Liontrust SF Monthly Income Bond Fund

The Fund returned 8.3% over the quarter, compared with the 5.7% average return from the IA Sterling Corporate Bond sector (the comparator benchmark) and 8.3% return from the iBoxx Sterling Corporates 5-15 Years Index (the target benchmark)*^†. 

Market backdrop

Despite improved performance over the final quarter of the year, 2022 proved to be one of the worst years for asset returns in the last 20 years. Central banks struggled to control persistently high inflation, with significant interest rate increases dominating markets in 2022.

In the final quarter, investor optimism focused on the belief that peak inflation had been achieved, following weaker inflation data. This led to a reduction in expectations for where interest rates would finally peak.  This saw all of the US Federal Reserve, Bank of England and European Central Bank deliver reduced rate increases of 50bps  in December. However, the accompanying hawkish commentary from the US Federal Reserve and European Central Bank resulted in yields moving higher towards the end of the quarter.

The exception was the UK, where yields fell as the political landscape stabilised following the inevitable regime change amidst the turmoil following September’s disastrous mini-budget announcement.

In October, Rishi Sunak was appointed as the new Prime Minister, with Jeremy Hunt the new Chancellor, who swiftly reversed almost all of the fiscal stimulus measures announced in the mini-budget, while also promising further fiscal tightening to come. This reassured market concerns about the scale of unfunded government spending plans, with equities and bonds staging large rallies in mid and late October, recovering much of the previous month’s underperformance, as 10-year gilt yields fell sharply from a decade high of 4.5%. The pound also recovered against the US dollar.

This positive sentiment was somewhat tempered by the latest inflation print, which, despite falling from 11.1% in October to 10.7% in November, remains more persistent than in the US and Europe. This saw the Bank of England maintain a more hawkish approach despite the drop in headline inflation.

The Bank of England now expects UK GDP to decline by 0.1% in 2022 Q4, 0.2% better than expected in the November Report. Inflation, however, is expected to fall sharply from mid-2023 to below the 2% target in years two and three of the projection.

On a similar trend, labour demand has begun to ease, with the unemployment rate rising slightly to 3.7%, however it still remains tight. Despite a somewhat resilient labour market, we have seen a clear deterioration in the real economy, with household consumption weak and most housing market indicators continuing to soften.

Q4 finally showed some encouraging signs that inflation might have peaked in the US which saw relief rallies in bonds, as Federal Reserve Chair Jerome Powell hinted that future interest rate hikes would be dialled down. Headline inflation fell to just over 7%, having peaked above 9% in June, following consecutive downside surprises, leading markets to start pricing in interest rate cuts as soon as late 2023.

Whilst there has been some softening in the economic data the labour market continues to be resilient with unemployment remaining at 3.6%. This Fed remains focussed on this and is watching for signs that the labour market is easing.

Similarly to the US, inflationary pressures have also started to alleviate in Europe, with euro area inflation falling from a peak of 10.6% to 10.1% in November. This was despite heavy reliance on Russian gas, as a milder than expected winter saw falling gas prices help to alleviate inflation pressures.

This was positive for risk assets, as investors grew more hopeful that we are approaching the end of monetary tightening. The ECB now expects average inflation of 8.4% in 2022, 6.3% in 2023, 3.4% in 2024 and 2.3% in 2025. It sees recession in the region being relatively short lived and shallow.

Fund review
The main contributor to the Fund’s performance was our long duration position, which delivered outperformance as UK Gilts rallied strongly from recent lows.

This was further bolstered by outperformance from the overweight credit position, as corporate bonds also rallied strongly amidst a risk-on tone as investors grew more optimistic that we are approaching the end of the monetary policy tightening cycle.

Sector allocation was the main driver, as key overweights to the Banks and Insurance sectors contributed strongly, as financials recovered strongly on more positive macro-economic sentiment. Our overweight to the Telecommunications sector also benefitted from the stronger tone into the end of the year.

This more than offset the drag from our more defensive allocations to Gilts and Housing Associations.

Stock selection was strong in our core sectors, particularly Insurance where our overweight position to higher beta subordinated debt from high quality names such as Royal London and Zurich performed strongly, as well as Telecommunications where our higher beta holdings such as Cellnex and longer spread duration holdings such as Vodafone outperformed.

This was offset by weak performance from our Real Estate holdings, as the combination of high inflation, tightening financial conditions, rising yields and the growing threat of recession have weighed on the property market, particularly amongst higher beta names, such as Aroundtown and Canary Wharf.

Rates positioning was proactive as we continued to actively manage the Fund’s duration over the quarter.

