Liontrust Sustainable Future Monthly Income Bond Fund

• Q4 saw bonds sell-off aggressively, partly as fears over the US economy were diminished by the data which followed, and the market digested the US Presidential election result.
• The Fund delivered negative performance from a duration management perspective. Our long interest rate positioning proved detrimental to performance as 10-year gilt yields climbed.
• We remain constructive on the outlook for corporate bonds based on attractive all-in yields, the carry from spread and additional alpha generation from stock selection.

The Fund returned -1.5% over the quarter, compared to -0.3% return from the IA Sterling Corporate Bond sector (comparator benchmark) and -0.5% return from the iBoxx Sterling Corporates 5-15 Years Index (target benchmark)*.

Market Commentary

In the first half of the year, UK yields behaved almost in lockstep with their US counterparts, which saw 10-year yields some 70 basis points (bps) higher by the end of June, before a sharp turn lower following a significant weakening of the US labour market in Q3. This proved somewhat short-lived however, and the final quarter of the year saw bonds sell-off aggressively, partly as those fears over the US economy were diminished by the data which followed, and the market digested the US Presidential election result.

Much of the UK moves were attributable to the budget delivered by Rachel Reeves in late October, where she sailed closer to the wind with her fiscal plans than we, and the market, anticipated. The mix of policies involved greater spending commitments and a substantial increase in employment costs for the private sector, which has pushed up inflation projections for 2025. This is a story which continues to play out and is impacting UK assets as we begin 2025. The near-term could prove quite noisy, with the possibility that the government has to revise its tax and spending plans to allay market concerns. How it responds to the situation will be important for the gilt market’s credibility going forward.

More broadly however, UK economic data has continued to strike a fairly lacklustre tone in our view. Surveys on business confidence, employment prospects and overall sentiment have been quite downbeat, with the prospects of significant increases in employment costs having a sizable impact. GDP growth has disappointed, with Q3 revised to stagnation at 0.0%, and early indicators for Q4 looking sluggish also. Pay growth figures released in December were firm, however, and neatly summarised the issue for the MPC – activity appears to be stalling while inflationary pressure remains. The decision to hold rates in December was largely expected, however, the 6-3 vote split with 3 members advocating for a cut was more dovish than markets had expected. With little in the way of additional colour around the decision given the lack of press conference or accompanying forecasts, we will have to wait until February for a detailed update on the committee’s thinking. 10-year gilt yields rose a little under 60bps over the quarter, to 4.57%.

In something of an odd quirk, the yield on the benchmark 10-year Treasury bond ended 2024 at the same level as its UK counterpart, 4.57%, having risen some 85bps. One can conclude from these relative moves that gilts actually outperformed treasuries over this period, although this could reasonably be described as a ‘least ugly’ contest. As it has done for much of this year, the Treasury market set the broad tone for its developed market peers, and a number of factors combined in pushing yields higher. Firstly, the fears over labour market cracking were calmed by subsequent firmer data, while the re-election of Donald Trump to the presidency alongside a Republican sweep of Congress reinforced expectations of inflationary policies around trade and spending. The Federal Reserve then validated market moves in December, delivering a ‘hawkish cut’, with outright dissent on the Federal Open Market Committee against cutting, increases to the median ‘dot’ which signals expectations for the path of the funds rate, and a change in language to signal greater caution going forward.

The Eurozone was something of an outlier in this quarter, although yields did still rise over the period, with 10-year Bunds around 25bps higher at 2.37%. This outperformance was attributable to further weakness in the growth outlook, and fears over what prospective tariffs from the US might do to already struggling manufacturing sectors in Germany and France. While Q3 growth did actually hold up reasonably better than initial expectations, signals from PMIs and other surveys have suggested concern over the future path of growth. Meanwhile, political volatility in France and Germany has done little to suggest these two important economies will have governments likely to galvanise the bloc’s prospects. The ECB has shown greater confidence in the path of rates being lower, which is to be expected given the concerns over growth and with core inflation somewhat lower than in the UK and US. 

Duration

The Fund delivered negative performance from a duration management perspective. Our long interest rate positioning proved detrimental to performance as 10-year gilt yields climbed 56bps in the quarter, reaching 4.57% in the year end.

We started the quarter with an overall duration positioning of 0.75 years overweight to the benchmark. This entails a cross-market 0.25 years long position in 10-year UK gilts along with a short position of 0.25 years in 10- year German Bund futures, which we initiated in Q2 last year and we kept through to year end. The rationale of the trade was that gilt yields are further away from our fair value target than Bund yields are. Our conviction has now strengthened given the recent underperformance of gilts and the difference between the two spiking from 1.7% to 2.20%.

During the quarter we added 0.25 years of duration on two instances. The first followed the gilt sell-off in the beginning of the quarter when yields surpassed the 4% level, while the second addition coming when gilts reached 4.5%.

