Liontrust Monthly Income Bond Fund

The Fund returned -0.3% over the quarter, outperforming the -0.5% return from the IA Sterling Corporate Bond sector (the comparator benchmark) and -0.9% from the iBoxx Sterling Corporates 5-15 Years Index (the target benchmark)*. 

This relative outperformance was driven by our underweight interest rate risk position, as government bond yields rose on the back of inflation fears. A hawkish turnaround from the Bank of England (BoE) saw a sharp spike higher in UK government bond yields, with 10-year Gilt yields rising more than 30 basis points (bps) to finish the quarter at 1.02%. The speed and scale of this saw the Fund benefit from its duration short to the UK, expressed through the 10-year part of the curve.

Government bonds in the US and Germany outperformed UK equivalents, with 10-year Treasury yields rising just 2bps to 1.49%, having dropped as low as 1.17% before rising sharply as the Federal Reserve also moved more hawkish in September. It was a similar story in 10-year German bunds, which were largely unchanged at -0.2% having reached a low of -0.5%, before retracing in the latter stages of the quarter. 

Strong performance from our duration short was offset by modest underperformance from the Fund’s overweight credit position. While sector allocation was positive, with our overweight to financials set to benefit from a rising interest rate environment, security selection was negative over the period. Our bank exposure, particularly the Asia-oriented HSBC and Standard Chartered, was a detractor, as uncertainty escalated around the outlook for the Chinese economy in the wake of the Evergrande and wider property sector struggles. We continue to believe these banks are well managed, however, and while there will likely be a hit to profitability near term, they remain well capitalised with more than sufficient buffers to weather potential impacts.

Our holding in WM Morrison was also a negative contributor, with the company subject to a counteroffer from another US private equity fund before going to an auction won by US venture capital fund CD&R, which made the original takeover bid in June. The expected increased leverage resulting from this bid, combined with change of control at par, continues to weigh on the bonds and we are monitoring the situation as it develops. Our USD denominated holdings also detracted over the period, as the US underperformed UK and European credit markets. These positions are predominantly in telecommunications and bank names such as Verizon, Telefonica, Lloyds and BNP Paribas.

Overall, the third quarter saw recent momentum in risk assets grind to a halt across equity and credit markets. Concerns over a combination of rising inflation pressures, moderating economic growth and negative developments in China was enough to offset the continued strong rebound in corporate earnings and ongoing positive news on Covid-19.

Inflation pressures continue to defy central bank expectations that the underlying factors are largely transitory, with US and eurozone levels setting new post-Global Financial Crisis highs of 5.4% and 3.4% respectively, while the UK reached a nine-year peak of 3.2%. This saw the Fed and European Central Bank (ECB) raise inflation forecasts for the year, although both are prepared to tolerate transitory overshoots versus the 2% target.

These pressures look unlikely to ease in the near term given ongoing supply chain disruption, growing consumer demand, labour shortages and, more recently, rapidly rising energy prices and fuel shortages. The Fed’s inflation forecast for 2021 is now 4.2%, while the BoE is expecting levels to peak above 4% and the ECB raised its guidance to a modest overshoot of 2.2% this year. These concerns are putting immense pressure on central banks and the potential timing of policy response.

After holding its dovish stance for much of the quarter, the Fed pivoted to a more hawkish tone at its September meeting, seemingly confirming expectations that quantitative tightening is set to begin before the end of the year. This will be done through tapering its asset purchase program, which looks set to be reduced faster than anticipated, concluding in mid-2022. Meanwhile, it also looks poised to raise rates much earlier and quicker than forecast, with the dot plot indicating a 50:50 split among members on the prospect of a first hike as early as 2022 and the median indicating rates could reach as high as 1% in 2023 and 1.75% by end 2024.

Following suit, the BoE made a similarly sharp hawkish pivot at its September meeting. Interest rates again look set to rise far sooner than anticipated, with the market pricing in an initial hike before the end of the year, although timing remains dependent on impacts from the furlough scheme ending. In contrast to the US, asset purchases should remain at least until the end of the year, with a 7-2 vote to continue the current programme. Meanwhile, the ECB, despite also raising inflation forecasts, remains in the more dovish camp, electing for only a moderate slowdown in its Pandemic Emergency Purchase Programme (PEPP). ECB President Christine Lagarde was quick to point out this is not the start of tapering, reiterating the Bank’s stance that it will tolerate modest transitory overshoots relative to its 2% inflation target, with interest rates remaining at current lows.

While developed markets grappled with inflation, emerging markets were rocked by fears around the Chinese economy. Headlines were dominated by reports that Evergrande, one of the country’s largest property developers, was on the brink of collapse, highlighting wider default risk across the country’s property sector. This has raised global concerns given the significant amount of debt obligations at risk and the sector’s sizeable contribution to the overall Chinese economy. This compounded developments around stricter regulations on the education and technology sectors, potentially inhibiting growth.

Elsewhere, the wait goes on to discover Angela Merkel’s successor after the German election ended in stalemate and a three-party coalition the most likely outcome. The two largest parties, the SPD and CDU, performed poorly, although the former narrowly ‘won’ with around 25% of votes and both leaders claiming mandates to form a new government. While fragmented, this result should mean a more centrist government, with far left and far right also performing poorly and unlikely to be part of any coalition. This makes it difficult to envisage any material changes in policy to worry investors.