After the move to neutral duration in late September as the disastrous Autumn mini-budget drove yields higher, we decided to take the Fund long duration relative to its benchmark for the first time in its history as 10-year gilt yields hit a decade high of 4.5%. The high all-in levels of yields, easing inflationary pressures, fiscal tightening, and the Bank of England’s reluctance to excessively raise monetary policy amidst the weak economic backdrop provides conviction to our overweight position.

This one year overweight is expressed entirely through the UK. Our neutral position the quarter prior was expressed through a half year overweight to the UK and half year underweight to the US, meaning we have now closed off our US position entirely. This was as yields grew closer to our fair value amidst continued hawkish rhetoric from Fed officials, despite inflation prints in the US surprising to the downside.

After a muted Q3, Fund activity picked up over the quarter. Issuance recovered as yields fell from their highs, with poor sentiment and technicals over the quarter providing us with ample opportunity to secure high quality bonds at discounted valuations.

Financials, banks in particular, was where we were most active. We rotated out of low coupon paper in Barclays, NatWest and Santander, as well as some short-dated paper in Lloyds, in order to participate in high coupon, longer dated new issues from the same issuers, as well as Credit Agricole and HSBC. This recently issued higher coupon paper is expected to be more defensive in a weak market, given it has lower extension risk given the higher spread resets and came to market at wider spreads to existing bonds.

We also re-entered and built a position in BPCE over the quarter, having not held it since 2017. BPCE is a mutually owned, retail-focused bank that has improved its sustainability credentials since last held. This was evidenced by their progress against demanding targets.

Outside of Financials, we established a position to Compass Group, following an attractively priced new issue. The company remains a high quality, robust business, with strong sustainability credentials, with bonds offering a much more attractive entry point following the spread widening over the course of the year.

A new position was initiated in Anglian water, a water and sewerage business that services the South-East of England. Bill collections remain strong despite the economic downturn, while asset valuations are indexed to inflation. Water utilities are a favoured industry in the Fund, generating consistently strong cash flows and operating in a natural monopoly environment. The bond added holds a high coupon as well, generating an attractive yield for the fund.

Against these new additions we exited our remaining position in Haleon, having already reduced it during Q3. Despite litigation fears on the drug Zantac, positive developments led to a recovery in the bond’s spread valuations to levels broadly in-line with before the controversy. This removed further potential upside in our opinion, whilst the negative overhang of the lawsuits remains. Therefore, we decided to divest the rest of our position.

Outlook
As we enter 2023, the market is approaching a potentially important transition period that could see the 2022 headwinds ease in the months ahead.

Inflation has shown definitive signs of peaking, and while still too high in an absolute sense, it could prove a positive surprise if price pressures ease faster than expected.

On a monetary policy level, the hiking campaign is likely near complete. In December, the Fed signalled that it expected the peak interest rate to be 75bps higher than current rate, which could easily be reached in the first few months of 2023.

Economic growth and corporate earnings are indeed expected to decline in 2023, but these expectations now seem to have been fully priced into equities and bonds at current levels.  We believe the focus of the market should turn to single name issuers and fundamentals and move away from monetary policy tracking.

Declines of the magnitude we saw in 2022 are usually followed by strong recoveries. Bonds, as represented by the Bloomberg US Aggregate bond Index, have never experienced two consecutive years of negative returns. Therefore, we think market declines seen in 2022 have ultimately yielded substantial long term opportunities in the fixed income markets. Slower growth should be constructive for fixed income securities, which, coupled with current attractive valuations and well positioned corporate balance sheets, presents an opportunity for the sector and offers investors attractive compensation.

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

Past performance does not predict future returns

*Source: FE Analytics, as at 31.12.22, B share class, total return, net of fees and interest reinvested.

KEY RISKS

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.

The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in the Fund 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. The Distribution Yield is higher than the Underlying Yield because the fund distributes coupon income and the fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining the fund’s capital appreciation. The Fund may invest in derivatives. The use of derivatives may create leverage or gearing. A relatively small movement in the value of a derivative's underlying investment may have a larger impact, positive or negative, on the value of a fund than if the underlying investment was held instead.

DISCLAIMER

This is a marketing communication. Before making an investment, you should read the relevant Prospectus and the Key Investor Information Document (KIID), which provide full product details including investment charges and risks. These documents can be obtained, free of charge, from www.liontrust.co.uk or direct from Liontrust. Always research your own investments. If you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances. 

This 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. Examples of stocks are provided for general information only to demonstrate our investment philosophy. The investment being promoted is for units in a fund, not directly in the underlying assets. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust.