Liontrust Monthly Income Bond Fund

Q3 2020 review

The Fund returned 2.0% over the quarter, outperforming the IA Sterling Corporate Bond sector average of 1.6% (the comparator benchmark) but slightly lagging the 2.2% from the iBoxx Sterling Corporates 5-15 Years Index (the target benchmark)*. 


While global equities delivered more mixed performance over Q3, credit markets continued their recovery, supported by a strong technical backdrop and ongoing economic improvement. Credit also remained remarkably resilient towards the end of the period despite being faced with a combination of both rising political uncertainty and infection rates. Those strong technicals, including low levels of issuance, ongoing central bank purchase programs and rising demand as investors continue to search for yield, drove a risk-on tone in credit over the period. As a result, corporate bonds outperformed and the Fund’s overweight credit exposure was a positive.

 

Performance was driven by strong stock selection, notably our subordinated holdings in the banks and financial services sectors. This was further supported by a positive contribution from broader sector allocation, with the benefits from our core allocations to insurance and banks more than offsetting the drag from our short  position in high yield, which outperformed investment grade, and more defensive gilt exposure.

Strong returns from credit were offset by underperformance from our short duration position, however, as it proved a volatile period for government bonds despite yields remaining broadly unchanged at quarter end. While the 10-year UK gilt yield finished the period just 6 basis points (bps) higher at 0.23%, it traded in a 25bps range as moves higher following positive Covid developments over summer reversed in the wake of rising infection levels, the return of Brexit uncertainty, and increasing potential of negative interest rates from the Bank of England.

Elsewhere, German 10-year Bund yields fell 7bps over the quarter, amid rising infection rates across the Continent and the unveiling of a €750 million pandemic recovery fund. US 10-year Treasury yields were also broadly flat, moving just 3bps higher, as uncertainty around the Presidential election builds and continued accommodative monetary policy was offset by the failure to agree a further fiscal stimulus package.

This underperformance from duration positioning remains in line with our long-term strategy to maintain a level consistent with short-dated funds/indices. Meanwhile, the continued recovery in credit has now fully covered the asset class’s underperformance earlier in the year, with credit positioning adding 7bps relative to the Fund’s benchmark since the start of the 2020, despite spreads remaining 19bps wider over the same period. This reinforces our conviction in our high-quality portfolio, which we believe continues to be well positioned to withstand the significant impacts arising from the Covid-19 pandemic.

Coming back to the macro picture in more detail, we saw heightened optimism regarding Covid-19 over summer as infections/hospitalisations remained low despite the gradual reopening of economies and progress in vaccine trials. Fears of a second wave resurfaced towards the end of the quarter, however, as infection rates rose across a number of European countries. This resulted in the reintroduction of localised lockdowns and concerns over potentially higher death rates as we approach winter. Governments remain reluctant to enforce widespread lockdown measures given the impact on the economy, favouring stricter local restrictions in problem areas.

Overall, economic recovery has continued with corporate earnings in particular surprising to the upside, although there are concerns around the pace of recovery, which appears to be slowing. In Europe, fiscal support measures for workers have been extended into 2021, while the UK also continues to offer government funding, albeit on a reduced scale, through the job support scheme. As stated, the EU also unveiled a €750 billion pandemic recovery fund, comprising a mixture of grants and loans available to member countries.

The recent deterioration in Covid developments coincided with rising political uncertainty as we build towards the Presidential election in the US, while Brexit negotiations also appear to have stalled. On Brexit, issues surrounding state aid and fishing rights are two of the main areas of disagreement. Relations became further strained following the release of the UK government’s Internal Market Bill, which appears to override parts of the Withdrawal Agreement relating to trade between the UK and Northern Ireland. This prompted the EU to call for the UK to withdraw measures from the bill and increased the probability of a hard Brexit or a “skinny” deal.

In the US, despite Joe Biden maintaining a relatively healthy lead in the polls, uncertainty continues to build, particularly in key swing states. Control of the Senate also came to the forefront after it failed to pass additional fiscal stimulus, with Democrats and Republicans disagreeing on the size of the package required.

As mentioned earlier, credit market technicals remain supportive, none more so than monetary policy, which is very accommodative. In Europe, the ECB’s corporate purchasing programs continue to buy corporate bonds, which, combined with a relatively benign period for new issuance, proved positive for credit spreads. In the US, meanwhile, the Federal Reserve announced it is moving to an average inflation target, which will permit temporary overshoots of its 2% target to compensate for periods where the level is below that. As for the Fed’s dot plot, that currently suggests interest rates will remain at/near zero until 2023. Finally, the Bank of England continues to discuss the potential of negative interest rates, although governor Andrew Bailey sought to address concerns by ruling it out in the near term. 

