Liontrust Monthly Income Bond Fund

The Fund returned -0.7% over the quarter, underperforming the 0.1% return from the IA Sterling Corporate Bond sector (the comparator benchmark) and 0.0% from the iBoxx Sterling Corporates 5-15 Years Index (the target benchmark)*.

This was driven by a combination of flattening government yield curves, in response to the accelerated timeline for central bank policy normalisation, and weaker performance from the Fund’s credit portfolio.

Over the quarter, government bond yields initially moved higher due to rising inflationary pressures and strong economic data, combined with some hawkish comments from central bank committee members. This reversed sharply, and yields fell, as investors sought safe-haven assets in response to the emergence of the Omicron variant, before retracing much of this move into the end of the year. UK 10-year gilt yields fell 5 basis points (bps) to finish 2021 at 0.97%, having dropped as low as 0.70% before a somewhat unexpected rate hike at the Bank of England’s (BofE) December meeting drove them back up. Despite US 10-year Treasury and German 10-year bund yields both ending the quarter 2bps higher, at 1.51% and -0.18% respectively, this belies similar intra-period volatility, falling as low as 1.35% and -0.40% on Omicron concerns before rising into year end.

In contrast, shorter-dated government bonds saw yields climbing in response to expectations of earlier and more interest rate hikes than anticipated, with two-year US Treasuries rising 45bps and two-year gilts up 26 bps. These flattening curves were a detractor in terms of our performance, with the Fund’s underweight interest rate risk stance designed to benefit from a steepening environment.

Our credit positioning was also negative over the quarter, as stock selection counteracted the contribution from sector allocation. Bank holdings delivered a positive sector allocation as they should perform well in a rising rate environment but this was offset by underperformance from some of our higher-beta subordinated holdings amid risk-off conditions post-Omicron. Similarly, we saw a negative contribution from some of our higher-beta subordinated holdings within insurance, while our underweight to the more defensive utilities sector was a further detractor. Against this, our overweight to housing associations was positive.

Elsewhere, the positive effect of our overweight to the more defensive telecommunications sector was offset by negative stock selection, based on some company-specific headlines. Markets have grown increasingly wary of record levels of corporate activity in 2021, particularly from private equity firms, with our holding in Telecom Italia impacted by a private equity bid for the company. This compounded a previously announced profit warning and subsequent rating downgrade from S&P but bond investors’ primary concerns now are the prospect of a leveraged buyout and potential separation of the company’s fibre network. We believe initial concerns have been overdone, with a successful bid not a foregone conclusion, and continue to monitor developments.

Our holding in BT was also negative, another company subject to ongoing speculation about a potential takeover. While we believe any bid would have a low probability of success, we expect this story to rumble on and felt the risk-reward trade-off in the bonds was no longer favourable. As a result, we decided to exit.

Overall, financial markets proved remarkably resilient over the final quarter of 2021, despite higher volatility following the emergence of Omicron and moves toward central bank policy normalisation. Discovery of the variant in late November saw a flight to safety amid the return of Covid uncertainty, with the newest mutation significantly more transmissible than previous strains and bringing a threat of renewed restrictions. As we learnt more about Omicron over the following weeks, however, the variant has proved less severe in terms of hospitalisations and death rates, with vaccine booster programs effective and helping to ease concerns.

While Omicron has weighed on global recovery to some extent, particularly within the services sector and across Europe following reintroduction of lockdown in several countries, overall economic data and corporate earnings continued to prove robust, supported by significant consumer savings still to unwind. An ongoing hawkish shift in central bank rhetoric, however, driven by escalating inflation concerns, drove fears over the impact of tighter monetary policy on global growth.

Inflationary pressures were exacerbated by ongoing supply chain disruptions, soaring energy prices, and tightening labour markets. Supply chain pressures are intensified by China’s ongoing zero tolerance policy in response to Covid-19, given the level of exports to the global economy.

In the US, inflation has reached a near 40-year high of 6.8%, combined with unemployment dropping to 4.2% and approaching pre Covid-levels. Following confirmation Federal Reserve Chair Jay Powell would remain in position for a further term, we saw a marked pivot in rhetoric, with hawkish statements from several officials and within FOMC minutes, as well as the decision to drop the term ‘transitory’ from inflation commentary. This has now shifted to highlighting risks are skewed towards more persistent inflation than previously anticipated.

This was followed by the decision to accelerate its tapering timeline, with asset purchasing expected to end as early as Q1 2022. While the Fed opted to keep interest rates unchanged, this faster tapering has brought forward the potential for earlier hikes, with the FOMC dot plot now indicating a median of three in 2022 and three more the following year.

