Europe, with US spreads widening by 39 bps. European high yield
(EHY) spreads widened by 19 bps from 456 bps to 475 bps, producing a total return of -0.6%.

Performance
In gross terms, the portfolio underperformed its benchmark by 29 bps, with a slight underweight position in
risk on the back of a moderately defensive outlook.
Unhelpful security selection in services, energy and leisure was the main cause of detraction. The
underweight in Pemex was the largest detractor at the individual security level, as Mexico’s government
indicated the budget would allow the state-owned company greater flexibility regarding oil production targets
given the current weak pricing and demand outlook. Not holding cruise-line firm Carnival Cruise also
hampered returns after management announced more asset disposals, amid a drive to permanently lower
the company’s cost base.
At the other end, the underweight in transportation and stock selection in retail contributed to performance.
At the individual security level, the overweight exposure to French food retailer Casino Group was the largest
positive, as the company’s investor presentation revealed plans to make further cost and capital expenditure
savings. In transport, not holding British Airways owner International Consolidated Airlines Group was
supportive after it announced the recovery in passenger traffic had begun to slow.

Activity
In the new-issue market, we were active in the telecoms sector, purchasing debt of Virgin Media O2, the joint
venture formed when Liberty Global and Telefonica combined their UK cable and mobile-phone operations.
This complements the existing holdings of Virgin Media bonds. The venture was rated Ba3 by Moody’s and
BB- by Fitch during the month. We also took exposure to fresh Electricite de France (utilities) debt rated BB-
by S&P, initiated a position in holiday-camp firm Center Parcs by purchasing new debt rated B by Fitch and
increased the allocation to PPF Telecom via fresh bonds rated Ba1 by Moody’s and BBB- by Fitch.
Elsewhere, the fund scaled up exposures to various companies, including automotive supplier ZF
Friedrichshafen, car manufacturer Volvo, chemicals firm SPCM and fertiliser producer OCI.
Activity in the secondary market involved opening a position in Stonegate (pubs/bars). Otherwise, additions
were made to existing positions, including car-part maker Valeo, transport-infrastructure business Atlantia
and Banca Monte dei Paschi di Siena, among others.
Sales activity included the liquidation of the holding in chemicals business Chemours. The fund trimmed
allocations in a number of other holdings, including food-retailing group Casino Group, specialist steel
business Vallourec, storage company Iron Mountain and consumer financial services group Intrum.

Outlook
Global economies continued to recover over the third quarter, but the outlook remains challenging. Evidence
of a second wave of Covid-19 infections is causing the re-imposition of some restrictions, albeit at a localised
level, creating an overhang for the fragile economic recovery. Given that Covid-19 is here to stay until a
vaccine is developed, the market has started to refocus on upcoming events, including the US presidential
election, ongoing Brexit trade negotiations and the review of fiscal support plans.
Default expectations have come down from earlier this year, and have stayed at these lower levels. However,
they appear to be detached from the weak macroeconomic fundamentals. The prospect of a 4% default rate
is supported by the belief that government and central bank support will continue. Current EHY spreads
compensate for such a scenario, but they do not look cheap given the uncertain outlook. Corporate earnings
remain severely affected by ongoing pressure on revenues. Consequently, issuers are experiencing rising

FOR INVESTMENT PROFESSIONAL USE ONLY                     2                           Issued September 2020 | Valid to end December 2020

FUND COMMENTARY | AUGUST 2020

levels of leverage. This is somewhat balanced by cost control, the focus on cash flow, and liquidity
management by firms. Overall, defaults have started to rise, with another €2.2bn in September, bringing the
total for the year to date to €7.4bn.
Technicals are supportive – driven by central banks’ ongoing corporate-bond buying programmes. Flows into
the asset class are still positive, though more balanced and prone to changes in market sentiment. The
primary market remains strong, with €27bn of new bonds issued during Q3, which is a quarterly record and
compares with a previous high of €22bn in 2016. The autumn pipeline looks set to provide a steady flow of
new issues, as companies come to the market as a means of funding, enabling them to shore up their
balance sheets and extend maturity profiles. Capital raising and capital injections by strategic shareholders
are also helping to bolster capital structures. Fallen angels continue to enter the EHY market but at a
reduced pace, and have increased the size of the market to its largest ever. Their arrival has also helped to
push spreads lower, as the weight of lower-yielding BBs has increased within the EHY universe.
With valuations driven by technicals, and seemingly detached from fundamentals, high yield spreads are
now about 70 bps wide of their 5-year average, and could still have room to grind tighter given enduring
fiscal and monetary support. The upside is clearly more limited after the sharp rally over the last six months.

FOR INVESTMENT PROFESSIONAL USE ONLY                     3                          Issued September 2020 | Valid to end December 2020

FUND COMMENTARY | AUGUST 2020

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FOR INVESTMENT PROFESSIONAL USE ONLY                                              4                                       Issued September 2020 | Valid to end December 2020