Liontrust SF Corporate Bond Fund

• Markets are now pricing in more central bank easing than earlier in the year, but mixed economic data has led to volatility across bond markets in Q3.
• The Fund delivered positive performance from a duration management perspective, with its long interest rate positioning contributing positively to performance. The Fund’s credit positioning also contributed significantly to overall performance.
• We believe that current spreads offer sufficient compensation for fundamental risk, and investment-grade credit offers an attractive return profile given our outlook for both the asset class and the broader economy.

The Liontrust SF Corporate Bond Fund returned 3.1%* over the quarter, compared with the 2.3% return from the iBoxx Sterling Corporate All Maturities Index and the average return from IA Sterling Corporate Bond sector of 2.5% (both are comparator benchmarks).

Market review

We mentioned in our previous quarterly update that the path for financial markets would likely be a bumpy one, and that sentiment has certainly rung true over the last three months. While there has been a decisive shift towards markets pricing more central bank easing than earlier in the year, the progression of economic data has been less straightforward, resulting in volatility both within and across the bond landscape.

The US has largely continued to lead the narrative in terms of the outright direction of yields among developed markets, with incoming data again providing competing narratives, with evidence of strong economic foundations alongside the suggestion of potential threats. The weakness has been largely concentrated in the labour data, with the August labour market report (released in early September) generating a sustained rally across bond markets. This concern was then seen as validated by the Federal Reserve’s decision to reduce the funds rate by an initial 50bps (basis points), having held out for longer than many other DM central banks.

While the market expected only a 25bp reduction, Chair Powell sought to reassure markets that the reason for the outsized move was not that the Fed was overly concerned about the underlying economy, but rather that this was an exercise in prudence: starting rates on a path to neutral and easing from a restrictive rate, having largely achieved the main tenets of its dual mandate. The incoming data will dictate the speed of further moves and ultimately the ‘terminal’ level of interest rates, but for now markets have largely bought into this narrative of a gradual cutting cycle. Having been as much as 80bps lower than where they started the quarter, 10y US yields ended September around 3.75%, some 60bps below their opening level.

Watching UK bond markets has remained a somewhat frustrating activity, as they have retained their strong correlation with the US as yields rose, but struggled to maintain that relationship during rallies. This is partly attributable to the mix of economic data outturns, which have shown firmer GDP growth (flattered by government spending), alongside some progress on services inflation and weakness in confidence measures. We remain convinced that UK yields should fall, as we believe the economic backdrop is not as strong as in the US, and if anything, will prove more akin to the Euro area longer-term. The Bank of England (BoE) reduced rates by 25bps in August, but emphasised ongoing data dependence, striking a decidedly cautious tone. The ongoing uncertainty over the upcoming Budget has also done little to help the UK bond market of late, with fears of increased issuance and the risk of fiscal largesse fuelling hesitation among market participants. We remain sceptical that the government will be willing to risk its fiscal credibility to such an extent that it engenders further marked volatility, such as we saw in late 2022, though risks do remain.

Europe, meanwhile, has seen a more marked deterioration in economic data. The manufacturing sector, in particular in Germany, has looked under severe pressure, with some forecasters looking towards potential German recession in the coming quarters. The ECB cut by 25bps for a second time in September, and having initially reiterated its data dependence – that data is now suggesting further easing at the next meeting in October.

Performance

Duration

The Fund delivered positive performance from a duration management perspective. Our long interest rate positioning contributed positively to performance as 10-year gilt yields fell by 17bps in the period.

We started the quarter 1.25 years overweight the UK relative to the benchmark. This is alongside a cross-market position of 0.25 year long to the 10-year UK gilt futures versus a corresponding 0.25 year short position in 10 year German bund futures, which we initiated last quarter. Even though gilt yields underperformed in late September, our view remains intact that gilt yields are further away from fair value than bund yields. UK markets continue to exhibit higher correlation to the US, a relationship we think will normalise once UK economic data weakens.

The level of duration was maintained until the rally in mid-September. Weaker economic data released at the time spurred uncertainty over whether central banks can keep rates high for longer, leading to a rally that saw the UK 10-year gilt yield drop to 3.75%. At this point we reduced duration by 0.25 years, bringing overall duration to 1 year overweight at quarter end.

Credit

The Fund’s credit positioning contributed significantly to overall performance. Both sector and security selection were positive for the period. In general, credit performed strongly, with sterling investment grade (IG) spreads ending the quarter marginally lower. Lower rated credit outperformed, with BBB spreads tightening by 3 bps while sterling high yield tightened by 68bps. The overall level of IG index spreads however remains at its tightest level compared to historic records, showing its resilience for yet another quarter.