As for the UK, inflation reached 5.1%, a 10-year high, and further signs of labour market strength also fuelled wage inflation, as unemployment fell to 4.2%. Similar to the US, this prompted a hawkish response from the BofE, which voted to raise rates 15bp to 0.25% by an 8-1 majority. While Europe is experiencing similar pressures, with eurozone inflation reaching 4.9% during the quarter, the European Central Bank (ECB) continues to be more dovish than its peers. Despite planning to end its Pandemic Emergency Purchase Programme (PEPP) in March, its Asset Purchase Programme is set to continue, and ECB President Christine Lagarde also ruled out rate hikes in 2022 regardless of inflation concerns.

Portfolio activity was relatively muted over the final quarter of the year. We participated in a new issue from Southern Housing Group, one of the largest non-profit housing authorities in the UK, offering affordable social housing at significant discounts to market rents. The company has suffered from an overly ambitious development strategy that weakened its fundamentals; however, a new management team is implementing a more prudent approach, with a focus on improving these fundamentals, which should see it outperform peers.

As highlighted, we exited our position in BT bonds following growing concerns around the future of the business as Patrick Drahi became the largest shareholder with an 18% stake. We continue to believe a takeover is unlikely given political opposition and complications regarding the pension scheme but have concerns around the potential separation of Openreach, which would have a detrimental impact on the credit fundamentals of the underlying business. As such, we viewed the risk-return profile as unfavourable and decided to exit, reinvesting proceeds into some favoured and attractively valued subordinated holdings in Rothesay Life and Standard Chartered.

We also sold our position in Morrisons, after participating in a tender offer for the bonds following the approval of its £7 billion private equity takeover from Clayton Dubilier & Rice. We viewed the tender as an attractive exit point, given the change of control at par and ratings pressure, with leverage expected to increase materially once the financing structure for the acquisition has been finalised. Following the tender, Moody’s has downgraded the bonds to high yield, with the rating under review pending confirmation of financing structure.

There was also a relative value switch within BNP Paribas bonds, with the company deciding to call the $ denominated subordinated notes held in the Fund on 3 January 2022. Following the announcement, the bonds were trading around par and we elected to rotate into another $ denominated note in a similar part of the capital structure. Following the sell-off in the wake of Omicron, we took advantage of market volatility to add to favoured higher-beta names, including Coventry Building Society and Nationwide Building Society AT1s, which had underperformed disproportionately and offered an attractive opportunity to increase exposure.

Having started the quarter with a duration short of four years relative to the benchmark index, split equally between the US and UK, we increased the UK position to 2.5 years to end 2021 with an overall short of 4.5 years. Following the sharp selloff in UK short-end yields early in the period, the differential between 10-year and three-year gilts compressed to near historic lows. We believe the market is pricing in too many rate hikes over the next 12 months and expect curves to steepen, putting in place a bear steepener to reflect this. Ten-year yields then trended back down towards 0.8%, having been as high as 1.2% early in the quarter, and we viewed this move as unjustified given continued inflation pressures, electing to increase the size of our short by 0.5 years.

As we enter 2022, risks remain largely the same as for the bulk of the past year, with Omicron causing rapid spikes in Covid infection rates, inflationary pressures continuing to build, and potential for central bank policy normalisation earlier than anticipated. As such, our strategic view remains largely unchanged. We continue to believe the rebound in the global economy will continue; we recognise short-term uncertainty has increased but data so far indicates Omicron is significantly less severe than previous variants.

Markets continue to focus on inflationary pressures within economies and, most critically, central banks’ response to this, with risk of policy error as they attempt to control inflation without stifling recovery. While some of these pressures are transitory, we continue to believe the broad-based nature of rising inflation will be ‘stickier’ than central banks believe and hold this view across the UK, US and Europe. This continues to be supported by supply chain disruptions, tight labour markets, and high energy prices, as well as the ongoing unwind of consumer savings.

Central bank rhetoric has pivoted to become markedly more hawkish to reflect this, with the Federal Reserve accelerating its tapering programme and the Bank of England raising rates in December, paving the way for further policy normalisation in both markets. However, we remain of the view that government bond yields are too low and should rise further given the growth and inflation outlook, with the Fund positioned to benefit from such moves.

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 source of yield. We remain committed to existing high-quality positions and believe they are well set to continue to perform as the market benefits from measures taken by central banks and national governments, and a generally improving outlook.

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

*Source: FE Analytics, as at 31.12.21, primary share class, total return, net of fees and interest reinvested.

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