Liontrust Monthly Income Bond Fund

Q2 2020 review

The Fund returned 8.7% over the quarter, outperforming the 7.5% average return from the IA Sterling Corporate Bond sector and matching the 8.7% from the iBoxx Sterling Corporates 5-15 Years Index*. 


Our overweight credit position was key to returns as corporate bonds rebounded strongly and outperformed government debt, supported by stronger risk appetite and favourable technicals. High yield performed particularly well, led by the European market, while investment grade was not far behind.

Stock selection was the principal driver of fund performance, particularly within our favoured insurance and telecommunication sectors. These recovered strongly from a tumultuous first quarter, with higher beta subordinated, longer spread duration and US dollar denominated bonds delivering positive contributions. Banks also saw a strong rally, as fears of a repeat of the financial crisis were dispelled over the period. All this far outweighed the drag from more defensive positions, primarily our gilt allocation and short in high yield, which suffered amid the risk-on tone in markets.

This strong recovery in corporate bonds broadly counterbalanced the underperformance in Q1, with credit positioning costing the fund just 20bps relative to the index over the first half of the year, despite sterling spreads remaining 36bps wider at the end of the period. This reinforces our conviction in our high-quality portfolio, which we believe continues to be well positioned to withstand the significant impact of the pandemic.

A strong quarter for credit was partially offset by underperformance from the fund’s short duration position. Despite the risk-on tone, government bonds held up well, demonstrating continued correlation with risk assets. UK 10-year gilt yields fell 18 basis points over the quarter, ending June at 0.17%, driven by a combination of the Bank of England’s commitment to keeping government borrowing costs low, discussion around negative interest rates, and Brexit uncertainty resurfacing. While German 10-year Bund and US 10-year Treasury yields were broadly unchanged over the quarter, this belies the underlying volatility, trading in ranges of 31bps and 43bps respectively. While our duration short has been negative in 2020, active management of the position has mitigated the impact by approximately 50bps over the first half of the year.

We saw a huge contrast in Q2 compared with the first three months of the year, as central banks and governments responded swiftly and in coordinated fashion to the threat posed by Coronavirus. They provided enormous amounts of stimulus to support economies both domestic and global and the combination of slowing infection rates, easing lockdown measures and early signs of a rebound in data contributed to positive returns from financial markets.

That said, the impact of Covid-19 on economic activity has been significant: the UK saw a decline in GDP of -2%, whereas the fall was higher in the US at -4.8%. Unemployment rose sharply in the US to 15%, the highest level in post-war history, although the furlough scheme helped support the employment number in the UK. What these figures demonstrate is the huge impact the response to Covid-19 is having.

As stated, central banks have been quick to respond to prevent the economic situation evolving into a financial crisis, ensuring borrowing costs are kept low and liquidity is available, not just for large corporates but for small and medium-sized enterprises as well. In the US, the Federal Reserve response has been significant in both size and speed, committing to unlimited government bond purchases and increasing the size of its quantitative easing (QE) programme. This has been targeted at investment grade companies but, importantly, was expanded to include corporate debt rated investment grade prior to 23 March, helping alleviate fears over access to liquidity for companies downgraded to high yield. The Fed has committed to keeping rates low until it is confident economic activity is back on track towards full employment and inflation at the 2% target level.

In the UK, the Bank of England increased the size of its QE programme, helping keep borrowing costs down, and liquidity has come via the Covid Corporate Funding Facility (CCFF). The furlough scheme is estimated to be supporting 7.5m people, helping reduce the impact of lockdown on the workforce. As for the European Central Bank (ECB), it also continued QE and eased collateral requirements to support small and medium-sized enterprises. European Commission president Ursula von der Leyen called for the power to borrow €750 billion for a recovery fund to support the worst-affected EU regions. This would be in addition to a €540 billion rescue package agreed in April. The ECB also offered support, expanding its Pandemic Emergency Purchase Programme (PEPP) to €1.35 trillion.

In terms of corporate behaviour, companies have looked to ensure they have adequate liquidity to manage their way through this downturn. Access to the CCFF, use of the furlough scheme, equity raises and dividend cuts have all been regular features as companies focused on balance sheet strengthening. This resulted in record levels of new corporate bond issuance, but the combination of strong technical support and renewed investor sentiment has meant this supply has been well received by the market.

As expected, the impact of lockdown strategies and uncertain economic outlook has had a negative impact in terms of credit downgrades. Our portfolio has not been immune, but we have not seen any downgrades to sub-investment grade, reflecting the quality of issuers held. While credit metrics across investment grade have largely been able to weather the storm due to strong pre-Covid starting points, earnings pressure has weighed heavily on already-weak metrics in the high yield space, leading to an acceleration in defaults. These have predominantly been US led, with the retail and energy sectors suffering the most.

Overall, the second quarter was dominated by positive sentiment as reductions in the infection rate allowed economies to restart and there were signs of promise in the early stages of vaccine development. This resulted in initial data releases suggesting the recovery may turn out to be sharper than widely believed, further boosting sentiment. However, the latter stages of the quarter saw renewed fears over a second wave, with new infections rising in the US and several emerging markets struggling to contain the virus. This serves as an important reminder that easing of lockdown measures must be carefully managed.

While significant uncertainty remains over the economic recovery, we will inevitably see attention turn back to political risks later in the year, with the US presidential election fast approaching, resurfacing US-China trade tensions and Brexit negotiations.