In terms of portfolio activity, new issuance has been relatively subdued over the summer months, in contrast to record levels during the second quarter. The notable exception to this was the US market, where issuance continued to set new records, and, combined with reduced costs of hedging, this offers value opportunities. One such opportunity in which we participated was a new USD Tier 2 issue from Barclays, which came at an attractive valuation relative to GBP equivalents, offering upside in a stable to improving market. This was funded by the disposal of our holding in Investec, which appeared fully valued following a significant recovery from the Covid lows and offered limited upside. It is also potentially exposed to a higher level of non-performing loans relative to more diversified peers given the high concentration to SME lending in the UK and South Africa.

We also disposed of our holding in Centrica based on the increasingly challenging outlook the business is facing, alongside the high level of internal restructuring. We reinvested the proceeds in a number of preferred names across the portfolio, including SSE.

As outlined in this recent article, we took the decision to relax the minimum portfolio weighted average credit rating on the Fund from A- to BBB. This allowed us to lift a large proportion of our positions in CDS Indices, reducing our short to the US high yield market consistent with our more constructive view on credit at present. Although not expected to peak until early 2021, the pace of acceleration in high yield defaults has slowed after doubling from pre-Covid levels, given better-than-expected corporate earnings and the number of weaker companies that have already defaulted, with the US contributing approximately two-thirds of 166 global defaults year to date. Further to this, we believe surviving companies are likely to fare better in a recovering market, with a short position likely to be a drag on returns. Ancillary benefits of reducing the CDS exposure include lower trading costs, basis risk and collateral requirements.

It is important to note this does not represent a change in the risk profile/strategy of the Fund, which remains committed to high-quality issuers, as reflected by the average issuer rating of our bond holdings of BBB+. The yield will also remain unaffected. The change simply allows us greater flexibility to maximise income and total returns, while maintaining a short duration position.

Following the initial move lower in yields, which saw UK 10-year gilt yields trough at 0.07%, we increased our long-standing duration short to 4.25 years relative to the benchmark. During the period, we also elected to close the short to the US, which we expect to be volatile as we build towards the election, moving this to the German market where there is less political uncertainty relative to the US and UK. Overall, our short position is currently expressed via 3.25 years to the UK and one year to Germany.

Looking into 2021, we remain constructive on investment grade credit, with technicals set to remain supportive, and also expect companies’ focus to shift towards improving credit fundamentals. As expected, corporate fundamentals have deteriorated, fuelled by the collapse in earnings combined with growing debt issuance; in investment grade, however, issuance has predominantly been defensive in nature to bolster liquidity buffers. This is reflected in high levels of cash on company balance sheets, keeping net leverage levels broadly flat. While further deterioration is likely in the near term as more periods of depressed earnings are factored into leverage calculations, we expect that, having weathered the initial storm, focus will shift towards creditor-friendly debt reduction and balance sheet repair supported by a rebound in corporate earnings.

Credit should also continue to be supported by strong technicals, with ongoing central bank corporate bond purchases, reduced supply given robust levels of liquidity, further fiscal support and rising demand for corporate bonds as a rare source of yield for investors.

As stated, we remain committed to our portfolio, which we believe is well positioned to withstand the economic impacts as a result of the pandemic, and do not view any of our holdings as exposed to a credit event. From a sector perspective, we continue to favour insurance, telecoms and banks, with cyclical non-financials generally over-owned, expensive and/or more heavily exposed to ongoing uncertainty.

Our outlook regarding interest rates also remains relatively unchanged, with government bonds still vulnerable to unprecedented supply and reflation risks. Moreover, with government bond yields close to zero (or below in a number of countries, including Germany), they offer limited ability to dampen portfolio volatility and actually provide meaningful downside risk during bouts of market weakness, supporting our longstanding short duration position.

We continue to believe 10-year gilt yields will remain in a relatively tight trading range of between 0.2% and 0.8%, as the Bank of England uses quantitative easing to limit any rises in yields and remains reluctant to introduce negative rates in the near-term. Given 10-year yields are currently languishing towards the lower end of this range, we believe there is scope for them to rise modestly as the magnitude of fiscal impact on gilt 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 believe there is a risk gilt yields rise and/or the curve steepens, supporting our preference to retain a short position.

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

 

Sep-20

Sep-19

Sep-18

Sep-17

Sep-16

Liontrust Monthly Income Bond B Gr Inc

3.7

5.0

0.8

6.7

10.6

iBoxx Sterling Corporates 5-15 years

4.5

10.9

0.2

1.2

14.1

IA Sterling Corporate Bond

4.2

9.0

0.1

0.6

12.2

Quartile

3

4

1

1

3

 

*Source: Financial Express, as at 30.09.20, 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.

Monday, October 19, 2020, 1:11 PM