Liontrust SF Corporate Bond Fund

The Fund returned 2.0% over the quarter, outperforming 1.9% from the iBoxx Sterling Corporate All Maturities Index and the IA Sterling Corporate Bond sector average of 1.8% (both of which are comparator benchmarks)*.

Against a constructive fundamental and technical backdrop, the Fund’s credit portfolio outperformed, generating positive contributions from sector allocation and stock selection. This was largely offset by underperformance attributable to the underweight interest rate risk position, however, leading to overall returns in line with the benchmark.

On the credit side, sector allocation was particularly strong, as our core overweights within the higher-beta banks and insurance sectors, as well as the longer spread duration telecommunications sector, benefitted from the generally risk-on tone and falling yields. Within banks, stock selection was also positive, driven by holdings in ‘disco’ (discount) bond securities. These are subordinated bank bonds past their original call date and therefore priced well below par as a result (trading at a significant discount, hence the ‘disco’ moniker), with essentially no duration exposure given the quarterly coupon reset.

Changes in banking regulation regarding what constitutes a capital instrument has seen some of these bonds, including our holdings in NatWest and Societe Generale discos, being called at par, resulting in a material capital uplift. The recent flurry of calls has also seen capital uplifts in outstanding securities, including our holdings in BNP and HSBC discos, which saw more than 10.5% and 6% price gains respectively in anticipation of also being called at par in the near future.

This more than offset the negative contribution from our holding in WM Morrison, following a private equity bid for the company. The expected increased leverage resulting from this bid, combined with change of control at par, offered little protection to the high cash price bond holding and we continue to monitor the situation as it develops.

As stated, the Fund’s short duration position was a detractor over the quarter, as government bond yields fell in both the UK and US. In the UK, 10-year Gilt yields were down 13 basis points (bps) over the period, ending the first half of the year at 0.72%, attributable to a combination of rapidly increasing Covid infections and a moderation in inflation expectations. The ongoing spread of the delta variant has resulted in heightened uncertainty around the easing of lockdown restrictions, with scheduled re-opening delayed by an initial four weeks, and markets are growing increasingly concerned over the knock-on effect this could have on economic recovery. Meanwhile the Bank of England is forecasting inflation will peak at 3% before falling back towards its 2% target next year, echoing the views of the Federal Reserve that any overshoot will be short lived. 

Moving to the US, there has been a marked flattening of the curve; two-year Treasury yields rose sharply after expectations shifted towards two potential interest rate hikes in 2023, while the 10-year yield fell 27bps to end the period at 1.47%, as the Fed holds firm in its belief the current inflation spike will be transitory. In contrast, German 10-year Bund yields rose 8bps over Q2 to -0.21%, as accelerated vaccine rollout and economic data continue to point to a strong rebound over the second half.

This data continued its positive momentum over the quarter, driven by successful vaccination programmes allowing economies to start reopening. US GDP rose at an annual rate of 6.4% in Q1, with retail sales up 9.8% in March alone, and around 7% growth is now expected for 2021 overall (up from 6.5%). Employment growth has also continued, confirming labour supply constraints are starting to reduce.

As for the UK, the economy grew at its fastest rate since last July in April, giving a year-on-year comparison of +27.6% versus the same month in 2020, at the height of initial pandemic panic. This parallel is more useful if we consider the latest growth spell puts the country just 3.7% below the pre-pandemic peak. In Europe, meanwhile, there are signs vaccination rollout is picking up, having been a laggard, and surveys of purchasing managers show euro-area activity growing at the fastest pace in 15 years.

While the spread of the delta variant is a potential concern, as it could slow the full reopening of economies, the increasing number of cases has not led to significantly higher hospital admissions in the UK so far, suggesting vaccines are working well.

A combination of record consumer savings built up over the pandemic being spent and ongoing fiscal support measures has resulted in a robust rebound in activity and, in turn, fuelled inflationary pressures – with the market increasingly focused on how permanent this may be and watching central banks for hawkish or less dovish leanings. Speculation around the Federal Reserve’s June meeting was particularly high, as headline inflation had crept up to 5% year on year and core to the highest level since 1992 at 3.8%.

