M&G (Lux) Optimal Income Fund - Revisiting the duration risk-reward opportunity

The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. There is no guarantee that the fund will achieve its objective. Past performance is not a guide to future performance. 

Is duration a risk worth taking?

Monetary policy works with a lag. The sharp increase in liquidity we experienced around the COVID-19 pandemic led to a resurgence of inflation about 18 months later. Central banks have now reversed course, causing money supply to fall, and this in turn will continue to put downward pressure on inflation. For investors, this means central banks are at the end (or very near the end) of their tightening cycle. This, we suggest, has created an attractive risk-reward opportunity for duration-bearing assets. We think is even more relevant given the historically high starting yields of many core government bonds.

Duration is starting to look attractive to us . At about 6.1 years, the fund is modestly long duration compared to its reference benchmark. To put this into context, duration was around 2.4 years at the beginning of 2022 (see Figure 1). In this scenario, we believe that owning duration is attractive: the downside is limited, as in our view rates are close to the peak, while the potential upside is good, as this time around central banks have room to cut rates significantly. In the portfolio, we continue to scale into boosting duration risk because of the value attached; eg, we have recently moved some portfolio duration away from euro assets, back into US dollar assets as US Treasuries underperformed and are now looking relatively more attractive.

Figure 1 – The fund’s duration evolution – we consider it reasonable value to hold a relatively high position

On 8 March 2019, the non-sterling assets of the M&G Optimal Income Fund, a UK-authorised OEIC, merged in the M&G (Lux) Optimal Income Fund, a Luxembourg authorised SICAV, which launched on 5 September 2018. *Data prior to 8 March 2019 refers to the OEIC.

Source: M&G, 30 September 2023. Information is subject to change and not a guarantee of future results.

While cash might appear relatively attractive today with interest rates at multi-year highs, it may soon lose its appeal if rates were to fall as investors would have to reinvest at a potentially much lower yield. Cash deposits are guaranteed up to €100,000 under the European Banking Authority’s deposit guarantee scheme. 

Based on the scenario below, should interest rates remain range-bound, we could still benefit from the higher coupon offered by owning duration today. However, if rates were to fall we could be in a strong position to benefit from rising bond prices (see Figure 2). So, in our view, owning more duration than we have owned historically makes sense from a risk-reward position. 

Figure 2 Scenarios for the potential risk-reward in 5-year German Bunds

Source: Bloomberg, 30 September 2023. Information is subject to change and not a guarantee of future results.

Dropping the ‘N’ from TINA

Until 2021, we were living in an environment of extremely low interest rates. As a result, many investors shifted their allocation towards equity, as that was considered to be the only way to generate some attractive returns. However, things have now changed considerably. Fixed income is finally back, providing investors with a valid alternative to stocks. Even more so if we look at valuations (see Figure 3). The expected yield from fixed income investing is now looking more attractive than the one provided by stocks. So in some respects we’ve gone from ‘There Is No Alternative’ (TINA) to ‘There Is an Alternative’ (TIA).

Figure 3 From TINA to TIA - Earnings yields of US shares vs. yields on US investment grade/US high yield corporate bonds

Past performance is not a guide to future performance

Source: Bloomberg, 30 September 2023. *12m Forward Earning Yield (EY); YTM = yield to maturity 

Flexibility to adapt to different economic environments 

As we move towards the latter part of the cycle, we believe a flexible and diversified approach will be crucial. The M&G (Lux) Optimal Income Fund is a fully flexible fund that over the years has demonstrated its capability to adapt to different market environments, in our opinion. We have never been static; the tactical changes in asset allocation since fund inception have been a reflection of our informed views on asset valuations and macroeconomic conditions (see Figure 4). Recently, as rates rose further, we increased our duration from neutral to a small overweight. On the other hand, tighter spreads and rising macroeconomic risks pushed us to reduce our credit risk to a more neutral stance. However, we continue to look for opportunities to explore dislocations in credit markets and occasionally we get involved in the primary market, where we can find new deals with attractive premiums 

Figure 4 Duration vs. credit risk through the years

On 8 March 2019, the non-sterling assets of the M&G Optimal Income Fund, a UK-authorised OEIC, merged in the M&G (Lux) Optimal Income Fund, a Luxembourg authorised SICAV, which launched on 5 September 2018. Data prior to 8 March 2019 refers to the OEIC. Note: Equity is considered with a CCC rating. Information is subject to change and is not a guarantee of future results. 

Source: M&G from 31 December 2006 to 31 August 2023

Moreover, by leveraging the long lasting expertise of our fund management team as well as one of the largest and most experienced credit analysts team in Europe, we suggest we have been able to offer a well-diversified product that captures opportunities across different asset classes and in different jurisdictions (see Figure 5).

Figure 5 Diversified sources of yield based on the fund’s exposure to different bond types

Source: M&G, Bloomberg, ICE BofA, 31 August 2023

Fund description

The fund aims to provide a combination of capital growth and income to deliver a return based on exposure to optimal income streams in investment markets. Typically, at least 50% of the portfolio is invested in a broad range of fixed income securities of any credit quality and from any country, including emerging markets, and denominated in any currency. The fund manager selects investments wherever he sees the greatest opportunities, based on his assessment of a combination of macroeconomic, asset, sector and stock-level factors. The manager may also hold up to 20% of the portfolio in company shares when he believes they offer better value than bonds. Companies that are deemed to be in breach of the UN Global Compact principles and/or involved in industries like tobacco, controversial weapons, unconventional oil and gas extraction, gambling and thermal coal are excluded (thresholds may apply). 

Performance: YTD, YTQ (%) and calendar-year performance (pa%) 

Past performance is not a guide to future performance

YTQ = year to most recent quarter.

*Benchmark: 1/3 Bloomberg Global Aggregate Corporate Index EUR Hedged, 1/3 Bloomberg Global High Yield Index EUR Hedged, 1/3 Bloomberg Global Treasury Index EUR Hedged.

The benchmark is a comparator used solely to measure the fund’s performance and reflects the scope of the fund’s investment policy but does not constrain portfolio construction. The fund is actively managed. The fund’s holdings may deviate significantly from the benchmark’s constituents. The benchmark is not an ESG benchmark and is not consistent with the ESG Criteria. 

The composite index was introduced as the fund’s benchmark on 7 September 2018. Fund performance prior to 7 September 2018 is that of the equivalent UK-authorised OEIC, which merged into this fund on 8 March 2019. Tax rates and charges may differ.

Source: Morningstar, Inc., as at 30 September 2023, Euro Class A Acc shares and USD Class A-Hedged shares, price-to-price, income reinvested. Not all share classes are registered for sale in all countries. Details in Prospectus.