Liontrust SF Corporate Bond Fund

The Fund returned -0.7% over the quarter, outperforming -1.0% from the iBoxx Sterling Corporate All Maturities Index but underperforming the IA Sterling Corporate Bond sector average of -0.5% (both of which are comparator benchmarks)*.

Relative outperformance versus the index was primarily driven by the overweight credit position, as spreads proved resilient in the face of rising yields. Sector allocation was the main factor, with our overweight to financials, including banks, insurers and financial services, set to benefit from a rising rate environment. This more than offset the negative impact of our gilt allocation and underweight to cyclical industrials.

Security selection was broadly neutral over the quarter, with positive contributions from names continuing to benefit from economies reopening and pandemic restrictions easing, such as office landlord Canary Wharf, student accommodation provider Unite and construction materials business Travis Perkins, but negative news affecting a couple of issuers in the Fund. Our holdings in banks with significant Asian exposure, namely HSBC and Standard Chartered, were detractors, for example, 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.

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 short duration position also added to performance, as 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 by 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 bunds, which were largely unchanged at -0.2% having reached a low of -0.5%, before retracing in the latter stages of the quarter. 

Overall, Q3 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 positive news on Covid-19.

Inflation pressures continue to defy central bank expectations that 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, rising energy prices and fuel shortages. The Fed’s inflation forecast for 2021 is now 4.2% while the BoE is expecting a peak above 4% and the ECB raised guidance to a modest overshoot of 2.2% this year. These concerns are putting 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 rate 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%.

Fund activity was modest over the period. While new issuance was relatively muted over summer, we did participate in deals from Investec, Santander and Annington, which came at attractive levels relative to existing secondary market securities. Outside of new issuance, we initiated a 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 compared to the underlying quality of its operations. Against this, we exited Rothesay bonds, which had 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.

We increased exposure to the housing association sector, which has strong sustainability credentials through its core operations in social and affordable lettings. We established a position in Optivo, one of the UK’s largest associations, as well as Blend Funding, a subsidiary of THFC (The Housing Finance Corporation) that ‘on-lends’ money borrowed from capital markets to smaller housing associations that could not get access to such rates. Both are high-quality issuers, rated single A, with strong and stable fundamentals and trading at attractive valuations relative to peers, such as the University of Liverpool, which we sold to fund these buys.

Against such additions, we continued to de-risk the portfolio at the margin, exiting some of our higher beta subordinated holdings in Coventry and Nationwide Building Society AT1 securities. The bonds have seen a strong post-pandemic recovery but valuations were beginning to look stretched and offered an attractive exit point.

Elsewhere, we switched a large part of our Gilt allocation into the recently issued inaugural Green Gilt, with the proceeds ringfenced for green government projects. These include clean transportation, energy efficiency, renewable energy, pollution prevention and control, living and natural resources, and climate change adaption. The green gilt trades broadly in-line with existing government paper, so there was no material cost in switching our position, and we prefer to support such projects rather than some of the less desirable elements of government financing.

Once again, we have been active from a duration standpoint, with several relative value trades during the period. Having started Q3 with an overall duration short of 2.25 years, split 1.5 years to the UK and 0.75 to the US, we looked to take advantage of market moves as Treasuries outperformed gilts over the initial part of the quarter, despite significant inflationary pressures and the US’s stronger growth outlook. As a result, we rotated 0.25 years 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 0.5 years. This leaves the Fund 1.75 years short in total, 0.75 years to the UK and one year to the US; 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 pricing in three 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.

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