Why flexibility is key in current bond markets

Stuart Steven & Aitken Ross

Wherever people fall on the ‘end of bond bull market’ debate, we are undoubtedly in a tougher period for the asset class as yields and interest rates start to climb.

And while we are confident there is still money to be made in fixed interest, we believe more flexible mandates such as on our Monthly Income Bond Fund can help generate returns while reducing volatility against a more challenging backdrop.

The first thing to understand is that, at its heart, Monthly Income Bond has always been a traditional investment grade bond fund: a minimum of 80% of the portfolio is in higher-quality credit. We believe in active management and have a focused portfolio of bonds (50 to 100), setting the fund apart from ‘quasi index’ peers. These core positions have generated the vast majority of returns and all the income since launch and we expect this to be the case in future.

On top of this core credit portfolio however, a flexible approach to managing interest rate risk can enhance returns, particularly in an environment where government yields are low and rising.

Many funds are keen to be short duration at present to protect against rising rates but short-dated bonds are generally undermined by extremely low government yields and tight credit spreads. As an alternative, we are able to buy 10-year corporate bonds (or longer) with significantly higher spreads and yields and use futures to reduce unwanted interest rate risk.

This not only helps generate higher income but in an environment that is supportive of credit (decent economic growth and very low defaults), it can also add to returns via capital gains if spreads contract.

Since launch in 2010, Monthly Income Bond has been structurally short duration, with an average of around four years equating to 60% of its iBoxx Corporate GBP 5-15 year Index benchmark. Moreover, over the last two years of historically low government yields, we have reduced duration to a reduced target of 2-2.5yrs.

Eliminating unwanted risk can also be important on the income side, with Monthly Income Bond currently the highest-yielding fund in the Investment Association’s Sterling Corporate Bond sector (Source: Financial Express, based on historic yield figures as at 30.06.18). The fact we have achieved this with an average single A credit rating highlights two points about our income generation – we are not taking excess risk to generate it nor are we willing to sacrifice credit quality.

With a flexible mandate, it is possible to buy favoured bonds first and foremost and then adjust the macro positioning and risk profile using derivative overlays. These opportunities may be in other currencies, countries, up and down the capital structure and across the curve but we have the tools to capture the specific value we are targeting.

The following table shows how this works in practice, comparing and contrasting sterling and dollar bonds from French telecom business Orange. As can be seen, the two bonds have the same level of credit risk and interest rate risk (duration) but the potential income, returns and yields on offer are very different.

 

ORAFP £8.125% 2028

ORAFP $8.5% 2031

Currency

GBP

USD

Credit rating

BBB+

BBB+

Same credit risk

Credit spread (in basis points)

116

168

Better value

Income yield

5.40%

6.30%

Higher income yield

Gross redemption yield

2.60%

4.60%

Higher total yield

Duration

7.7

8.3

Similar duration

Optionality

Standard

Favourable

Better optionality

Outstanding

£500m

$2,460m

Better liquidity

 

Source: Bloomberg, as at 11.06.18

The US dollar bond has close to an extra 100 basis points of pick up in income yield as well as offering over 50bps of additional credit spread for the same risk – which suggests good value versus the equivalent sterling bond.

As well as enhancing returns and income, mandate flexibility has also allowed us to reduce volatility over the medium to long term. Synthetically reducing duration has brought volatility down, as the source of the latter, especially over the last two years, has largely been rate markets rather than credit itself.

Given a relatively robust global economic backdrop, we expect this will continue to be the case, so our interest rate hedges should help protect capital as government yields trend higher, and also continue to dampen volatility. As a further measure, we use short positions in credit default swap (CDS) indices to reduce volatility and ensure we have a degree of tail risk protection at all times.

As all these protection strategies are effectively buying ‘insurance’, the cost results in a small drag on performance, but this has been negligible compared to the total returns generated. Moreover, this has enhanced our returns, particularly relative to short dated funds, as it has allowed us to purchase longer bonds and more subordinated debt while still remaining true to our macro view.

In summary, the flexible mandate on Monthly Income Bond is designed to allow for strong performance and income throughout the economic cycle. By using the skills within the team, we also employ government cross market and curve trades to further add to returns and reduce dependency on credit positioning. This is particularly beneficial when nearing the end of the credit cycle as it allows us to de-risk while still having the opportunity to continue delivering alpha for investors.

In recent months for example, we have used credit curve steepening to take advantage of market inefficiency. Spreads were rising not because of underlying credit concerns but rather as a result of investors selling long bonds to reduce interest rate risk. Our mandate allowed us to buy these longer bonds – which were also cheap as the market was biased towards selling – and hedge out the additional interest rate risk.

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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 issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in Funds managed by the Sustainable Future 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. The Monthly Income Bond Fund has a Distribution Yield which is higher than the Underlying Yield because the fund distributes coupon income and the fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining the fund’s capital appreciation. The Distribution Yield and the Underlying Yield is the same for the SF Corporate Bond Fund.

Disclaimer

This content 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. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust. 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, July 4, 2018, 10:28 AM