While this meeting bought no change to policy rates, as expected, there were signs of Fed members becoming slightly more hawkish, as their projections (via the dot plot) indicated possible interest rate rises in 2023 (a change since March, where 2024 was the earliest expected point for hikes). The Bank also increased its headline inflation estimate to 3.4%, up a full percentage point from March forecasts, and admitted levels could end up ‘higher and more persistent’ than expected as reopening continues, with rapid shifts in demand plus bottlenecks, hiring difficulties and other constraints limiting how quickly supply can adjust.

These announcements resulted in a sharp selloff in bonds, although this quickly reversed as subsequent comments from officials allayed fears over tightening policy too quickly. Fed chair Jay Powell advised investors to view the dot plot with a ’big grain of salt’, calling its forecasting capacity into doubt and claiming lift off on rates is well into the future. Even with the raised forecast for this year, the FOMC remains steadfast that inflation will trend down to its 2% goal and continues to claim it has the tools to stop things running too hot. Tapering also remains a discussion for the future, with the Fed reiterating the economy is not yet at the point where slowing asset purchases is appropriate. Highlighting the febrile atmosphere around his comments, Powell joked that markets could consider the June session as the ‘talking about talking about’ tapering meeting.

In the UK, inflation climbed to 2.1% in May from 1.5% in April, exceeding the Bank of England's 2% target for the first time in almost two years. Economists had expected an increase to 1.8%, again leading to speculation over when policy tightening may be needed, and, mirroring the Fed, the BoE upped its expectations for inflation but insisted this does not pose a threat to growth. On the Continent, European Central Bank President Christine Lagarde also acknowledged a recent pickup in inflation and is another in the temporary spike camp, with the Bank opting to continue its elevated pace of monetary stimulus for now.

There was moderate Fund activity over the quarter. As highlighted earlier, there were calls for our holdings in NatWest and Societe Generale discos, which saw them exit the portfolio, and we reinvested the proceeds across a number of favoured names. We participated in new issues from Rabobank, Coventry Building Society and NatWest Group, which all brought subordinated bonds to market at attractive valuations relative to existing secondary securities. We also topped up in our position in HSBC discos, where there is room for a further significant capital uplift should the bonds be called at par, as well as adding to Axa USD bonds, taking advantage of the potential change in capital treatment, which should result in these offering better value than GBP equivalents over the longer term.

Elsewhere, we participated in a new issue from Anglian Water, which brought a sustainability linked bond to market at an attractive valuation. The company has clear benefits for both society and the environment through its provision of clean and waste water services, delivering safe drinking water to customers. The management team is highly regarded, demonstrating a strong commitment to sustainability, through strong operational business performance, funding and company culture. We also reinstated a position in Direct Line Group, at an attractive re-entry level, with bonds trading cheap relative to recent history. The company has also made progress on its responsible investment policies, fully integrating ESG analysis and minimum standards within its portfolio. Management appears to have a clear focus on social issues, particularly customer and employee satisfaction, evident throughout its published strategy, net promoter scores and satisfaction surveys.

We exited our position in logistics warehousing landlord Segro, viewing the bonds as fully valued after strong performance throughout the pandemic given the accelerated move towards e-commerce, which requires more than three times the logistics space. The proceeds from this, along with cash as a result of strong net inflows into the Fund over the period, were reinvested into a number of favoured names where we see good value including Glas Cymru (Welsh Water), Whitbread, Travis Perkins and Clarion Housing Group.

We also opted to take advantage of relatively benign market conditions to de-risk the portfolio at the margin, through a number of relative value switches, particularly within the insurance sector. One example was taking advantage of a flat curve in Aviva bonds, rotating out of longer duration into shorter duration paper, to reduce interest rate risk for no loss of spread.

