Liontrust GF Absolute Return Bond Fund

The Liontrust GF Absolute Return Bond Fund (C5 share class) returned -0.5% in sterling terms in Q1 2021 and the IA Targeted Absolute Return, the Fund’s reference sector, returned 0.9%. The Fund’s primary US dollar share class (B5) returned -0.4%.

The aggressive selloff in sovereign bond markets was the driver of a small drawdown for the Fund in Q1. We did not manage to generate enough alpha in the quarter to offset the headwind from this beta. With government bond yields finishing March significantly higher, the Fund should not face as large a headwind going forwards so we remain confident we can produce positive absolute returns over rolling 12-month periods.

Market backdrop

The forward-looking nature of financial markets meant that the key topic for the first quarter was reflation. Delays in vaccine rollouts were viewed by the markets as being short term in nature, with the economic recovery post crisis being the focus. January’s Georgia runoff elections produced a Democratic clean sweep, with the Senate split 50/50 Vice President Harris has the casting vote. This further catalysed the reflationary narrative as an initial emergency fiscal package was passed and a further infrastructure bill is being worked on.

Bond markets had been rigged by central banks to be very expensive and were thus vulnerable to a rise in inflation expectations. US Treasury 10-year yields rose 0.83% during the quarter. With the starting yield so low, this produced the worst quarterly return for US Treasuries since 1980.

A spike in US inflation in April and May is mathematically inevitable due to the year-over-year change in energy prices; headline consumer price inflation (CPI) could reach 3.5% with core around 2.5%. The more important consideration is the direction of CPI in the months and years after this spike. We believe that inflation will prove to be sticky above 2% in the US for a few reasons. Firstly, there is a lot of economic stimulus still working its way through the system, both fiscal and monetary in nature. Secondly, related to that point, there is a global recovery gathering pace creating shortages in inputs; sustained higher producer price inflation (PPI) will feed through to CPI.

Inflationary pressures in services had dropped during the crisis for obvious reasons connected to lockdowns, as the leisure sectors re-open those businesses that have survived will seek to rebuild profit margins and balance sheets through raising prices. There is a huge pent-up desire for leisure activities; demand will outstrip supply, even with some consumers likely to be more cautious about returning to life in public spaces again.

The classic inflationary feedback loop is wage inflation. The nuance we presently have is that additional income is not necessary to boost demand. There was already over US$2 trillion of excess savings in the US alone, and that was before the latest Biden stimulus cheques arrive. In aggregate, this savings pile will be spent over the next few years, providing a strong impulse to consumption. Wage inflation itself will actually fall as the leisure sectors reopen, entirely due to the industries involved employing a greater proportion of lower paid labour; this is a simple averaging impact.

Any form of protectionism, or trade barriers erected, will structurally add to price pressures too – a reversal of the disinflationary tailwind that globalisation has created for the prior decades. Technological advancements will continue to exert downward pressures on prices in most industries; this mega-trend will not dissipate, but there are enough other factors at work to conclude that an overshoot of inflationary targets should occur for the next few quarters.

Financial markets are involved in a battle, or maybe one could call it a negotiation, with the Federal Reserve about how high Treasury yields can go until the Fed intervenes. The Fed has explicitly stated that it would like to see inflation above 2% for a sustained period to compensate for prior shortfalls; that is what average inflation targeting (AIT) means. With the Fed being likely to tolerate higher inflation, what would the trigger be for it to want to cap or reduce market yields? A steeper yield curve can aid growth through boosting the banking sector’s profitability and investor confidence in the recovery. It is only when yields have risen enough that it begins to either choke off growth, or threaten to, that the Fed would be catalysed into action. The two most prominent transmission mechanisms would be a significant slowdown in US housing activity relating to higher mortgage rates, or a taper tantrum that led to a 10% plus fall in US equity indices; the latter is the most likely trigger in my opinion.