There was concern around accelerating Covid-19 cases early in the quarter but this eased as vaccine and booster programmes remain effective in limiting hospitalisations and deaths. Vaccination rollouts continue and are now being administered to school children, with more than 85% of the UK population fully vaccinated and major European nations not far behind at between 75% and 90% and the US just below 70%.

There was modest Fund activity over the period. We initiated a new position in Royal London Mutual Insurance Society, the UK’s largest mutual life, pensions, and investment company. It has strong sustainability credentials, falling under our Saving for the future theme, given its sizeable pensions and investment offering helping individuals prepare for retirement. From a credit perspective, the company is a high-quality issuer, rated single A at parent level, reflected in its robust underlying fundamentals and strong capital position. Given these fundamentals, we initiated a position in subordinated bonds, which offer good value when compared to the underlying quality of its business operations. Against this new position, we reduced our exposure to existing insurance holdings, including Rothesay and Zurich bonds, which have performed well.

Another name added was Medical Properties Trust, a US-based healthcare REIT and the second-largest owner of hospital beds in the US. The company falls under our Building better cities theme, as the owner of 425 properties including hospitals, rehabilitation, surgical and other medical facilities. It is rated high yield at BB+, with its acquisitive business model resulting in high leverage alongside a relatively concentrated tenant base. Its credit fundamentals are strong, however, owing to a resilient business model and lease structure, with high levels of cashflow visibility allowing the company to operate at higher levels of leverage. Furthermore, its acquisition strategy is reducing tenant concentration, and as such, we believe it is a prospective upgrade candidate to investment grade, which is not reflected in relative valuations. This was funded through selling our holding in Aroundtown hybrids, which looked fully valued after a strong recovery.

We also established a position in Clarion Housing Group, the UK’s largest housing association, owning and managing a portfolio of 125,000 homes. The company is highly rated from a sustainability perspective, given its core operations in social and affordable lettings, and another high-quality issuer, rated single A, with strong and stable credit fundamentals, while trading at attractive valuations relative to similarly rated peers.

During the period, we disposed of our holding in Heathrow bonds. They had recovered strongly after being heavily sold off at the height of the pandemic last year and were trading at a relatively narrow discount to pre-pandemic levels. We viewed this as an attractive exit point, given ongoing travel restrictions and still low passenger traffic figures, which are not expected to fully recover for several years.

Once again, we have been active from a duration standpoint, with several relative value trades over Q3. Having started the quarter with an overall short of 4.5 years, split 3.5 to the UK and one to the US, we extended our position to five years in total. This was done via the UK as 10-year gilt yields drifted lower towards 0.5%, which we viewed as unjustified given building inflationary pressures and continued economic recovery. As the period progressed, however, US Treasuries outperformed gilts and we sought to exploit this by rotating one year of our short out of the UK and into the US on relative value grounds.

As the market began to price in inflation risks, combined with that hawkish shift in central bank rhetoric, the UK underperformed the US markedly, and given the speed and scale of the shift higher in the latter’s yields, we felt it prudent to reduce the size of our UK short by one year. This leaves the Fund four years short in total, split equally between the US and UK; both are via the 10-year point of the curve, which we believe remains more vulnerable to inflation risks than the short end. This is particularly true of the UK, where the short end is now pricing in three rate hikes by the end of 2022.

Looking ahead to the end of the year, sentiment continues to be dominated by the inflation debate, and the extent to which current pressures will prove transitory. Central banks and the wider market appear to be coming round to the realisation inflation will be higher for longer than anticipated but we continue to believe it will prove even ‘stickier’ than these revised expectations and above the 2% targets for longer than projected. This is supported by ongoing supply chain disruptions, labour shortages, rising energy prices and fuel shortages, in an environment where consumer demand continues to rise.

Even if inflation does ease back to the 2% area, if we do not see a further rise in nominal yields, then real yields will remain negative. We therefore continue to retain our short duration, with government bonds still vulnerable to unprecedented supply and reflation risks. As outlined, our position is split between the UK and US, where we see greater inflation pressures than in Europe and anticipate tighter monetary policy earlier than forecast.

While a rising rate environment undoubtedly presents risks for credit markets overall, we remain constructive on investment grade. We believe tighter monetary policy has been well communicated and will be introduced in a gradual and orderly manner, with central banks having learnt their lesson from the taper tantrum of 2013. Meanwhile, it is important to remember the reason we are entering into a rising rate environment is due to the strength of the underlying economy, which is ultimately supportive of credit and broader risk assets.

Corporate spreads remain resilient, supported by robust underlying fundamentals and technicals. Already-strong fundamentals should continue to improve as recovery continues and more periods of weak earnings drop out of calculations, further supporting spreads. As conditions improve, we expect companies’ focus to remain on enhancing fundamentals, including creditor-friendly debt reduction and balance sheet repair, and technicals should also remain supportive, as demand for corporate bonds persists as a rare source of yield.

We remain committed to our existing high-quality positions and believe they are well set to continue to perform as the market benefits from measures taken by central banks (quantitative easing and relaxed capital requirements), national governments (fiscal stimulus and SME guarantee programs), and the improving outlook.

Traditional short-dated bonds remain expensive, both from an all-in yield perspective as well as on a spread basis, with low expected returns, wide bid/offer spreads and shorter spread duration. Instead, we see ongoing value in the medium part of the credit curve, with steepening offering attractive longer spread duration opportunities. From a sector perspective, we continue to favour insurance, telecoms and banks, with cyclical non-financials generally over-owned and expensive.

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

*Source: Financial Express, as at 30.09.21, primary share class, total return, net of fees and interest reinvested.

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.