Within our portfolio, the biggest sector outperformers were utilities, banks and insurance. In utilities, acute issues in the UK water segment have pulled spreads wider. However, our big underweight position on the sector has been a source of positive attribution. Security selection also contributed, largely from not owning Thames Water. Following a negative draft determination and near-term liquidity concerns, the ratings agencies downgraded Thames Water, leading to widening spreads and Thames Water exiting the Iboxx IG indices at the wides.

In the financials space, banks and insurance continued their strong performance this quarter due to improved and strong fundamentals. Supply dynamics in senior paper have been particularly strong in September, although less so in tier-2 securities, which supported technicals within the subordinated sector. This has helped our overweight position and has added to performance. We remain constructive on T2 bonds and hence we maintain our current positioning. Also, our holding of the BNP discount bond has continued to perform well this quarter on expectations of it being called, which were a result of a similar security, a HSBC legacy bond, being called earlier this year.

On the other hand, real estate negatively impacted our performance. The losses were primarily due to security selection, although our slight overweight in the sector partially offset this. This quarter, the real estate market experienced a “risk-on” phase with higher beta names recouping most of their losses. Our exposure however is in more defensive names with fewer governance issues, which led to underperformance in security selection.

Trading activity

Trading activity remained lower throughout the quarter. Fewer issuers came to market in the first half of the quarter, although issuance activity saw a surprise uptick as the quarter progressed.

In financials, we continued to top up across favoured names. Outside of financials, we switched between senior Severn Trent paper to a similar tenor alternative, which offered an attractive pickup in spread. We also sold our position to bonds issued from the Anglian Water holding company. Following the default of the Thames Water holding company, we were uncomfortable with the potential risks with the structure, and the lack of information from Ofwat, the industry regulator, on financing payments from it. We reinvested proceeds into Anglian Water operating company bonds, which sit under its ‘whole business securitisation’ structure and offers significantly stronger protections.

Outlook

Our thesis on developed markets remains largely unchanged from earlier in the year. While the initial part of the year showcased the strength of the US economy, recent developments indicate a shift in market pricing. As a result, the Fed’s rate cut, and ECB’s cautious approach reflect a broader trend of easing monetary policy.

In the UK, we continue to think that economic backdrop is fundamentally weaker than in the US. Despite stronger than expected data earlier in the year, consumer outlook remains uncertain, and although headline inflation has declined, services inflation progress is slower and remains high. We still think there are encouraging signs on this front however, with labour market cooling continuing across a variety of indicators, which we think should feed through to demand and weigh on services inflation going forward.

European and UK corporates are still in a strong position, characterised by low leverage and ample liquidity. We believe these companies are well positioned, especially as we enter a phase of monetary easing.

Credit spreads remained stable this quarter, largely due to supportive fundamentals underpinning corporates. Although the potential for further spread tightening is limited given current levels, progress on inflation and lower interest rates should continue to provide a supportive backdrop to corporate credit. Supply dynamics saw a significant uptick in September, which was an unexpected development in both sterling and European markets. With year-to-date sterling supply much lower than anticipated, this was a notable shift in trend.

We believe that current spreads offer sufficient compensation for fundamental risk, with all-in yields hovering around 5.5%, and investment-grade credit offering an attractive return profile given our outlook for both the asset class and the broader economy.

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

*Source: FE Analytics, as at 30.09.24, total return, net of fees and interest reinvested.

**Source: FE Analytics, as at 30.09.24, primary share class, total return, net of fees and interest reinvested.

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.

All investments will be expected to conform to our social and environmental criteria. Bonds are affected by changes in interest rates and their value and the income they generate can rise or fall as a result; The creditworthiness of a bond issuer may also affect that bond's value. Bonds that produce a higher level of income usually also carry greater risk as such bond issuers may have difficulty in paying their debts. The value of a bond would be significantly affected if the issuer either refused to pay or was unable to pay. Overseas investments may carry a higher currency risk. They are valued by reference to their local currency which may move up or down when compared to the currency of the Fund The Fund can invest in derivatives. Derivatives are used to protect against currency, credit or interest rate moves 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. The Fund uses derivative instruments that may result in higher cash levels. Cash may be deposited with several credit counterparties (e.g. international banks) or in short-dated bonds. A credit risk arises should one or more of these counterparties be unable to return the deposited cash. The Fund may encounter liquidity constraints from time to time. Participation rates on advertised volumes could fall reflecting the less liquid nature of the current market conditions. Counterparty Risk: any derivative contract, including FX hedging, may be at risk if the counterparty fails.

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