From a duration standpoint, we increased the Fund’s overall short from two to 2.25 years relative to the benchmark and also continued to be active in terms of tactical positioning. As yields moved lower in the US, despite ongoing strength of economic data and colossal fiscal stimulus packages, we sought to exploit this relative value opportunity, rotating 0.25 years of our short to the German market into the US. We also chose to close our remaining 0.25 years German short, rotating this into the UK, where we see more potential for yields to rise given greater inflationary pressures and stronger economic recovery thus far.

As the US yield curve steepened throughout the period, with the shorter end pinned by the FOMC’s interest rate forecasts, we rotated our US short out of the 10-year point and into the five, reducing beta while being better positioned to benefit from a change in outlook for rates. This trade was subsequently reversed later in the period, as we believe the 10-year point offers the best risk-reward trade-off in term of underappreciated inflationary pressures. Towards the end of the quarter, we decided to increase the size of the short to the UK market by 0.25 years to 1.5, following the squeeze lower in yields.

At the end of the first half, our duration position was expressed via a 1.5 year short to the UK and 0.75 years to the US, both via the 10-year point of the curve.

Looking forward, our view continues to be for a strong rebound in the global economy in H2, fuelled by the vaccination programme. As stated, markets are focusing on inflationary pressures and central banks’ response to these and while the latter continue to stress the transitory line, this belies underlying economic conditions. While there will undoubtedly be a large transitory element to the recent spike, we believe inflationary pressures will persist and be ‘stickier’ than policymakers expect, given unprecedented levels of pent-up consumer demand, ongoing supply constraints and the strong growth outlook.

As such, we feel monetary policy may need to be tightened earlier than forecast to combat these pressures and be realigned with the economic outlook. The sharp rise in inflation has outstripped the uptick in government bond yields year to date, resulting in a further deterioration in real yields. Even if inflation does ease back to the 2% target area, as forecast by several central bank policymakers, if we do not see a further rise in nominal yields, then real yields will remain negative. This supports our preference to remain short duration, with government bonds still vulnerable to unprecedented supply and reflation risks.

We remain constructive on investment grade credit as corporate spreads remain resilient, supported by robust underlying fundamentals and technicals. As conditions improve, we expect companies’ focus to remain on enhancing fundamentals, including creditor-friendly debt reduction and balance sheet repair. We are committed to our existing high-quality positions and believe they are well set to continue to perform as the market benefits from measures taken by central banks (quantitative easing and relaxed capital requirements), national governments (fiscal stimulus and SME guarantee programs), and the improving outlook. Demand for corporate bonds also persists as a rare source of yield for investors.

We believe traditional short-dated bonds remain expensive, both from an all-in yield perspective as well as on a spread basis, with low expected returns, wide bid/offer spreads and shorter spread duration. Instead, we see ongoing value in the medium part of the credit curve, with curve steepening offering attractive longer spread duration opportunities. From a sector perspective, we continue to favour insurance, telecoms and banks, with cyclical non-financials generally over-owned and expensive.

Discrete years' performance* (%), to previous quarter-end:

*Source: Financial Express, as at 30.06.21, primary share class, total return, net of fees and interest reinvested.

KEY RISKS

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The majority of the Liontrust Sustainable Future Funds have holdings which are denominated in currencies other than Sterling and may be affected by movements in exchange rates. Some of these funds invest in emerging markets which may involve a higher element of risk due to less well-regulated markets and political and economic instability. Consequently the value of an investment may rise or fall in line with the exchange rates. Liontrust UK Ethical Fund, Liontrust SF European Growth Fund and Liontrust SF UK Growth Fund invest geographically in a narrow range and has a concentrated portfolio of securities, there is an increased risk of volatility which may result in frequent rises and falls in the Fund’s share price. Liontrust SF Managed Fund, Liontrust SF Corporate Bond Fund, Liontrust SF Cautious Managed Fund, Liontrust SF Defensive Managed Fund and Liontrust Monthly Income Bond Fund invest in bonds and other fixed-interest securities - fluctuations in interest rates are likely to affect the value of these financial instruments. If long-term interest rates rise, the value of your shares is likely to fall. If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds. Mentioned above five funds can also invest in derivatives. Derivatives are used to protect against currencies, credit and interests rates move or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions.

DISCLAIMER

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.