Liontrust Strategic Bond Fund

August 2020 review

The Liontrust Strategic Bond Fund returned 0.3%* in sterling terms in August. The average return from the IA Sterling Strategic Bond sector, the Fund’s comparator benchmark, was 0.2%.

 

Market backdrop

 

Global growth is now forecast to be -4.3% in 2020, not nearly as bad as it could have been given the nature of the Covid-19 crisis. The recovery is uneven by both sector and country; many nations are reaching their point of maximum mobility given infection rates are rising once again. However, the sheer quantum of monetary and fiscal support has underpinned economic systems and ensured markets remained investable. To be clear though, we do not want to invest in the generic market and choosing the correct rates exposure and quality credits has never been more important. We have maintained our low duration stance, with a preference for the US market. Within credit, we prefer to spend our risk budget on high yield, where the valuations are much more compelling than in investment grade, provided you invest in the long-term survivors. For more detail, we recently published our latest thoughts on fixed income strategy.

Federal Reserve Chair Jay Powell was expected to announce a new monetary policy framework at the upcoming September FOMC meeting, however, he chose to front run this at the Jackson Hole central banking symposium instead. This was the most significant event for bond markets during the month and we expand upon it below.

The Fed and inflation averaging is this MMT (Modern Monetary Theory)?

For a decade or so, most G7 central banks have used a single point inflation target as a core mechanism to guide investors and manage monetary policy. The wisdom of such a mechanism has often been questioned. The US Federal Reserve became the latest central bank to water down inflation targeting in their approach to economic management. After a review of its modus operandi, the start of which predated the Covid-19 crisis, the Fed concluded that its focus should be on reducing any deviation below full employment (“assessments of the shortfalls of employment from its maximum level”) and that it should switch to an average inflation target (“following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time”).

Unemployment is key. With many looking for a job, and following a period of below-target inflation, folk are of the opinion the Fed will let the economy run “hotter” than previously expected for the foreseeable future. This clearly has implications for the fixed income markets.

Long-dated bonds are less valuable. Rising inflation expectations, assuming the Fed is successful, means the real worth of a nominal fixed income stream declines. Investors demand more interest, so the price of fixed income bonds falls, as does the value of equity dividends or any other projected cash flow.

Earnings are a “nominal” concept – higher inflation should create higher nominal earnings and boost stock prices, even if inflation erodes the real value. So, if inflation is cumulatively 100% in the next decade, Netflix should be valued at twice the price in ten years as it is now (of course, its real worth remains the same). Clearly sectors and companies with pricing power will win out.

But we’ve been here before. For a decade since the financial crisis, central banks have used aggressive policy to hammer down the price of money without much evidence of increasing general prices.

This is perhaps where MMT comes in. Parts of this new policy have the market convinced Jay Powell has decided to adopt MMT, an alternative economic theory that downplays the role of traditional monetary policy (basically interest rate changes) in economic management. It’s the theory that governments should print and spend as much money as they like to push the economy to full employment and thereby stimulate growth by running a big deficit, funded by printing money. Go and buy a bridge and get some folk to build it. Those folks then take their salaries and spend them on other stuff, thereby kick-starting the economy and boosting employment further. If the economy runs too hot, raise taxes rather than play with interest rates.

Can that work? It sounds simple. First, you need spare capacity: are there bridge builders waiting to be employed? If not, you risk “crowding out” other investments. So far, so good, as the US has lots of people; possibly some are skilled bridge builders.

Second, you need a fiat currency: print your own money and have it used as a unit of exchange and value. You don’t need to promise to give people something like gold if it all goes horribly wrong. The US dollar is still (just) the world’s reserve currency. The problem is once you lose this status, you don’t get it back: see sterling.

Crucially, you need faith in that currency: if there is an unlimited amount, then the value may decline. Each unit of that currency may be worth less in terms of the number of bridges it can buy. So, eventually your own domestic population may stop accepting the currency as payment, or you need a friendly central bank and a belief in QE to maintain a finite supply.

Furthermore, you need few competitors to your currency: if consumers are worried the currency will fall, rather than buy goods and services, they may hoard in gold, property or other financial assets. Apple may rise to be worth US$3trillion.

Finally, you need a closed system: if you need to import goods and services and run a trade deficit, you need to hope your currency still holds value internationally. If not, you’d struggle to exchange goods and services for that currency, or lot more of it will be demanded. Examples of when it hasn’t worked include Zimbabwe, Argentina, Weimar Republic, Italy 1945-1999 and the UK in the 1970s/80s.

Of course, MMT reduces or removes the role of the central bank in setting rate policy. Hand the keys of the treasury to the politicians. Let them spend as much as they want. Political cycles, snouts in the trough? Nothing to worry about.

Powell reducing rates, preparing to let the economy run hot, petitioning Capitol Hill to increase fiscal spend, hoping to weaken the dollar. MMT? I think not. It’s a few decades since we studied economics, but fiscal and monetary policy working together wasn’t a new concept even then – indeed, Roosevelt made a reputation from it 90 years ago. NND – New New Deal – not MMT?

Now if only the European Central Bank and Bank of Japan had tried this instead of monetary manipulation madness masquerading as Quantitative Easing and yield curve control, perhaps we’d have had a decade of decent growth post the financial crisis instead of the anaemic period we had.

Rates

At the end of August, the Fund had 3 years’ duration, with a strong preference for the US. There was a small net addition to duration during August after the roughly 20 basis points rise in government bond yields; any meaningful rebound would be used to trim the additional exposure back down again. Overall, the Fund retains a low duration exposure and associated small correlation to sovereign bond markets.

We rotated the Fund’s TIPS (Treasury Inflation Protected Securities) exposure from the 10-year tenor into the 30-year; the latter has more dependence on structural trends so the inflation breakeven tends to be less volatile than shorter dated TIPS. The Fed’s inflation pronouncements at Jackson Hole have aided this position.

Allocation

The Fund continues to be significantly exposed to credit having made a large asset allocation increase during the crisis. The combined weighting is approximately 75%, split between 53% investment grade and a little over 20% high yield including overlays.  Within high yield, we have continued rotating the CDS index overlay (using iTraxx Xover) into physical holdings.

Selection

Turnover within credit was very low in August as a combination of thin liquidity and low volatility generated very few opportunities. We are relaxed about this as we are extremely comfortable with the companies whose debt the Fund has exposure to. The one purchase was a high-quality high yield bond new issue from Level 3 Communications, a key subsidiary of the US telecommunications company CenturyLink.

Discrete 12 month performance to last quarter end (%)**:

 

 

Jun-20

Jun-19

Liontrust Strategic Bond B Acc

2.8

5.5

IA Sterling Strategic Bond

3.8

5.3

Quartile

3

2

 

*Source: Financial Express, as at 31.08.2020, accumulation B share class, total return (net of fees and income reinvested.

 

**Source: Financial Express, as at 30.06.2020, accumulation B share class, total return (net of fees and income reinvested. Discrete data is not available for five full 12 month periods due to the launch date of the portfolio.

 

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.

Thursday, September 10, 2020, 1:22 PM