Liontrust Strategic Bond Fund

January 2020 review

The Liontrust Strategic Bond Fund returned 0.8%* in sterling terms in January, compared with the 1.4% average return from the IA Sterling Strategic Bond sector.

 

Market backdrop

Economic data continued to improve in January, industrial production levels having found a base during the final quarter of 2019. Real economic growth for 2020 is forecast to be 2.5%, with nominal growth approaching 5%. Even though the real growth number is below the historic trend, it is still decent, and we believe there is upside risk. Fiscal policy boosts should prove to have far greater efficacy than monetary policy. In January, two challenges to the growth outlook arose, namely Iranian tensions and the coronavirus outbreak; we believe both will be overcome but examine them in more detail below.

Prior to that, as befits bond managers, we should mention central banking developments during January. The US Federal Reserve kept rates on hold and is likely to continue to do so until there is a significant change in economic data. One nuance from Fed Chair Jerome Powell’s narrative is worth mentioning, that of emphasising a symmetrical inflation target. This suggests the Fed will be more tolerant of inflation running above their “symmetrical” 2% target for a longer period to make up for prior undershoots. The European Central Bank is undertaking a review of its monetary policy strategy; we anticipate a move towards symmetry, partly to signal intent to reach the inflationary target. In our opinion, a better signalling impact would be achieved by removing negative rates which are no longer fit for purpose.

Finally, central bank voting members often signal intent in speeches ahead of a policy-setting meeting. In the UK, two previously neutral members of the Monetary Policy Committee spoke in very dovish tones and the bond markets moved to price in the probability of a rate cut. The dovish noises turned out to be a false flag, or in Carney’s last meeting as Governor of the Bank of England he once more lived up to his nickname as the “unreliable boyfriend”. In our opinion the correct decision was made; the UK faces economic pressures regarding a new trading relationship with the EU, but rates are too low regardless of this.

Moving on to the Chinese coronavirus outbreak or the 2019 novel coronavirus (nCoV) to give the proper name to it. There is clearly a very sad human cost to nCoV, but our job is to look beyond this to the potential economic costs. The obvious comparisons are made to the SARS (itself a form of Coronavirus) outbreak in 2003. The speed of response by the Chinese authorities has been much more rapid this time and nCoV currently has a mortality rate of 2-3% compared to approximately 10% for SARS. Once the spread of contagion starts to slow, we can begin to assess the length of any disruption; at the time of writing there are positive signs regarding this. A rough estimate is that nCoV will knock 2% off Chinese growth in Q1, but only about 0.2% for the full year as catch up activity occurs, and offsetting economic stimulus is implemented. Since 2003, China has increased considerably from 5% of global GDP to 18% as of 2019, so without a recovery the impact is meaningful. In this regard, money market rates have already been cut and 1.5 trillion yuan injected. As the year progresses, we would expect a fiscal boost too.

It might already seem like a long time ago, but we must not forget that the year started with the Trump Administration assassinating an Iranian general. A fragile de-escalation appears to have been achieved, but one cannot rule out further antagonistic behaviour from either country.

Historically, a conflict tends to lead to a short-term increase in approval ratings for the respective country’s leaders. But this popularity-boosting effect has become much more transient. In our view, a full-scale war between the US and Iran would definitively not be a vote winner in the US; exhibiting military strength from a distance is one thing, but there is no public appetite for sending troops in.

With over 20% of global oil supply passing through the Strait of Hormuz, a huge price jump in oil prices would be inevitable if a war occurred. Examining various economists’ estimates shows a US$5 increase in the oil price knocks 0.1% off global GDP.

The US would no longer suffer the drag that it has on prior oil price spikes: first, the delta on shale capital expenditures is high enough to offset the import effects and, second, the US is already 90% self-sufficient in oil with more marginal production becoming profitable at higher prices. As an aside, many commentators seem to have overlooked the fact that natural gas prices have remained resolutely weak during these troubles with Henry Hub prices languishing at about $2.10.

Overall though, we view the blips in the oil price as being mainly redistributive as opposed to disruptive. Unless a war does occur, then the aggregate impact is on sentiment not fundamentals.

Rates

As a reminder, the Fund continues to be run with a low beta duration approach, approximately 3 years’ duration contribution compared to our neutral of 4.5 years and an index over 7 years. Within the Fund’s rates exposure, we continue to strategically prefer the US market and believe further compression versus Europe is likely in 2020.

The Fund undertook a good number of rates trades during January. Overall duration was reduced intra-month by selling Canadian bond futures with the underlying bond market exhibiting expensive relative valuations.  Duration was switched from the UK to the US as the former rallied on the dovish central bankers’ comments.  Within the US we reinstated a curve steepening position, selling 30-year Treasury futures into the 5-year contracts. The rationale behind this is that a more inflation tolerant Fed will be late to raise rates thereby damaging the real value of longer-dated bonds. Also, within yield curve management, we took profits on half of the Fund’s 5s10s flattener in Germany.

On the cross market front, the remaining profits were taken on being long Switzerland versus short Germany. A new position was established in the Antipodean markets, long 15-year New Zealand debt versus short Australia 10-year futures. The differential at the 10-year had reached wide levels and this has the added kicker that the Kiwi curve had become particularly steep, making the 15-year the preferred long.

Allocation

A lower risk credit approach has also been maintained; buying extra carry is beneficial provided it has benign volatility characteristics. The key is to recognise that credit spreads are tight and not chase the riskiest parts of the market. The Fund has a lot of available risk budget to buy credit when valuations warrant it.

The Fund is a little below its 50% neutral position for the allocation to investment grade; even more when one beta adjusts holdings. In this lower volatility credit market, we will seek to add some more defensive stock picks to take advantage of carry. Floating rate notes have done their job well and now that the short end of the US yield curve is flat to mildly upward sloping, these will be slowly rotated into conventional bonds.

Obviously, there is yield carry to be had in high yield too – the clue is in the name – even though the capital upside from the beta has been eroded. We used the small credit widening during January’s mini crises to sell protection on iTraxx Xover, the European high yield credit default swap index. This takes the Fund’s overall high yield rating to 20%, split evenly between stock picks in physical bonds and the Xover overlay. The Fund has offset any European systemic concerns from this long risk Xover position by buying protection on Senior Financials versus Main using CDS indices.

Selection

January saw a huge flurry of investment grade new issuance in Europe. By the time the inevitable tightening from the initial price talk had occurred most bonds were fair value at best. The Fund did participate in a 7-year Euro denominated bond issued by New York Life; this won’t make investors in the Fund rich but offers good defensive carry for an AAA/AA+ rated instrument. In the secondary markets we bought bonds in Sempra Energy’s 2028 US dollar debt. This gas and electric US utility has a credit spread of 1% at this tenor which we view as relatively attractive.

In the high yield universe, a secured tranche of Techem, a German metering company, was purchased. In Grifols, the blood plasma company, the Fund switched from 2025 debt to a 2027 maturity for an extra 0.5% yield. Not only is the latter debt not call constrained, it is also senior within Grifol’s capital structure.

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

 

 

Dec-19

Liontrust Strategic Bond B Acc

8.7

IA Sterling Strategic Bond

9.3

Quartile

3

 

*Source: Financial Express, as at 31.12.2019, accumulation B share class, total return (net of fees and income reinvested.

 

**Source: Financial Express, as at 31.12.2019, 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.

Tuesday, February 11, 2020, 3:05 PM