Liontrust SF Monthly Income Bond Fund

The Fund made a flat return over the quarter, compared to 0.4% return from the IA Sterling Corporate Bond sector (comparator benchmark) and 0.2% return from the iBoxx Sterling Corporates 5-15 Years Index (target benchmark)*.

Market review

The first quarter of 2024 was characterised simultaneously by a continuation and a reversal: a continuation of the volatility seen in 2023, as markets try to price the likely path of short-term interest rates in the face of incoming information; and a reversal of the sudden repricing in December which had seen UK 10-year yields sink as low as 3.5% at one stage.

As the initial impact dissipated following the Fed’s December ‘pivot’ and weak UK inflation data, yields began the year trending higher, in what would remain the broad theme for the quarter, albeit punctuated by sudden moves in either direction. This points to the market’s nervousness amid the uncertainty of outcomes and resultant paths that policymakers will choose, or be forced, to take.

Having risen around 10 basis points (bps) off their lows in the last week of 2023, 10-year gilt yields pushed higher in January and February, peaking around 4.20%, before retreating in March and ending the quarter below 4%. There were similar moves in the US and Europe, where the majority of economic upside surprises came from.

This has seen markets push back their pricing of the first rate cuts from spring to summer. Still, there has been enough flexibility in the data to allow the three major central banks to point to impending cuts in the second half of 2024, although they remain guarded over the magnitude and frequency of any easing cycle. The lingering memories of the recent inflation spike no doubt cast a doubtful shadow over any urges to move too quickly.

Most recently, the Fed elected to leave their dot-plot unchanged, continuing to signal the most likely scenario being three hikes this year. Chair Powell has seemed keener to point to the risks of overly restrictive policy on the economy, even when pushing back on cuts in March, as he did following the Fed’s January meeting. Part of the reason for the moves higher in yields was the bumper upside surprise in non-farm payrolls for January, although this was largely revised downward in the March data release. Nevertheless, economic data has been firm, with inflation also surprising to the upside in both January and February. To us, the US looks like the most vulnerable to a further delay in rate cuts, at least from a fundamental perspective, however the decision of the Federal Open Market Committee (FOMC) also depends on its collective view of how restrictive the current monetary policy stance is.

The UK was confirmed as having been in technical recession in the latter half of 2023, although initial signs from Q1 appear to show this will be short-lived and shallow, with monthly GDP growth again tracking above 0.0%. The labour market continues to loosen slowly, as vacancies and wages remain on a downward trend, albeit from admittedly elevated levels. Given the lack of reliability in the ONS Labour Force Survey data, other measures have gained greater prominence and appear to confirm the easing of pressure in the labour market. Inflation data has been mixed, with December a modest upside surprise, followed by a downside miss of similar magnitude in the January numbers, and another small miss in February inflation. The ongoing bifurcation of inflation, with goods inflation weakening further to 1.1% and services stickier around 6%, is a theme seen in most advanced economies. There were methodological changes in the most recent UK print which skewed services inflation higher than it otherwise would have been, but it remains in line with Bank of England forecasts. The most recent MPC meeting saw no votes for a hike for the first time since the hiking cycle began, and an explicit acknowledgement that the Bank rate could be cut and still remain restrictive.

The European Central Bank (ECB) has done little to push back on market pricing throughout the quarter, with president Lagarde pointing to the impact of rate hikes in softening demand, and strongly hinting towards June as the likely time for a first cut, given the accumulation of data the Governing Council will have by then in order to make its judgment. Although such data has generally beaten expectations, this comes from a position of relative weakness, with growth in the euro area looking fairly anaemic over the next two years, and less labour market pressure than has been observed on the other sides of the Channel and Atlantic.

Fund performance

The Fund delivered flat performance in absolute and negative performance in relative terms, driven by yields retracing last quarter’s moves given the Fund’s long interest rate position relative to the benchmark. However, this was slightly offset by credit spread compression and stock selection.

Our active duration management was muted this period. We started the quarter being 0.75 years long to the UK with yields standing at 3.54%. However, stronger-than-expected economic data released at the beginning of the quarter pushed yields close to 4%, at which point we increased our duration positioning by 0.25 years. This brought the overall overweight position to 1 year, which we kept in place until the end of the quarter. The UK 10-year finished the quarter at 3.93%, which remains above our fair value target of 2.5-3%.

