Morningstar Magazine - August/September 2018 - 27

Sharp Losses for
Some European
Fixed-Income Funds
Over the month of May, most of the pain from
rising Italian sovereign rates was felt by
passive funds replicating indexes with large
allocations to Italy. In particular, X II iBoxx
Eurozone Government Bond Yield + Swap ETF
and Amundi IS Government Bond Lowest
Rated Eurozone Investment Grade ETF suffered
losses of 4.5% and 2.6% during the month,
respectively. These ETFs offer exposure
to the higher-yielding and, respectively, lowerrated, eurozone government bond markets,
and were therefore more exposed to Italy than
ETFs tracking broader market indexes. These
investment propositions will shine in bull markets
but are particularly vulnerable in times of market
stress when investors tend to seek refuge
in the quality of better-rated issuers, as the recent
turmoil illustrated. Thus, despite their
competitive fees, we are not convinced of their
benefit for investors over the long term, as
reflected by our Morningstar Analyst Rating of
Neutral for both funds.
European inflation-linked bond funds also incurred
some of the largest losses over the month,
which shouldn't come as a surprise given that Italy
represented around 31% of the Bloomberg

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Barclays Euro Government Inflation Linked All
Maturities Index as of April 2018. Bronze-rated AXA
IM Euro Inflation (which held 36% of assets in
Italy) was one of May's worst performers,
suffering a 2% loss. However, the fund's year-todate record is far from tarnished. It continues
to rank in its category's second quartile thanks
to gains from its Italian exposure earlier in
the year, as well as the structural advantage of its
low fees. Over the three- and five-year periods
through May, the fund remains ahead of its
average peer, a welcome reminder for investors
to stay focused on longer-term returns as
well as costs.
Within European diversified bond funds, two funds
managed by Deutsche Asset Management
also stand out due to their large exposure to Italy
in recent months. At the end of May, Deutsche
Invest I ESG Euro Bonds (rated Bronze) had
53.3% of assets in Italy, compared with 14.3% in
its benchmark, iBoxx EUR Overall 1-3 Years
Index. The fund experienced a sharp drop in
returns, losing 1.92% in May, of which 1.75% was
attributable solely to the Italian sovereign
bond position. That caused it to slip from the
category's top quartile for the year to date through
April to the bottom quartile one month later.
Managers Claus Meyer-Cording and Andrea
Ueberschär nevertheless argue that
supportive factors such as the general low-yield
environment, Italy's appropriate institutional
and constitutional checks and balances,
competent treasury management, and relatively
low ownership of BTPs outside of domestic
investors remain in place, even if these
aren't recognized by the markets at the moment.
In this context, they have made only minor
adjustments to the fund's portfolio over the month
of May, reducing its interest-rate duration
from 2.3 to 2.1 years, but remaining overweight
in Italy. In their all-maturity portfolio, DWS
Vermögensbildungsfonds (rated Silver),
the managers have slightly reduced their exposure
to 10- and 30-year maturities to better weather
the current volatility, but they remain committed
to their exposure to Italy for the long term.
The team also maintained positions in Spain and
Portugal, which in their view should not
suffer contagion effects due to their strong

fundamentals, in particular due to their stronger
pro-European political orientation. Such
bold bets are a hallmark of the fund's adventurous
style, which has paid off for patient investors
over the long term.
At the other end of the spectrum, some
Morningstar Medalists such as Gold-rated BGF
Euro Bond and its short-duration sibling
BGF Euro Short Duration (rated Silver), were less
affected by Italy's recent troubles. The
management team led by Michael Krautzberger
had been overweight in Spain and underweight
in Italy for several years, as they were encouraged
by higher gross domestic product growth
in the Iberian nation. In the weeks coming up to
the Italian elections, the team had nevertheless
reduced the fund's underweighting as they
thought that the spreads between Italy and Spain
had become too large. In the immediate
aftermath of the elections, the team took
advantage of a sell-off in Italian corporate bonds
to add to their exposures there, while maintaining
an underweighting to the government bonds.
The team was also prepared to add to positions
in Spain and Portugal in case contagion
effects led to price weakness there, though these
opportunities ultimately resorbed fairly quickly.
The funds' defensive qualities shone throughout
this period, and the team's knack for building
a portfolio of diversified, relative value strategies
is evidenced by strong relative returns
year to date as well as over the longer term.
Bronze-rated PIMCO GIS Euro Bond also treaded
lightly in European peripheral risk, as the
team preferred to add value off the beaten track,
such as in mortgage-backed securitized debt
(U.S. nonagency MBS, combined with exposure
to callable Danish mortgages), select credit
holdings, and a modest tactical currency overlay.
These exposures helped fuel the fund's
top-quartile ranking year to date. Over the longer
term, the team's deft use of a wide range
of performance drivers has served investors well,
despite the fund's higher-than-average costs.
Mara Dobrescu, CFA, is associate director, fixed-income
strategies, with Morningstar Manager Research, EMEA.

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Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2018