Stuart Steven

Why we favour short duration, investment grade, banks and insurers

Stuart Steven

We continue to believe a short duration approach can reduce risk for bond investors, particularly with gilt yields likely to be volatile as fiscal and monetary policies evolve. Liontrust Monthly Income Bond Fund (MIBF) has a long track record of mitigating volatility and as companies face a difficult path through and ultimately past Covid-19, we expect to see limited downgrades in our favoured bank and insurance sectors, particularly given our focus on top-tier names.

 

We predict gilt yields will trade in a tight range for the foreseeable future, kept in check by economic weakness and quantitative easing (QE), and the Bank of England (BoE) doing everything in its power to ensure the Government can fund debt at as close to zero as possible. We do see some risks to this scenario, however, with inflation one potential problem as well as the BoE proving unable to support the Government as much as necessary and consuming its own balance sheet in the process.

 

MIBF maintains a short duration position although we have reduced this recently to around minus four years relative to the index. Over time, the short has increased as yields have trended lower but the two exceptions have been during periods of major uncertainty and, apart from now, we also lengthened duration in the run up to and aftermath of the Brexit vote in 2016.


Duration positioning on Monthly Income Bond Fund

 

While we are keen to remain true to being a short duration vehicle, lengthening our position amid Covid-19 has helped safeguard the portfolio by introducing additional insurance via more risk-free assets. For now, we intend to maintain a smaller short between minus four and minus two years, in line with 10-year gilts yielding between 20 and 80 basis points. We still think short duration is the right approach but with very little return coming from gilt yields over the next few years, it makes sense to maintain the optionality to benefit should the BoE ultimately lose its budget financing battle. If gilt yields are rangebound, and we are correct on the range, we can also make some tactical alpha trading within these levels in what are expected to be difficult months ahead.

 

Most of our duration short (3.4 out of 3.9 years) is via the UK but we have freedom to express the view via different markets as well as various points of the curve. This flexibility has helped mitigate the broadly negative impact of being short duration in a period where we have seen government yields in the UK compress from 3.5% to 0.25%.

 

In the UK, we are short the 10-year part of the curve as we feel that if there is a back up in yields, the 10-year benchmark or even longer maturities will likely underperform. We also have 0.5 years of our short via the US, on the expectation that America’s economy will recover quicker than the UK and Europe.


Moving to credit, MIBF also retains a short position in high yield, where we generally see weaker balance sheets and more challenged sectors. Since early March, the US indices where we are short have already had seven defaults, spread across the energy, retail and services sectors. The one common factor is that recovery levels are significantly lower than we would expect: historically, rates have been 30 and 40 cents in the dollar whereas that has now plummeted to between two and seven cents.

Not only are we seeing a considerable pickup in defaults across the US but these are also particularly painful for anyone long these bonds. Around 13% of the US high market is energy, with another 5% in commercial services and 4% in transport, and with many of these companies trading at distressed levels, there is plenty of pain to come and we feel shorting these indices can help our overall volatility management.

Again, to cover the risks to this view, a V-shaped recovery would create a better environment for distressed high yield businesses but the chances of that are looking very remote. We would clearly review our position if QE support is extended to the high yield market in aggregate.

Overall, investment grade has experienced a good recovery since the collapse in March and long-term technicals are positive, with support from central banks via QE programmes. If we are in a situation where government yields remain depressed and equities are struggling to pay dividends, the only place to go for income is corporate bonds, although, along with equities and high yield, another wave of Covid-19 offers a potential risk to the asset class.

Notwithstanding the recovery, we remain positive on investment grade credit and continue to have confidence in our favoured sectors, which we expect to perform well as the market normalises. While banks and insurers have underperformed this year, this has been attributable to technicals rather than underlying credit conditions.

With banks, many people clearly felt the current crisis would be a rerun of 2008 and the financial sector would bear the brunt but this is a very different situation and, for the most part, banks are proving to be the solution rather than the problem. They are needed by the government as a conduit to make sure companies can continue to source funding and we have seen capital requirements relaxed as a result. The reason banks have lagged so far in the recovery is that technicals have held the sector back, with high levels of new issuance coming to market at significant discounts to existing bonds.

Insurance has been a similar story although the recovery has been more pronounced. Again, the market was initially concerned insurers would be hit hard by a huge escalation in claims as a result of Covid-19 but this has not been the case and we believe the interruption suffered by businesses would not actually be covered by traditional policies. In any case, this remains a sector benefiting from strong solvency positions.

While our favoured areas have been able to generate returns during lockdown, we continue to have no holdings in parts of the market most exposed to Covid-19 uncertainty, namely autos, oil and gas and airlines, and minimal positions in consumer goods and services. While we expect to see limited credit downgrades in banks, insurance and telecoms, sectors facing periods of zero revenues are obviously far more exposed to significant downgrades or even credit events.

In total, we believe only around 4% of the MIBF portfolio is vulnerable to a meaningful credit rating downgrade as a result of Covid-19. Positions that have fallen include property developer Hammerson, where the bonds have dropped from a cash price of around 130p to 100p and stayed low. We believe that while the company could possibly fall from investment grade to high yield, we are adequately compensated for this risk as it is trading with a spread of 650bps, and are happy to retain the position given the flexibility in the business model. Moreover, it also trades very cheaply compared to many BB issuers and we are comfortable with our 1% position.

While there are bonds facing long-term structural problems due to Covid-19, other names have been hit disproportionately purely because of market liquidity and we have already seen a strong rally in our most deeply subordinated holdings in Nationwide, Coventry Building Society and Direct Line.

To conclude, our core view is that government bond yields will be rangebound over the coming months and while we have lengthened duration as a safeguard, the portfolio remains short and we intend to trade tactically between minus two and minus four years. From a credit perspective, the investment grade recovery should be led by our favoured sectors, having lagged so far, and we are short some high yield indices in the expectation that US defaults will continue to pick up.

We believe investment grade is the place to be, with our sector positioning well set to capture the recovery. MIBF remains a high-quality focused portfolio, offering market-leading yield against a backdrop of collapsing equity dividends.

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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.

Tuesday, June 16, 2020, 3:03 PM