Liontrust Strategic Bond Fund

The Liontrust Strategic Bond Fund returned -1.8%* in sterling terms during October. The average return from the IA Sterling Strategic Bond sector, the Fund’s comparator benchmark, was -1.4%.

Market backdrop

US labour market data at the start of October set the scene for a weak month for sovereign bonds. Nonfarm payrolls were reported to have grown by 254k in September; the first revision to this reduced it down to 223k but that is still a strong number. The downward trend in the six-month moving average of nonfarm payrolls remained intact but it was undoubtedly a strong data release compared to forecasts. Outside of one month’s data, the bigger picture is that the US labour market has moved much closer to being in balance. Most of this has so far been achieved through a combination of hiring falling and increased supply (through recovering participation rates and a surge last year in net immigration). It is not plain sailing as smaller businesses have felt the impact of higher interest rates much more than their larger cousins – with margins under pressure, this impacts the demand for labour.

The Federal Reserve (Fed) has sometimes described the labour market as “non-linear,” effectively meaning when unemployment goes up it can suddenly accelerate. With consumption still robust, I continue to expect unemployment to peak in the 5-6% region in this cycle. 

On this side of the Atlantic, in a unanimous decision the European Central Bank (ECB) cut interest rates by 25 basis points (bps) to 3.25%, as anticipated by all economists and market pricing. The rational for the cut was based on the ECB’s “…updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission.” As many may recall, at the September ECB meeting press conference President Lagarde stated that there was a “…relatively short period of time” between then and the October meeting which strongly hinted toward a pause at this October meeting; so, what changed? Firstly, and most importantly, inflation data surprised to the downside, including further progress being made on sticky services inflation. Secondly, as well as hard economic data, there has also been a downturn in soft data such as the fall in the PMI surveys. Economists and the markets had adjusted to the data, along with strong hints from ECB governors, such that the interest rate cut this week was 100% forecast.

The recent weaker data has accelerated the pace at which the ECB will seek to return to a neutral monetary policy stance. With monetary conditions still characterised as “restrictive,” updated economic forecasts will empower a faster pace of rate cuts. I think the market will turn to focus on estimating where neutral is and my best estimate for the Eurozone is that it is in the high-1% to 2% area. For the market to start to look for policy to move to loose territory it would take a further deterioration in the economic data and/or an exogenous shock.

Finally, in a continued reminder of the amount of supply the bond market is having to absorb, we had the first Labour budget for 14 years in the UK. I am not going to go into the minutiae of any of the changes, but rather focusing on the bigger picture. The cumulative tax rises by 2027/28 are expected to reach an annual rate around £40 billion; over 60% of this is attributable to the change in employers’ national insurance contributions (NIC). Spending is set to increase by almost £70 billion a year over the next five years, albeit two thirds of this is current spending and the other third capital spending. The Office for Budget Responsibility (OBR) estimates that borrowing will increase by £140 billion over the next five years relative to the March budget projections; on this I must note that an increase was inevitable as March’s spending projections had zero credibility. I also note that Chancellor Reeves has left herself only a small buffer of £9.9 billion, meaning there is very little room for error in the plans. 

Overall, it was an expansionary budget with spending going up by more than taxes. The tax burden is set to drift upwards to 38.2% of GDP compared to the prior trajectory of around 37.1%. The OBR estimates the size of the state by the end of the decade to be about 44% of GDP. While there will be a boost to growth in the next few years through the front-loading of extra current government spending, the longer-term impact is more mixed. Hopefully, the capital investment will lead to greater productivity gains and higher economic capacity; this is something we’re unable to judge for a few years. Also, there will be some classic economic “crowding out” of the private sector. On the higher employer NICs, if these are passed through to customers via price increases then they are clearly inflationary. However, our gut feel is that more of the cost will be absorbed and medium-to-larger companies (the increase is not binding for very small companies) will end up shedding staff either through redundancies or natural attrition. 

The rise in gilt yields due to the budget was a rational market reaction in isolation; economic growth will be higher than previously forecast and there is the aforementioned huge amount of extra supply for the bond market to absorb. However, in the build up to the budget, the gilt market had already hugely underperformed other sovereign bond market and I would argue that a large portion of the UK term premium (or, to cut through jargon, extra risk priced into gilts) can now start to fall. We are global developed market fixed income managers, so the UK is only a small part of our investment universe; furthermore, we psychologically tend to avoid gilts to avoid accusations of home market bias. Presently, we believe gilts are very cheap both in outright terms and relative to other sovereign bond markets.

Fund positioning and activity

Rates

The Fund’s duration was increased during the month to finish October at 7.5 years of exposure. When the differential between gilts and bunds was close to 200bps we switched some German duration into the UK. The spread between New Zealand sovereign bonds and US Treasuries narrowed significantly during October; we took profits on half of the Fund’s position. This leaves the geographic split of duration as 3.5 years in the US,     -0.7 years in Canada, 0.5 years in New Zealand, 1.7 years in the Eurozone, and 2.6 years in the UK. As a reminder, we continue to think that yield curves will steepen further. The Fund’s net duration exposure in the 15+ year maturity bucket is zero; we prefer short-dated and medium-dated bonds. 

Allocation and selection

Credit spreads remain expensive by historic standards; the Fund is underweight with 41% in investment grade (48% in bonds minus a 7% overlay) and 14% in high yield (20% in bonds minus a 6% overlay), compared to neutral levels of 50% and 20% respectively. Credit fundamentals remain robust. We are just awaiting a better valuation opportunity to increase exposure.

At the stock level, profits were taken in a Bank of New York Mellon subordinated bond which had become fully valued. Other credits that had reached tight spreads and were sold accordingly included AIA, Chorus, Aggreko, and Julius Baer. We replaced those bonds with new investment ideas in SIG, a buildings materials supplier focused on insulation, and Techem, a German metering company. Furthermore, a new issue afforded us the opportunity to buy back into Heimstaden Bostad’s bonds as our confidence in the company remaining investment grade has greatly increased and the underlying fundamentals continue to improve.

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

*Source: Financial Express, as at 31.10.24, accumulation B share class, total return (net of fees and income reinvested).**Source: Financial Express, as at 30.09.24, accumulation B share class, total return (net of fees and income 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.

The fund manager considers environmental, social and governance (""ESG"") characteristics of issuers when selecting investments for the Fund. 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 invests in emerging markets which carries a higher risk than investment in more developed countries. This may result in higher volatility and larger drops in the value of the fund over the short term. 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.

DISCLAIMER

This is a marketing communication. Before making an investment, you should read the relevant Prospectus and the Key Investor Information Document (KIID), which provide full product details including investment charges and risks. These documents can be obtained, free of charge, from www.liontrust.co.uk or direct from Liontrust. Always research your own investments. If you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances.

This 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. Examples of stocks are provided for general information only to demonstrate our investment philosophy. The investment being promoted is for units in a fund, not directly in the underlying assets. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice.