Lower inflation calls for higher flexibility: M&G (Lux) Optimal Income Fund

Lower inflation, low growth expectations

We have talked many times about the efficacy of monetary policy, and that it works with a delay. The substantial quantitative easing (QE) measures implemented during the COVID pandemic resulted in an excess of liquidity within the system. With something of a lag, this liquidity expansion translated into strong consumption and higher inflation. The situation then reversed as central banks raised interest rates and reduced liquidity through quantitative tightening (QT) operations.

Lower liquidity means inflationary pressures are diminishing and in our opinion will likely continue to do so, particularly as monetary policy remains tight on a historical basis. Higher interest rates mean that growth will soften, although at a slower pace than usual given consumers were in a strong financial position to start with. However, the impact of higher rates is now starting to manifest itself, as the labour market is slowly deteriorating (see Figure 1).

Figure 1. Has a tighter monetary policy worked? US unemployment and ‘quit’ rates are at pre-COVID positions¹

Source: M&G, Bloomberg, US Bureau of Labour Statistics; 30 June 2024 for the unemployment rate, 31 May 2024 for the quits rate (latest data available)

Overall, it appears that the economy is moving back into balance, with inflation returning towards target and the labour market approaching pre-COVID levels. Consequently, we believe central banks should gradually start to adopt a more neutral stance on monetary policy. This would allow them to achieve their desired inflation target while keeping the economy afloat. However, if central banks persist with their QT operations and higher-for-longer rates, the risk of a monetary policy mistake will significantly increase, along with the risk of defaults. This means we are currently at a crossroads and will closely monitor the decisions made by central banks, adjusting our portfolio positioning accordingly.

Duration and credit risk - favouring the valuation signal

We have two levers integral to the investment process that we use as we seek to deliver an optimal income for clients. The first is how much duration risk we want to take, compared to the wider market and relative to previous cycles. Currently we like the risk-reward for owning more duration. The portfolio has around 6.7 years’ worth of interest rate risk as a result, ie an overweight position. Figure 2 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 a lot more compelling.

Figure 2. The risk-reward in 10-year US Treasuries remains favourable

Source: Bloomberg, 30 June 2024. 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.

Actively adjusting credit risk (corporate bonds) is another lever we use. At the moment, we believe valuations are around ‘fair value’, so not as attractive as we’d like (see Figure 3). Our current neutral position – portfolio spread duration is around 4.3 years - is based on the view that the asset class trades at relatively expensive levels, and against an uncertain economic backdrop, albeit with selective active opportunities. We are in a "wait-and-see" mode and remain prepared to adjust our strategy based on the future trajectory of the economy.

Figure 3. Credit spreads for the Global Investment Grade Corporate Bond Index since 1998

Past performance is not a guide to future performance.

Source: Bloomberg, ICE Bank of America indices, 30 June 2024. Note: spread is adjusted for rating and maturity changes over time. 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.

• PORTFOLIO ACTIVITY IN 2024 – It is worth looking at how active changes to our relative duration and relative credit views correspond at an asset level. Figure 4, below, shows that over the first half of the year we have kept long duration stable at 6.8-6.7 years, but adjusted our weights within what is a spread-tight credit universe.

Figure 4. Key changes in fund portfolio positioning over the first six months of 2024

Source: M&G. Portfolio positioning for the M&G (Lux) Optimal Income Fund at 31 December 2023 vs 30 June 2024. *Vs portfolio neutral weight of 33%

• A FLEXIBLE REMIT –We believe that the fund has an interesting, forward-thinking, and flexible remit across what can be an exciting asset class to own. Figure 5 shows how we have actively rotated across the three core bond assets (the green ‘orbits’ of global government, investment grade, high yield in the chart). Today, we are perhaps where a global investment grade fund might sit in terms of credit quality, but with more duration. For most of the strategy’s lifetime, we have been nearer the high yield world, against a backdrop of lower rates/wider credit spreads.
  

Figure 5. Duration risk versus credit risk in the Optimal Income strategy through the years

Source: M&G Investments; portfolio positioning between 31 December 2006 and 31 May 2024

On 8 March 2019, the non-sterling assets of the M&G Optimal Income Fund, a UK-authorised OEIC which launched on 8 December 2006, 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.

Performance year to date

For most of the year so far, and against most expectations, we have seen "sticky" inflation and reasonable economic growth. As a result, interest rates have risen as investors reassess the magnitude of central banks’ rate cuts, while credit spreads have mainly tightened, reflecting an environment of positive growth and relatively low defaults.

In this environment, the performance of the strategy on an absolute basis has been supported by credit and by our exposure to higher-beta names such as high yield bonds, long-dated investment-grade debt, and selected financials. Conversely, our long duration positioning has detracted as rates have generally risen in the six months under review.

Versus the benchmark, the overweight exposure to financials and long-dated investment grade corporate bonds has generally contributed to relative return, while the underweight exposure to high yield had a negative impact. Our relative bias to longer duration has detracted.

Figure 6: 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 June 2024, Euro Class A Acc shares and USD Class A-Hedged shares, price to price, income reinvested. Performance data do not take account of the commissions and costs that may incur on the issue and redemption of units. 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

• 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. There is no guarantee that the fund will achieve its objective and you may get back less than you originally invested.
• Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund.
• High yield bonds usually carry greater risk that the bond issuers may not be able to pay interest or return the capital.
• The fund is exposed to different currencies. Derivatives are used to minimise, but may not always eliminate, the impact of movements in currency exchange rates.
• Investing in this fund means acquiring units or shares in a fund, and not in a given underlying asset such as building or shares of a company, as these are only the underlying assets owned by the fund.

Further risk factors that apply to the fund can be found in the fund's Prospectus. The Fund’s sustainability information is 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.

Learn more about the fund

_{¹ The quit rate is the frequency at which employees voluntarily leave their jobs within a specific time period. A lower quits number indicates a slowdown in the jobs market (and vice versa) as workers become less confident of their employment outlook.}