Our credit positioning performed strongly over the quarter, and it was primarily driven by our stock selection of T2 subordinated securities within the insurance and banking sector, along with stock selection in financial services. Performance from sector allocation was mixed. We strongly benefitted from our overweight position to insurance, although this was offset by our allocation to gilts, our overweight position in telecoms and idiosyncratic risk in the Utilities sector.

Overall sector positioning has not changed. We remain underweight in utilities, consumers, and industrials. Recently, we have made small moves to reduce credit beta given credit spread tightening. The continued resilience in the macroeconomic environment, coupled with low recession risk, has led to greater than expected credit spread compression with the sterling corporate index moving tighter by 20bps to finish the quarter at 114. As a result, we have been moving up the capital structure in financials by rotating from tier 2 into senior paper within favoured issuers.

Trading activity

Trading activity remained high over the quarter, with modest moves lower in rates leading to some opportunistic borrowing. Relative value trades were also high, as we reacted to spreads compressing throughout the quarter.

In financials, we participated in trades that reflected our thoughts on valuations given strong performance and spread tightening. As mentioned previously, we sold out of tier 2 paper and bought similar maturity senior paper for both HSBC and Lloyds.

Elsewhere, with many financials’ issuers coming to market, we participated in a new issue from Société Générale, which was funded by disposing of Coventry Building Society perpetual bonds. Later in the quarter, we regained exposure to Coventry through a new issuance of senior paper. On a relative value basis, we also performed switches within issuers like M&G, and from BPCE into Santander.

Outside of financials, we diversified through adding a new holding of Cadent Gas to the Fund. Cadent provides exposure to resilient, regulated cashflows at a comfortable leverage and spread pickup to electricity network peers. We added a new longer dated holding from Scottish & Southern Energy, funded from our existing holding of their hybrid bonds, which looked fully valued as it approached its call date. We also lengthened our Anglian Water position into a new issue that came at an attractive level.

On disposals, we reduced idiosyncratic risk by completely exiting out of Mobico, having sold its hybrid bonds last quarter. We also made the decision to exit from Thames Water in February. Our analysis on Thames Water was part of a wider UK water sector engagement exercise and review. We met with each of our holdings and the higher leverage, poor operational performance and challenged outlook from Thames Water contributed to our decision to dispose of our holding. We reinvested the disposal proceeds into more defensive names at attractive valuations, such as Suez and Vonovia.

Outlook

Economic data releases over the quarter surprised to the upside, which led to a repricing and pushed back rate cut expectations from March to June. However, central banks have been indicating their confidence over cutting rates in the second half of the year, which is supportive for fixed income valuations, while also supporting the likelihood of a soft economic landing.

At the same time, we are yet to fully see the impact of higher rates filtering through to the real economy and expect that this will only accelerate. Inflation has broadly shown signs of softening and we expect it to fall further amid weaker consumer demand due to the ongoing transmission of higher interest rates. The latter will also result in weaker economic growth, ultimately making central banks higher for longer narrative unsustainable.

Therefore, we still see significant value in government bonds, with continued upside as we are above fair value, and we maintain a long duration position.

While corporate spreads have performed strongly in the first quarter of 2024 and many credit markets are on the tighter end of their historical ranges, we continue to believe that corporate credit offers value, with all-in yields above 5.5%.

While we expect economic growth to be challenged looking forward, we continue to believe that corporate bonds can perform well against this backdrop. Corporate fundamentals remain robust, with low levels of leverage, high interest coverage and ample liquidity. Though corporate fundamentals will inevitably weaken through a period of economic deterioration, the strong starting point significantly above long-run averages, means that investment grade companies should be able to navigate this period. Defaults are expected to trend lower towards the long-term average over 2024, so current levels of return more than adequately compensate for the lower inherent risks and still provide an attractive entry point.

In terms of sector positioning, we remain underweight to consumer sectors due to the delayed impact of interest rate hikes still to have their full impact. The Fund remains overweight financials, based on attractive valuations and this is expressed through overweight positioning to both the banks and insurance sectors. We also remain overweight to telecoms due to their resilience and growth characteristics and remain underweight to the utilities sector.

Overall, we remain constructive on the prospects for corporate bonds, based on attractive valuations and strong fundamentals.

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

*Source: FE Analytics, as at 31.03.24, B share class, total return, net of fees and interest reinvested.

**Source: FE Analytics, as at 31.03.24, primary share class, total return, net of fees and interest reinvested.