JCB ACTIVE FUND IS A PORTFOLIO OF LONG ONLY AAA AND AA+ RATED EXPLICITLY GUARANTEED GOVERNMENT BONDS. SINCE INCEPTION ANNUALIZED RETURNS ARE CURRENTLY 6.60% NET OF ALL FEE’S.

• VOLATILITY ARRIVES ON CUE IN SEPT; DEUTSCHE BANK GIVES RISK A SCARE
• NEGATIVE MEDIA COUNT AT 16 YEAR HIGHS FOR BONDS, CONTRARIAN SIGNAL?
• WHAT WOULD TOTAL RETURNS LOOK LIKE IN A MIRROR IMAGE BOND SELL OFF? YOU SHOULD ‘’BEAR’’ THAT IN MIND.

September produced the challenge to status quo in markets we had written about in the August monthly, with increased volatility across all asset classes. Markets continue to grapple with quantitative easing policy and balance sheet expansion and contraction in the central banks of Japan, the US, Europe, and England. To see out the year we also have to contend with the US presidential election, Italian senate referendum - a possible BREXIT moment for Eurozone - and stressed European Banks, led by Deutsche Bank and Commerzbank.

All of these possible event risks would normally drive investors towards the safety and security of Government Bonds, and yet mainstream newspaper or social media feeds tend to be extremely negative towards bonds. In fact, the ‘’hawkish’’ (higher interest rates) count in global media is something that quantitative analyst Neil Tritton (and our London-based Advisory Board member) monitors, peaking at a 16 year high in September. We have seen

headlines such as ‘’short of the century’’ and ‘’end of bond bull market’’ littering media outlets. This is misleading. Bonds may well find a new post BREXIT valuation range, however, to achieve a sustainable sell off would require central banks to materially and consistently lift interest rates. Globally this looks extremely unlikely after rate cuts this year from Australia, Japan, Europe, New Zealand and Canada. The ‘’bears’’ tend to forget that the record asset prices we are all enjoying are a result of low interest rates, but the mirror image would be a brutal deleveraging which happens much faster than a re-leveraging that we have already experienced. It is hard to see how any central bank would be a material interest rate hiker into collapsing financial asset and property prices.

The other major problem for the bond ‘’bears’’ is time. If you are short or underweight bonds, unless the market sells off immediately, you are paying away ‘’carry or coupon’’, ie the interest payments made by the bond’s issuer (in our case, Australian dollar denominated Governments). That carry or coupon is all powerful over time and is the main source of return for this asset class. An August 2016 study by Bank of America/Merrill Lynch looked at bond returns in a bear market that entirely mirrors the rally of the last 30 odd years. A bloodbath you might think, with bond yields getting higher and higher over that time. Assuming an investor stayed invested throughout that period, the returns are incredible. German Government Bonds, starting at a negative observable yield, produce a total return in excess of +350%. US Treasury Government Bonds returned more than 400%. Australian Government Bonds were higher again. That discredits the long-term ‘’bear’’ narrative. This major advantage of bond ownership is that carry or income continues to grow as the market sells off. Bonds are entirely unique in this manner: as their price declines the income opportunity set of the asset class grows. When bonds rally, investors are in receipt of ‘income’ (coupon/carry) plus an unrealised capital gain. When bonds prices decline, investors are still in receipt of income, whilst also having an unrealised capital loss. This unrealised loss does not need to be crystalised. If you own a bond to maturity, you will receive income during the ownership period, plus return of principal upon maturity. The critical thing to assess, of course, is the creditworthiness of the bond-issuer - in our case AAA and AA+ rated Governments, to repay in the future.

Diverse opinion from buyers and sellers is a hallmark of financial markets. Bulls and bears set the market clearing price and the challenge is to pick the optimal time to buy and sell in all asset classes, whilst at the same time maintaining a balanced asset portfolio that spreads and reduces risk. We always suggest a balanced and diversified portfolio, in which government bonds, with income guaranteed by government and immense liquidity, are an anchor or bedrock asset class. Investor life-cycle and risk tolerance thereafter will dictate the allocation size as a percentage of the portfolio.

We still maintain that AUD bonds are broadly range-bound over the balance of 2016 as the RBA move to the sidelines into a pause and assess phase. However, given the extreme negative sentiment of the media, any ‘’shock’’ could produce a powerful rally, as underweight investor positioning would be seriously challenged. The market is priced the FOMC to raise interest rates once in December and has already discounted this scenario. We would expect Bonds to do well on any such move, similar to the powerful bond rally after the singular FOMC hike in December 2015. We continue to tactically position the portfolio around this opportunity set and will continue to manager through the volatility.

FUND UPDATE FOR SEPTEMBER

JCB Active Fund returned -9 bps (gross) in August, beating the index significantly by 28 bps. Government Bonds traded in a wider range over the month, with the curve steepening aggressively on the announcement of a 30 year syndicated new issue for the Australian Government due in early October. The fund retained an underweight position early in the month which generated outperformance verses the index on the selloff. Markets also grappled with changes to the policy mechanics of the Bank of Japan’s Quantitative Easing policy, which now seeks to steepen the Japanese bond curve to improve the net interest margin for financials. Additionally, the threat of a September FOMC rate hike loomed over the market. Both of these event risks passed without major incident, and we added duration thereafter, moving towards index allocations into month end, locking in outperformance over the month versus the index.

We will look to set tactical underweights and steepening positions into the pricing of the new 30-year bond, as we believe this will be offered at a discount to fair value over the medium term and hence will look to participate in the new syndicated deal in early to mid-October.