Liontrust GF SF European Corporate Bond Fund

The Fund returned 0.4% in euro terms over the quarter, outperforming the iBoxx Euro Corporate All Maturities Index’s -0.8% (which is the comparator benchmark)*.

This strong relative performance was primarily driven by the Fund’s underweight interest rate risk position, which benefited from the aggressive selloff in government bonds. The sharp rise in bond yields was fuelled by investor concerns over potential earlier-than-anticipated tightening of monetary policy in response to economic growth and inflation expectations being revised materially upwards. Central banks sought to calm market concerns over re-inflation pressures, but it was not enough to appease sceptical investors with yields rising sharply. Given the extent of stimulus packages and significant increase in their debt burden during the pandemic, governments are keen to keep borrowing costs low.

US Treasuries led the way, with 10-year yields increasing 83 basis points over the quarter to 1.74%. The UK followed suit, with 10-year gilt yields rising 65bps to 0.84%; the move was less pronounced in Europe, although German 10-year Bund yields still rose materially, increasing 28bps to reach -0.29%.

Despite pressure from rising yields, corporate credit spreads remained remarkably resilient, finishing the period tighter than pre-pandemic levels, with notable exceptions among some of the more heavily impacted industries such as airlines. Valuations look set to test investors’ resolve as we approach previous all-time tights, although the unprecedented scale of, and ongoing commitment to, fiscal and monetary support measures continue to provide a positive environment for credit.

As a result, the Fund’s credit portfolio also contributed strongly to the outperformance, through a combination of sector allocation and stock selection. Our overweight in financials was a particularly strong contributor, with banks set to reap the benefits from higher yields, while stock selection within the insurance sector was positive as subordinated holdings in names such as Axa, Phoenix Group, Swiss Reinsurance and Zurich were among the top performers. There was a similar story in non-financials, as our higher-beta hybrid and high-yield holdings such as Cellnex, Telecom Italia and Orsted benefited from spread compression relative to higher-rated peers, while more Covid-exposed names outperformed defensive areas of the market and positions such Intercontinental Hotels Group produced strong returns.

Our decision to hold USD-denominated bonds was another positive, notably within the insurance sector, with the US credit market outperforming sterling and euro equivalents following confirmation of a sizeable fiscal stimulus package, which the OECD estimates will take total US fiscal support to around 15% of GDP.

Overall, the first quarter proved a strong period for risk assets, which continued to rally and surpassed pre-pandemic levels, as investors became increasingly confident about global growth prospects. Accelerated vaccine rollouts, alongside stronger-than-expected economic recovery, has driven this improved outlook, which led to bond yields coming under pressure and a sharp rise over the period.

In a bid to get the pandemic under control, vaccination rollouts accelerated rapidly as we entered the year, with the UK having partially vaccinated close to 60% of the adult population by the end of the quarter and the US fast approaching 40%. More importantly, rollouts appear to be having a significant impact on infection, hospitalisation and death rates, which have all fallen sharply, and these economies are on track to continue their re-openings over the coming months. In contrast, Europe has seen a much slower vaccine rollout and infection rates are beginning to rise again, resulting in lockdown restrictions being re-introduced or extended in several countries. Progress has been hampered by delays in regulatory approvals and contract negotiations, ultimately resulting in supply shortages and exacerbated by the temporary suspension of the AstraZeneca-Oxford vaccine on concerns regarding a potential link to blood clots.

Despite concerns regarding vaccine rollouts, markets largely looked through this and focused instead on economic data releases that surprised to the upside across all regions. Notably, economic activity appears to be above market expectations as indicated by strong PMI releases. This was particularly the case in the manufacturing sector, which was buoyed by rising demand and demonstrated significant improvements across the UK, US and eurozone. Services also rebounded well in the UK and US, which is particularly encouraging given they are predominantly service-led economies, although Europe lags behind in this regard as the prospect of tighter lockdown restrictions for longer weighs on the sector.