This means that we ended the year with an overweight of 1.25 years of duration relative to the benchmark.

Credit Performance

The Fund’s credit positioning had a positive impact on the Fund’s performance, which came from stock selection. Sector selection was slightly negative. In general, credit performed strongly, with sterling investment grade spreads ending the quarter 23bps lower. High yield also performed strongly with spreads tightening by 45bps, indicating the strength of the credit market despite the turbulent macro environment.

Within our portfolio, the biggest outperformer was real estate which delivered positive returns from both sector and security selection. REITs tightened significantly over the quarter, hence our moderate overweight position to the sector proved beneficial. From a stock selection perspective, the fund benefitted from our holding in Annington Funding, following its agreed sale of its Married Quarters Estate back to the Ministry of Defence. Annington subsequently announced a buyback for its outstanding bond issues, at an attractive uplift from their pre-announced levels.

In the financials space, banks and insurance continued their strong performance and our stock selection contributed positively to performance. We remain constructive on tier 2 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.

Our underweight positioning to utilities was negative over the quarter, as the sector tightened versus the benchmark. However, this was limited by positive stock selection within, with limited exposure to names impacted by President Trump’s potential sustainable energy reforms and positive exposure to higher quality UK water names which outperformed with the release of Ofwat’s Final Determination – a regulatory decision that sets pricing decisions over the next five years.

Trading Activity

Credit trading activity was busy over the quarter, amid a backdrop of volatile rates markets.

In financials, we performed a number of relative value switches. Following strong performance, we switched out of Aviva perpetual bonds into the long-dated bonds following strong performance, and switched out of US dollar denominated BNP AT1 securities into the euro denominated AT1s.

Outside of performance-driven trades, we extended our position in Annington into a bond that offered better protection in case of an adverse outcome from the legal battle. Later in the quarter, we participated in a tender for our position, after the company made the decision to sell its portfolio of properties to the Ministry of Defence and take back outstanding bonds. The takeout level was attractive and the upside of our new bond was higher than it would have been if we stayed in the original position.

Issuance activity was higher over 2024, and last quarter we participated in a number of new issues. We added the inaugural bond from Kingspan. Kingspan is a company that offers a range of insulation, roofing and cladding solutions with exceptionally sustainable products which we believe will help decarbonise our economies by reducing the energy required to keep our buildings at the correct temperatures. We also participated in a new issue from Center Parcs. This was funded by selling out of our position in Whitbread. Center Parcs operates high quality, family holiday destinations in the United Kingdom and Ireland. It encourages domestic travel which reduces the carbon impact of holidays and is making strong progress in reducing their own emissions.

We disposed of our position to Cadent Gas, following fears of declining volumes and increasing electrification leading to stranded asset risk. Valuations between gas and electricity networks have narrowed, so we reinvested the proceeds into a new holding in Electricity North West. Electricity North West is an electricity distribution network that assists both in adding new renewable connections to the grid and also in allowing those in their area to access low carbon technology like electric vehicles or solar panels.

Outlook

We remain constructive on the outlook for corporate bonds based on attractive all-in yields, the carry from spread and additional alpha generation from stock selection. We are cognisant however that spreads have performed strongly and are now looking in expensive territory, although there is scope for further tightening.

There has been a deterioration in overall credit fundamentals, such as interest cover metrics, as increasing all-in cost of new financing has resulted in an upward trend in blended funding costs and a corresponding reduction in interest cover. Leverage has returned to long run averages, reflecting an increase in debt levels exceeding lower EBITDA growth, due to a combination of lower revenue growth and rising costs. However, both of these metrics remain at healthy levels.

We therefore think that additional performance will be generated from credit selection, an area where we have delivered outperformance over recent years. We are exposed to high quality names that on a relative basis offer attractive value and good exposure to the asset class. This is reflected in our overweight positioning to financials through both the banks and insurance sectors, overweight telcos which we view as a high-quality resilient sector. We expect there to be potential for additional capital upside from declining government bond yields and the Fund retaining its long interest rate position.

When credit spreads are combined with still elevated gilt yields, all in yields over 5% still present an attractive opportunity. Currently, our Fund’s gross redemption yield is 5.60%, stemming from high quality investment grade credit.

For 2025, we expect a low growth economic environment, and even though markets have been recently challenged with persistent inflation and higher rates for longer, we believe the UK will start showing signs of weakening economy sooner than the market expects. Growth has disappointed in the latter half of 2024, and the recent market moves could further hamper its progress. With a labour market which looks to be continuing to loosen, and broad economic sentiment foundering, we think yields will end 2025 lower than they have started. Over the longer term, we expect gilt yields to fall as the weaker underlying fundamentals in the UK economy come into sharper focus.