The Liontrust Strategic Bond Fund returned -0.4%* in sterling terms in September. The average return from the IA Sterling Strategic Bond sector, the Fund’s comparator benchmark, was -0.5%.
Market backdrop
Well, it had to happen. Investors, returning from summer holidays took fright. Why? Inflation. Why now? The promise of central bank action. Yields on core G7 bonds moved to or above prior year-to-date highs – 1% for a ten year gilt anyone?
Indeed, the Bank of America UK Gilt index fell around 3.8% in September, to stand down over 7.6% for the year to date. So much for a risk-free store of value. Equites in general struggled. Most corporate bonds, high yield in particular, seemed unfazed.
Inflation. Central bankers in the US and Europe acknowledged explicitly mild concern that prices for some goods and services had risen a bit and could remain elevated. Pictures of panicked petrol purchasers at UK fuel pumps and of ships waiting to dock in California suggested more than mild concern was required. The most recent G7-wide CPI data for the 12 months to end August showed inflation rising at 4%. Most, ourselves included, would suggest this number under-reports actual consumer price rises and conclude that – in the short term at least –CPI could move even higher.
Why now. Inflation is not necessarily “bad”. Indeed, the G7 has been trying to find it for a decade. However, contrary to economic logic, if consumers expect lots of inflation (as opposed to hyperinflation of course) they often hoard cash so as to be able to pay for essential goods and services in the future. That seems to be contributing to the mood in the US, where after six months of inflation averaging over 4%, consumer confidence has plunged. And the stockmarket, the darling of almost all central bankers, really doesn’t like a worried consumer. Mr Bailey appears to have taken note.
We have said repeatedly that the past decade of free money has created economic imbalance and asset price bubbles. Powell and Lagarde now seem to agree. Both the US Federal Reserve and European Central Bank appear to be set to taper bond purchases – reducing monetary accommodation, as distinct from tightening monetary policy. Sovereign debt started to fall as investors realised the “buyer of last resort” may not be around as much. Equities, led by tech and so-called growth stocks started to fall on the understanding that bloating a balance sheet with cheap leverage might not be such a good long-term strategy after all.
Rates
We raised our duration from 2.5 years† at the end of August to 3.0 years by end of September. Since July we have added about 40% to our duration exposure (from 2.2 years to the 3.0 today). That sounds dramatic. That sounds as if we believe rates markets offer value. To be clear: we still have a duration more than four years below the global bond index and about six years lower than leading gilt indices. We believe rates have further to rise. Once released, the inflation genie is difficult to put back in his bottle.
As always, some rates markets fared better, some worse. UK Gilts were in the eye of the storm – yields moved close to 1%. We had been “short” and closed that out as part of our duration increase. Likewise, Germany fared worse than Switzerland and the long Swiss position reported last month was closed at a nice profit.
About the only poor alpha position was a US curve steepener, where we owned 10 year bonds and were short 30 year bonds. In mid-September that moved against us. However, by month end investors had realised the Federal Reserve might be a little late to raise rates, and long-dated bonds fell nicely.
We also now own a small amount of New Zealand bonds, with a corresponding short in Australia. The former is expected to raise interest rates in October. We believe that move is in the price. Australian debt on the other hand is yet to reflect an inflationary environment.
Allocation
There was not much change to asset allocation. We remained modestly overweight higher quality high yield bonds (about 23% against our neutral position of 20%). High yield performed well during the period. Or rather, the core, quality markets we invest in did – anyone unlucky enough to be sucked in to “global” high yield (which looks a lot like second-rate emerging market grouping to me) will be watching Evergrande extremely closely. In the event of an unmanaged default (less than 50% probability we would say), core high yield would not be immune. However, we would welcome a repricing and, all other things being equal, see it as a chance to increase yield and risk in the portfolio in return for more sensible expected levels of reward.
Likewise, investment grade was largely unchanged. We see it as fully valued and continue to avoid AT1, most hybrids and to hold about 40% against our expected 50% of portfolio value. Yields on sovereign bonds have not yet reached the level where they look attractive compared with low default investment grade. That time may come soon – if so, we think it’s a warning of a good 10% core equity correction.
Selection
The bond market was awash with new supply in September. No surprise. And perhaps of even less surprise were prices – most new issues offered poor or zero premia to secondary markets. So, we watched most come and go, secure in the knowledge that if the market turns, it is often the most recent bonds to market that suffer the most. As we said, we have only 40% investment grade against a 50% neutral level and are happy to pick off bonds from potentially over-levered competitors.
We did buy a couple of names in the finance space. First, we added AIA Insurance subordinated debt, which was still A rated. The company is well diversified, most of its businesses are highly regulated and it has a nice solvency ratio. It also helps that it is multi-line and multi-geography. Additionally, it is not a frequent issuer so we expect a rarity premium to attach to the bonds over time.
Second, we bought back into an old favourite: Pershing Square. Most will recognise this well-known investment vehicle. It is significantly over-capitalised and we believe a little under-rated. The new issue gave us an opportunity to add BBB+ risk for a yield more than double that available on the equivalent US Treasury at the time. Recently, to receive that kind of yield has meant fishing in the high yield pool. Needless to say, we were reasonably circumspect and bought senior bonds.
Outlook
Government bonds continue to be under pressure. Inflation continues to rise. Central banks appear to have run out of patience. As Q3 ended, only the sovereign market seemed to have noticed. If yields do continue to rise, equities and the lower echelons of high yield could be vulnerable. That would give us an opportunity to increase our currently low level of fund beta.
Discrete 12 month performance to last quarter end (%)**:
Sep-21 |
Sep-20 |
Sep-19 |
|
Liontrust Strategic Bond B Acc |
3.0% |
4.0% |
5.9% |
IA Sterling Strategic Bond |
4.6% |
3.6% |
7.1% |
Quartile |
3 |
2 |
3 |
*Source: Financial Express, as at 30.09.2021, accumulation B share class, total return (net of fees and income reinvested.
**Source: Financial Express, as at 30.09.2021, accumulation B share class, total return (net of fees and income reinvested. Discrete data is not available for five full 12 month periods due to the launch date of the portfolio.
Fund positioning data sources: UBS Delta, Liontrust.
†Adjusted underlying duration is based on the correlation of the instruments as opposed to just the mathematical weighted average of cash flows. High yield companies' bonds exhibit less duration sensitivity as the credit risk has a bigger proportion of the total yield; the lower the credit quality the less rate-sensitive the bond. Additionally, some subordinated financials also have low duration correlations and the bonds trade on a cash price rather than spread.
Key Risks