Liontrust Strategic Bond Fund

October 2018 review

October was a torrid month for risk assets with equities feeling the brunt of a market reappraisal of risk. The ongoing Italian political saga continues with EU consternation over a proposed 2.4% Italian fiscal deficit in 2019 met by intransigence by Salvini and Di Maio.  Ultimately, given the wealthier nature of his supporter base, Salvini is likely to blink first when financial markets react negatively to headlines. The infamous “bond vigilantes” are at work in Italy.

 

Market based discipline on erratic politicians continues to expand elsewhere too. For the past few years government yields had been low enough that any increase had been interpreted as vindication of the strength in the economic recovery. It is clear that US Treasuries have now reached the stage where increases in yield do have a meaningful impact on the generic price of risk; attention has switched to the monetary cycle and whether the FOMC will overshoot on their tightening path. Economic growth is still strong, data released in late October showing that US GDP was up by 3.5% in Q3, but worries about disruptions from trade wars are increasing. Some leaders in the Western world have not even studied basic economics and do not realise that trade is not a zero sum game - it can have benefits for all as any 16 year old economics student could tell you. However, trade frictions could knock 0.3-0.5% off global growth but are unlikely to completely derail the cycle.

 

Certainly economic data has been a little weaker than elevated expectations of late. The negative turndown in the last two months is partly due to expectations having being too high and also to heightened uncertainties creating an impediment to investment. The last few weeks has been a growth scare and a repricing of risk, as opposed to an inflation scare and this can be clearly seen by the fall in US breakeven inflation levels meaning lower expectations are factored in to the market for future inflation. However, labour markets are tightening and, as we have posited for a long time, it is wage inflation that creates the feedback for general inflation to accelerate. The latest year-on-year increase in US wages has been released on 2 November at 3.1%; although there is a base effect of a low number in October 2017 there has undoubtedly been a pick up in the pace.

 

We have used this volatility to make some changes to the Fund; namely moving from a net 10% to 25% high yield weighting using liquid credit derivative indices, opposing the movement downwards in yields by shortening duration and buying inflation breakeven protection. We believe that we are late cycle and the first two of these position changes in the Fund are certainly tactical in nature for the next few months. Strategically, rates are still some way from peaking in the US and completely out of whack in Europe. The time to aggressively buy duration and credit has not come yet, but there are myriad ways of exploiting this volatility.

Rates

We continue to use the volatility to alter the extent of the duration short within the Fund.  When rates sold off we increased the Fund’s adjusted underlying duration to approaching 4 years, after they rallied it was taken down to the 3 year area where it finished the month; on the first day of November roughly half a year of duration was added back in. We would increase duration further if the US 10 year yield hits 3.25% and reduce if it fell to nearer 3.0%. We continue to have a strong preference for US duration over Bunds, the spread between the two widened during October but we are convinced there will be some mean reversion over the next few years.

 

The Italian oscillations enabled the spread between France and Germany to reach our 40 basis points target intraday, at which point we dutifully took profits. This remains a cheap and efficient way of capturing volatility in European markets without taking excessive mark-to-market risk in Italian government bonds.

 

Positions were increased in Australia and Norway, not due to their AAA status but rather as simple relative value calls. On the other side of the equation we have become more concerned over a US curve steepener and have reduced 30 year US duration exposure to zero.  And finally we have bought some inflation protection with 0.75 years of duration exposure (a quarter of the Fund's overall duration) in TIPs. 

 

Allocation


The largest change to the Fund during October was in asset allocation. As the selloff in risk assets intensified we removed the credit default swap index protection from the Fund due to the improved valuations available. This had the effect of taking the net weighting from 10% to 20% but without incurring significant trading costs or disturbing our favoured high yield stock picks. When the markets reached what we believed to be the short term capitulation point we chose to be contrarian and added 5% high yield risk using the US CDX HY index; at the time of writing it has rebounded and we are close to taking profits on this tactical position.

 

Selection


October was a month that was a lot more about the macro than the micro but this does not preclude us from eking out a few extra basis points for the Fund from stock rotation. We sold some outperforming euro high yield names such as Wepa and Iqvia to switch into Gestamp. The latter is an auto parts supplier that has been hit by poor sentiment towards the sector; there are undoubtedly industry pressures but buying a quality credit when it is oversold is a core part of our day job.

 

We also undertook a couple of relative value switches within the capital structures of the same names. A shorter dated 2025 maturity Softbank bond had significantly underperformed the 2028 maturity in both price and spread terms which made the switch very compelling. Satellite operator SES has been recovering well this year, partly aided by the potential for spectrum sales; longer dated US dollar bonds had seen their spreads tighten from just below 400 basis points to nearly 300 basis points.  The profit was banked and a position was established in SES’s subordinated euro-denominated bonds which had been a relative laggard.

 

Fund positioning data sources: UBS Delta, Liontrust.

 

Adjusted underlying duration is based on the correlation of the instruments as opposed to just the mathematical weighted average of cash flows.  High yield companies' bonds exhibit less duration sensitivity as the credit risk has a bigger proportion of the total yield; the lower the credit quality the less rate-sensitive the bond.  Additionally, some subordinated financials also have low duration correlations and the bonds trade on a cash price rather than spread. 

 

For a comprehensive list of common financial words and terms, see our glossary here.

 

 

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. Investment in Funds managed by the Global Fixed Income team 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. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

 

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.
Wednesday, November 7, 2018, 3:30 PM