While we have maintained high conviction in our existing holdings throughout the crisis, there was moderate portfolio activity over the quarter, as the widespread market sell-off presented a number of opportunities.

As mentioned, new issuance was a feature of the period as corporates sought to bolster near-term liquidity, and rising risk appetite and government purchasing meant this was well absorbed. The fund took part in a new issue from SSE, which brought a sterling hybrid to market offering an attractive yield pick-up over its senior bonds. SSE is a well-diversified business with a strategic focus on investing in renewable energy and regulated networks. We also participated in a new issue from RBS.

We selectively added exposure to names where valuations have been heavily impacted by the pandemic over the near-term. These bonds were still trading close to the wides, having not participated in the ensuing rally, but we believe they have been oversold as their medium-long term outlook remains robust. One example was Unite Group, the UK’s largest purpose-built student accommodation provider. We topped up our existing position, with the company set to continue benefitting from favourable market dynamics such as a growing demand/supply imbalance and low reletting risk as 56% of the portfolio is under nomination agreements. Unite has proved more resilient to the pandemic than the market is pricing in, with reservations for 2020/21 at 81%, and following our decision to increase exposure, it also completed a £300m share placing to improve near-term liquidity, demonstrating prudent management.

Elsewhere, we increased our exposure to National Express, a well-diversified transportation services business by geography and contract profile. The company continues to demonstrate a strong commitment to investment grade with a robust liquidity profile ensuring it can withstand the impact on its trading from Covid-19. The fall in bond price provided an opportunity to gain exposure to a company that is well set to recover when economies re-open.

Segro is a new addition to the portfolio, a high-quality logistics real estate landlord that is positioned to benefit from the accelerated transition to e-commerce in the wake of the pandemic, with the sell-off providing an attractive entry point. The company has also successfully completed a £680m equity raise, resulting in a comfortable liquidity position that allows it to capitalise on the significant supply/demand imbalance for logistics real estate.

Against these investments, we reduced some of our exposure to subordinated financials, which had performed particularly well during the rally, with the additions mentioned offering greater relative value as they traded close to their respective wides in terms of spread. We took advantage of the underperformance in US dollar credit in the initial stages of the crisis, rotating out of some of our sterling-denominated telecommunications bonds into duration-matched USD equivalents. The spread and yield pick-up on offer had reached all-time wides in some cases, despite the same level of credit risk.

With high yield more exposed to the impacts of the pandemic, we increased our short position to -15% (from -10%) early in the quarter through the US market. This index has considerably more exposure to the most significantly impacted sectors, namely energy and retail, where we anticipate a sharp spike in defaults. The fund benefitted from this move with nine defaults in the index since early March, with an average recovery rate below 10 cents. Later in the period, we reduced the position back to -10%, closing the short to European high yield in June as we see it as less exposed to defaults and the asset class will indirectly benefit from the EU recovery fund. Unlike in the US, the European HY CDS index is yet to suffer a default.


We continue to believe high yield is more challenged as earnings pressure, rising cost of debt, liquidity constraints and ineligibility for central bank support leaves the market vulnerable to sharp economic downturn. While not our base case, our short position therefore provides protection against periods of renewed market weakness.

In line with previous guidance, we increased the long-standing duration short back to four years relative to the index, after 10-year UK gilt yields fell to near all-time lows. This is currently expressed via a 3.5 year short through the UK market and 0.5 years to the US.

Looking to the rest of the year and beyond, a near-term deterioration in credit fundamentals is inevitable given the significant disruption to corporate earnings but we remain positive on investment grade credit: it offers a rare source of yield and strong fundamentals give enough headroom to withstand much of the negative impact. As detailed earlier, this is combined with a high level of technical support fuelled by central bank purchases, alongside an expected reduction in new issuance following elevated levels in H1. Companies have ensured they had funding in place but their focus is now turning to balance sheet repair. With credit spreads above long-term average levels, there is scope for a gradual grinding tighter in spreads. We remain committed to existing positions, which we see as well placed to withstand the economic impacts, and do not view any of our holdings as exposed to a credit event.

On the duration side, we continue to believe recently announced QE programs will limit any increase in gilt yields over the coming months, with the Bank of England explicitly saying it will extend QE if necessary to keep yields in check. On the other hand, renewed bad news on the virus or a hit to the economy will likely result in a government bond rally. Given this, we expect 10-year gilt yields will remain in that relatively tight trading range between 0.2% and 0.8%, recently finding a base at the bottom end of this. As such, we feel there is now scope for yields to rise modestly as the magnitude of the fiscal impact on issuance hits the market, and we will look to increase duration as they trend towards the higher end of our expected range.

 

Longer term, we see an ongoing risk that gilt yields rise and/or the curve steepens, supporting our preference to retain a short position. Further to this, with government bonds yielding close to zero (or below in a number of countries), it is our belief that government bonds have limited ability to dampen portfolio volatility and actually provide meaningful downside risk during bouts of market weakness or volatility.

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

 

Jun-20

Jun-19

Jun-18

Jun-17

Jun-16

Liontrust Monthly Income Bond B Gr Inc

3.6

4.0

0.1

14.4

3.2

iBoxx Sterling Corporates 5-15 years

5.8

7.1

0.7

7.1

8.6

IA Sterling Corporate Bond

5.8

5.6

0.6

6.4

6.1

Quartile

4

4

4

1

4

 

*Source: Financial Express, as at 30.06.20, primary share class, total return, net of fees and interest reinvested.

 

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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.

Thursday, July 16, 2020, 3:28 PM