Liontrust Strategic Bond Fund

The Liontrust Strategic Bond Fund returned -0.5%* in sterling terms in December. The average return from the IA Sterling Strategic Bond sector, the Fund’s comparator benchmark, was -0.4%.

The year reached its conclusion with myriad central banks hiking rates by 50 basis points in December. Central bankers started 2022 way behind the curve with inflation clearly not having been “transitory”. The late starting to the rate-hiking cycle has meant that terminal rates will have to be higher and recessions deeper in order to conquer inflation. I found it interesting contrasting the statements from December 2021 with those of December 2022.

The US Federal Reserve ended 2021 with fed funds rates in the 0% - 0.25% range, stating “..the Committee expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment”. By the end of 2022, fed funds rates were at 4.25% - 4.50% with further policy tightening a foregone conclusion. The statement is now decidedly hawkish, saying “…no participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023. In view of the persistent and unacceptably high level of inflation, several participants commented that historical experience cautioned against prematurely loosening monetary policy”. The increase in sovereign bond yields in 2022 across differing tenors can be seen below:

The European Central Bank was even more dovish a year ago: “…in support of its symmetric 2% inflation target and in line with its monetary policy strategy, the Governing Council expects the key ECB interest rates to remain at their present or lower levels until it sees inflation reaching 2% well ahead of the end of its projection horizon … this may also imply a transitory period in which inflation is moderately above target.”

Move the calendar on a year and the tone has completely shifted. Accompanying the ECB’s policy decision in December 2022, inflation forecasts were revised upwards: it is expected to be 8.4% in 2022, 6.3% in 2023, 3.4% in 2024 and 2.3% in 2025. Excluding energy and food, the numbers are much lower than headline inflation in the first two years (3.9% in 2022, 4.2% in 2023), slightly lower in 2024 (2.8%), and a smidge higher in 2025 (2.4%).  With those inflation forecasts it is no surprise that the ECB’s Governing Council “…judges that interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target. Keeping interest rates at restrictive levels will over time reduce inflation by dampening demand and will also guard against the risk of a persistent upward shift in inflation expectations”. At the press conference Lagarde was asked for further colour on the “steady pace” and her reply was that it implies 50bps hikes “for some time”, taken to mean at least one more meeting and possibly two. She then went on to say that market expectations for the terminal rate (which had been about 3% for the deposit rate) were too low. It was by far the most hawkish press conference Lagarde has ever hosted. The ECB states that the monetary policy path is data dependent, but it sounds like there will need to be a significant change in the economic data to alter the current hawkish mindset. However, as the eurozone slips into recession this year, the ECB’s view is likely to be challenged.

I believe that one of the over-riding themes for bond markets in 2023 will be this tension between hawkish central banking rhetoric and financial markets attempting to price in rate cuts toward the end of the year. In my opinion, the key determinant of when central banks will be able to cut rates is the labour market. 

Using the US as an example, whilst the level of inflation is obviously too high, the direction is very encouraging.  Core goods prices have been falling over the last few months, with the biggest driver being used car prices.  Shelter inflation, one of the stickiest components in the consumer price inflation baskets, will start falling rapidly in late Q2/early Q3 as a natural lagged impact from a weakening housing market feeds through. The lag is mainly due to the measurement methodology that the BLS uses to calculate rents and owners’ equivalent rents (OERs).  This just leaves core services inflation, which (excluding shelter) was rising at 6.6% according to the inflation data released for November. Core services inflation exhibits a high degree of correlation to nominal wage inflation, itself a function of a very strong labour market. There remains a big imbalance between demand and supply of labour; until this imbalance has corrected the Fed will continue to be hawkish.

It is our opinion that by the end of 2023 the US economy will have weakened enough to significantly reduce the pressure on wage inflation; after all, unemployment has historically been a late cycle indicator. So, the Fed will be able to cut rates. Whether it chooses to cut is another matter. Just as delays to raising rates have contributed to a higher terminal rate for this cycle, delays to cuts when the time comes would only lead to more loosening being eventually required. 

Fund positioning and activity

Rates

The Fund started and finished December with a duration position of 5.25 years (reminder: range 0-9 years, neutral 4.5 years). We sold 0.5 years of duration on the 6^th December when 10-year Treasury yields had reached 3.52% and Bund yields were at 1.80%, as we believed that yields had tactically fallen too far and fast. The hawkishness of central banks, in particular the ECB, caused a significant rise in sovereign bond yields. We added the duration back on the 28^th December with US Treasuries at a yield of 3.81% and Bunds at 2.46%. We had a preference to add to European duration given its recent underperformance relative to the US. The duration exposure is 2.35 years in the US, 1.5 years in the Eurozone, 1.0 years in the UK and 0.4 years in New Zealand. 

Allocation

Having reduced the size of the Fund’s credit overweight in November, there was less activity in December.  Similarly, stock level turnover was low during the month as a seasonal fall in liquidity created wider bid/offer spreads, prohibiting most relative value switch opportunities.

Strategically, we believe credit offers long-term value both examining spreads and, particularly, the all-in yield. However, the upcoming recession in 2023 and reduction of central bank liquidity mean that we need to see more of a premium to justify a large overweight position. Investment grade exposure is a little above our 50% neutral level at 55% and the high yield weighting is 27% compared to a neutral level of 20%. As a reminder we have a quality bias within credit, limited exposure to the most cyclical parts of the credit market, and the Fund owns no CCC rated bonds.

We displayed the changes in sovereign yields in the commentary above – for completeness we also present the changes in credit yields and spreads during 2022:

Discrete 12 month performance to last quarter end (%)**:

Past Performance does not predict future returns

*Source: Financial Express, as at 31.12.2022, accumulation B share class, total return (net of fees and income reinvested.

**Source: Financial Express, as at 31.12.2022, 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 (08.02.18).

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

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.

The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in the Strategic Bond Fund involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Fund may invest in derivatives. The use of derivatives may create leverage or gearing. A relatively small movement in the value of a derivative's underlying investment may have a larger impact, positive or negative, on the value of a fund than if the underlying investment was held instead.

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