It would be remiss of me not to mention the ECB, which has increased the pace of its PEPP purchase program to alleviate upward pressure on bond yields. The ECB has not yet mentioned increasing the size of the PEPP, so this is presently just a front-loading of the purchasing. In the broad, eurozone inflation might not overshoot the 2% threshold, but similar pressures to those seen in the US are also building. As vaccine supply picks up in Q2, the battle between bond markets and the ECB might begin in earnest. In the meantime, ECB officials will be taking pleasure in the rise in inflation expectations as vindication of the markets’ view on their policies for the economic recovery. The ECB’s preferred measure is to look at 5-year, 5-year forward inflation swaps, which takes out the idiosyncratic “noise” in the early years. This measure shows the expected average level of inflation over five years, beginning five years in the future (so covering a period 5 years from now until 10 years from now). The rise in market expectations here is clear to see in the chart below. Ultra-loose monetary policy combined with expansionary fiscal policy leading to inflation, who could possibly have predicted that?

So, for the foreseeable future, the negotiation between the financial markets and central banks will continue. Rates markets volatility and direction will be key for almost all financial assets.

Carry Component

We split the Fund into the Carry Component and three alpha sources for clarity in reporting, but it is worth emphasising we manage the Fund’s positioning and risk in its entirety. As a reminder, the Carry Component invests in investment grade bonds with <5 years to maturity; within this there is a strong preference for investing in the more defensive sectors of the economy.

Regarding the overall Fund shape, with credit spreads at tight levels the proportion of the Fund in the Carry Component has been run at about 60%. This has freed up risk budget to implement more alpha trades, particularly within Rates.

Within the Carry Component, we have a mild preference for euro-denominated credit relative to US dollar investment grade issues; this is purely based on the valuation metric of wider spreads. In particular, those bonds that are not eligible for the ECB’s CSPP buying programme tend to have slightly wider spreads; numerous US companies that have bonds outstanding in euros provide opportunities in this regard.

Alpha Sources:

Rates

The overall Fund duration^† was kept low, in the vicinity of 1-year duration exposure, during the quarter. This is below the longer-term neutral level of 1.5 years as we focussed on conserving capital as much as possible in the rising yield environment. Any interest rate exposure was a drag; fortunately, the Fund is predominately invested in the short dated 0–5-year maturity bucket, which did not suffer as much as longer-dated tenors.

Examining alpha positions: the Canadian-US box trade (long Canadian 5-year and short the Canadian 10-year both versus the US) was taken off successfully. Initially profits were taken on the 5-year leg, turning the position into a pure 10-year relative value trade; this was then closed out for a gain in this quarter.

A new cross market position was entered into: long 5-year Swiss debt relative to Germany. The differing shapes of each country’s yield curves means that the progression of time alone should enable the Swiss bond to outperform; however, the market has now moved in the Fund’s favour and we are close to taking profits.

A position the Fund lost money on was going long UK debt relative to France. Too much emphasis was being placed on the UK’s faster vaccination rollout and not enough on the medium-term economic damage that Brexit is causing. When the French vaccination programme catches up the differential between the two yields should start to narrow. Although we do believe this trade should make money this year, the position hit our sell discipline level and was closed out. We will watch closely for a better re-entry level once the cooling off period has expired.

Allocation

There were no market-neutral allocation positions taken during the quarter. Valuation discrepancies tend to occur in periods of credit market dislocation. However, the Fund did use its risk budget to buy some shorter-dated high quality, high yield; the one part of the market that we believe offers compelling value. We like the decent spread “breakeven” of bonds with an average maturity of 5 years and a credit spread of approximately 250 basis points; one can afford to have spreads widen by 50 basis points over the rolling year before you would lose money. As a reminder, the high yield limit in the Fund is 10% as it is a low-risk Fund; these are quality companies such as Charter, Ziggo, Grifols and Catalent.

Selection

The majority of the selection picks produced a small amount of spread tightening during the quarter but individually there were no standout performers. We took the rest of the profits on the long-dated Eli Lilly bonds in euros. In February, a new issue gave the opportunity to buy a 15-year Becton Dickinson bond, but the allocation we received was poor, so we locked in the gain just after quarter end. In the US dollar market, the Fund purchased a single A rated tier 2 bond issued by Zurich Insurance which offers good long-term value.

Discrete 12 month performance to last month end**

Discrete data is not available for five full 12 month periods due to the launch date of the portfolio.

*Source: Financial Express, as at 31.03.21, total return (net of fees and interest reinvested), C5 class.

**Source Financial Express, as at 31.03.21, total return, C5 class. Discrete data is not available for five full 12 month periods due to the launch date of the portfolio

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. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team 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 Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

DISCLAIMER

The information and opinions provided 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. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.