The US was the primary driver of positive sentiment overall, as President Biden saw his bumper $1.9 trillion stimulus package approved in March. This had been eagerly anticipated after the Democrats took control of the Senate following a surprise victory in Georgia’s run-off elections earlier in the year. The newly elected President is also looking to boost infrastructure spending by more than $2 trillion, although it remains to be seen whether these plans will also be approved.

A combination of significant stimulus, vaccine rollouts and increased economic activity has led to a material upward revision in growth forecasts, while a mixture of base effects, supply concerns and pent-up consumer demand – with an estimated $2 trillion of excess savings – has driven inflation forecasts higher. This blend has seen Treasury yields come under pressure, with investors concerned the Federal Reserve will need to step in and tighten monetary policy sooner than expected in order to combat inflationary pressures.

Despite upgrading its own growth, employment and inflation forecasts, the Fed has repeatedly reiterated it expects inflation to be transitory and is happy to overshoot target levels in the near term before it normalises as base effects and supply constraints ease. This would mean interest rates remain on hold for the foreseeable future, with hikes not expected before 2024. Nevertheless, we remain somewhat unconvinced by the Fed’s stance, with inflation likely to be stickier given potential for strong growth and supply/demand trends to persist. While the Fed median may not have moved, recent meetings have seen an increased dispersion in member voting around the timing of hikes.

Similar to the Fed, the Bank of England maintained a dovish tone, with the Monetary Policy Committee citing high levels of uncertainty over the economic outlook and claiming it has no intention to tighten policy until there is ‘clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably’. While recovery has not been as pronounced in the UK, resulting in less pressure on the BoE to change its stance, the speed at which the market moved from being concerned about negative rates to discussing potential timing of hikes highlights the substantial shift in outlook.

Finally, the European Central Bank took a more reactive approach to the rise in yields, stepping up the pace of its emergency bond buying programme to combat higher borrowing costs. The Bank has taken the view that the rise in yields is unjustified given significant uncertainty remaining and the fact it also expects inflation pressures to be transitory.

Portfolio activity was relatively modest over the beginning of 2021, although we did add exposure to a number of names through the new issue market. We participated in a new issue from Prologis, the global leader in the logistics property market with $2.1 trillion worth of goods passing through its distribution centres annually, representing 2.5% of global GDP. The company has clearly made a concerted effort to incorporate sustainability into its business strategy and operations, with significant green bond issuance in recent years displaying a commitment from management to accelerating initiatives and targets. The company is set to continue benefiting from the accelerated shift to e-commerce as a result of the pandemic, given the already-large supply/demand imbalance for logistics space.

Elsewhere, we gained exposure to Canary Wharf Group via its debut bond issuance, which owns approximately 45% of the Canary Wharf estate and is the largest sustainable developer in the UK, having established over 10 million square feet of sustainable certified buildings. The bonds came at a compelling valuation, compensating for the uncertainty surrounding office space post Brexit and Covid, with the latter accelerating working from home trends. However, the company is relatively defensively positioned, with long average lease terms and more than 70% investment grade tenants, many of whose offices are UK headquarters. It also offers some of the cheapest prime rents, significantly below that of the West End and City districts.

We also participated in new issues from existing names in the fund, namely Koninklijke Ahold Delhaize and Cellnex, rotating out of existing bonds for a pick-up in spread duration at attractive valuations given our constructive view on credit markets. Finally, we have built an allocation to ‘disco’ (discount) bond securities. These are subordinated bank bonds that are past their original call date and priced well below par (trading at a significant discount, hence the disco moniker) as a result, with essentially no duration exposure given the quarterly coupon reset. The bonds exhibit low volatility, with yields well above cash levels, and changes in banking regulation regarding what constitutes a capital instrument are likely to see them called at par in future, resulting in a material capital uplift.

Against these new additions, we divested from a number of holdings on relative value grounds. We sold our holding in Unibail Rodamco despite the company recovering from its recent pandemic-driven wides, as we view the retail sector as challenged given the shift to e-commerce. The company also requires asset sales to manage its debt load at a time when retail property valuations are under substantial downward pressure. We also exited our holdings in Orange hybrids and SEB following strong performance.

