The enduring case for taking rates risk in 2024: M&G (Lux) Optimal Income Fund

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 and you may get back less than you originally invested. Past performance is not a guide to future performance

Higher-than-expected inflation has prompted a rise in bond yields as market participants reassess the size and timing of any future interest rate cuts. Currently, yields are once again approaching the highs seen in October 2023. Given we argued then that bonds are finally at good value, does the investment opportunity still remain because of elevated yields and uncertainty on the direction of rates? (Spoiler alert! We believe the opportunity remains, just as long as you’re active, flexible, and well-informed in your bond selection process).

Higher-than-expected inflation has prompted a rise in bond yields as investors reconsider their forecasts for potential interest rate cuts – both the size and timing. Currently, yields are once again approaching the highs seen in this cycle. The last time we reached similar levels was in October 2023 when the US 10-year Treasury yield surged to 5%. In hindsight, that proved, in our view, a tremendous opportunity to purchase bonds. In the subsequent two months, the US Treasury index returned nearly 8%, while the USD labelled share class of Optimal Income¹ delivered a +11% total return, gross of fees, to 31 December 2023. Past performance is not a guide to future performance.  

But the surge in yields - and then subsequent decline - occurred rapidly, leaving many investors behind. Subsequently, many of these investors have held onto cash with the intent to deploy it when valuations become attractive again. While the market doesn't often offer second chances, it seems that investors may have another opportunity this time around.

Here are three reasons why we believe current rates are still attractive and investors should consider adding duration:

1. Rate cuts have almost been priced out: Market movements often fluctuate between extremes rather than following a smooth path. While the US Federal Reserve has maintained a consistent message, market participants have been mainly erratic, shifting from expectations of ‘higher for longer’ rates, to forecasts of multiple rate cuts in 2024-25. Presently, investors have returned to the higher for longer mindset, with almost no cuts priced in for this year (see Figure 1 below, based on expectations for 2-year US Treasury yields). Consequently, most of the negative news has already been factored into the market in our view.

Figure 1. The Tale of Two Narratives: Investors are now expecting almost no rate cuts in 2024

Source: M&G, Bloomberg, 18 April 2024

2. The Inflation Conundrum: The recent upside surprises in US inflation have provoked some investors to believe that pricing pressures are making a comeback. We have argued against this view for a while now: As long as money supply remains constrained, it is difficult to achieve a sustained and significant inflation ‘reacceleration’. At present, money supply is still contracting (see Figure 2 below) and it would seem that we are now moving into an environment of "too little money chasing too many goods". This scenario is disinflationary and therefore typically good for duration. While some level of sticky inflation may persist, we suggest that there is no need to be overly concerned about inflationary pressures.  

Figure 2. Too little money chasing too many goods? Inflation vs. Money Supply in the US

Source: M&G, Bloomberg, 31 March 2024.

3. An attractive risk-reward profile for core government bonds: In our view, the risk-reward proposition for owning duration (eg US government bonds) remains strong. The downside risk associated with holding government bonds appears limited, while the potential upside could offer the possibility of double-digit returns. Figure 3 below - which is based on M&G’s internal scenarios of expectations for total returns of 10-year US government bonds - illustrates our belief that the risk-reward for duration-bearing assets is improving. 

Figure 3. Risk-reward in 10-year US Treasuries

Source: Bloomberg, 30 April 2024

Past performance is not a guide to future performance. For illustrative purposes only. The scenarios presented are an estimate of future performance based on evidence from the past on how the value of this investment varies, and/or current market conditions and are not an exact indicator. 

Optimal Income 2024 - Long duration + high quality credit exposure  

We believe the opportunity to deploy cash and increase duration in investment portfolios has re-emerged as a result of a unique rates-inflation dynamic, one that has largely come from the central bank response to the COVID pandemic of 2020-21. This may be the final chance for investors to take advantage of the situation, however. Optimal Income remains well positioned in this environment in our view, with a historically high duration position of 7.1 years within a high credit quality portfolio (average rating of A).

Additionally, the fund offers a yield to expected maturity (essentially, an estimate of the annualised return until the expected maturity of its underlying holdings) of c4.5%, gross of fees, in Euro terms. In US dollar terms, this rises to around 6.3% and in UK sterling terms, this is now around 6.0%. All yields are calculated to 30 April 2024. Past performance is not a guide to future performance

Figure 4: 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 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.

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.

Source: Morningstar, Inc., as at 30 April 2024, 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.

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, while applying environmental, social and governance (ESG)  criteria. It seeks to make these investments using an exclusionary  approach, as described in the prospectus. 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. The fund’s recommended holding period is five years. In normal market conditions, the fund’s expected average leverage – how much it can increase its investment position by borrowing money or using derivatives – is 200% of its net asset value. 

Main risks associated with the fund

Further risk factors that apply to the fund can be found in the fund's Prospectus. The Fund’s sustainability information are available to investors on the Fund page of the M&G website.

The views expressed in this document should not be taken as a recommendation, advice or forecast.

This is a marketing communication. Please refer to the Prospectus and the KID before making any final investment decision.

Other important information

• For an explanation of technical terms, please refer to the glossary via the link:
  https://www.mandg.com/dam/global/shared/en/documents/glossary-master-en.pdf
• You can find our sustainability-related disclosures here.

Learn more about the fund

¹M&G (Lux) Optimal Income Fund (USD A-acc share class) has been used as we are comparing performance to US Treasuries, which are denominated in USD