We were active during the period in terms of tactical duration positioning, deciding to rotate 0.5 years of our short out of the German market into the US early in the year, on expectations of fiscal stimulus and inflationary pressures. Following the speed and size of the moves higher in yields, we elected to reduce our overall position to two years short but subsequently increased this back to three years following a retracement lower in yields. Finally, towards the end of the period, we rotated our 0.5 years UK short back into Germany, as the modest move in Bund yields versus the US and UK created an attractive relative value opportunity. The Fund ended the period with a duration short of three years relative to its benchmark Index, expressed via 2.5 years to the German market and 0.5 years to the US.

While Covid-related risks are set to remain elevated for the foreseeable future, given the potential for new strains, vaccine rollout problems and the extension of lockdown measures in Europe, markets appear prepared to look through these risks. The significant acceleration in rollout programs, which appear highly effective in reducing infection, hospitalisation and death rates, supports optimism, enabling economies to re-open swiftly and further strengthening the already faster-than-expected global recovery.

As a result, we are constructive on investment grade credit, as corporate spreads remain resilient despite rising yields, supported by robust underlying fundamentals and technicals. While fundamentals will likely suffer further after an extended period of lockdown restrictions, the re-opening of economies over the coming months, supported by vaccine developments, will see an improvement in credit metrics, driven by a strong rebound in earnings from pent-up consumer demand. We expect companies’ focus to remain on improving fundamentals, including creditor-friendly debt reduction and balance sheet repair. On the technical side, a number of positive factors persist, with central banks committed to loose monetary policy and ongoing corporate bond purchase programs, low supply given robust liquidity, extended fiscal support measures, and demand for corporate bonds as a rare source of yield for investors.

We remain committed to our high-quality portfolio, which we believe is well positioned to withstand the economic impacts as a result of the pandemic, and do not view any of our holdings as exposed to a credit event. From a sector perspective, we continue to favour insurance, telecoms and banks, with cyclical non-financials generally over-owned, expensive and/or more heavily exposed to Covid-related uncertainty.

Our outlook regarding interest rates also remains relatively unchanged, with government bonds still vulnerable to unprecedented supply and reflation risks. Despite having already risen sharply already this year, they remain broadly in line with end 2019 pre pandemic levels. As stated, we view inflation as being less transitory given unprecedented levels of pent-up consumer demand, alongside ongoing supply constraints, and combined with the strong economic growth outlook, this supports our preference to be short duration. While central bank rhetoric remains dovish to help contain government borrowing costs, this belies the underlying economic conditions, even after accounting for residual uncertainty. As such, we believe monetary policy will need to be tightened earlier than forecast to combat inflationary pressures and to be realigned with the economic outlook.

We continue to believe government bonds offer limited ability to dampen portfolio volatility and actually provide meaningful downside risk during bouts of market weakness or volatility, supporting our longstanding short duration position.

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

*Source: FE Analytics, as at 31.03.21, primary share class, in euros, total return (net of fees and income reinvested). Discrete data is not available for five full 12-month periods due to the launch date of the portfolio.

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. The majority of the Liontrust Sustainable Future Funds have holdings which are denominated in currencies other than Sterling and may be affected by movements in exchange rates. Some of these funds invest in emerging markets which may involve a higher element of risk due to less well-regulated markets and political and economic instability. Consequently the value of an investment may rise or fall in line with the exchange rates. Liontrust UK Ethical Fund, Liontrust SF European Growth Fund and Liontrust SF UK Growth Fund invest geographically in a narrow range and has a concentrated portfolio of securities, there is an increased risk of volatility which may result in frequent rises and falls in the Fund’s share price. Liontrust SF Managed Fund, Liontrust SF Corporate Bond Fund, Liontrust SF Cautious Managed Fund, Liontrust SF Defensive Managed Fund and Liontrust Monthly Income Bond Fund invest in bonds and other fixed-interest securities - fluctuations in interest rates are likely to affect the value of these financial instruments. If long-term interest rates rise, the value of your shares is likely to fall. If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds. Mentioned above five funds can also invest in derivatives. Derivatives are used to protect against currencies, credit and interests rates move 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.

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.