A go-anywhere approach to fixed income investing in an environment of rising inflation

5 min read 15 Nov 21

In an uncertain economic environment, where inflation is rising and bond asset valuations remain tight – very like the one we navigate today – a fully flexible fund with a clear focus on active return generation is more important than ever, in our view.

Inflation is a challenge for fixed income investors because rising prices can erode the present-day value of the future interest payments a bond will make, as well as the amount investors such as us get back when a bond matures.

The M&G (Lux) Optimal Income Fund is one of the most flexible bond funds within our M&G Fixed Income range. It is a “go-anywhere” strategic bond fund and since the strategy was launched in 2006, we have been able to move freely between investment grade corporate bonds, high yield bonds, government bonds, emerging markets debt and even equities (the latter up to 20%). We believe this flexibility provides the scope for us to capitalise on shifts in sentiment and emphasis those areas in the bond market and beyond offering the best - indeed optimal - prospects at any one time.

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.

Being active to changes in the interest rate and inflation outlook

As we respond to changes in inflation and interest rate expectations, we believe it helps to be active and flexible in our interest rate risk outlook (‘duration’) and views on corporate bonds (‘credit’) to support active return generation.

Firstly, from a duration perspective, we believe that the combination of monetary and fiscal stimulus could result in higher growth and higher inflation. This in turn will put pressure on government bonds, particularly longer-dated ones. Moreover, government bonds don’t offer a favourable risk-reward as rates are generally close to zero, therefore offering limited upside in their price. In this context we maintain a low duration positioning in our strategy compared to the wider market.

Secondly, we believe the corporate bond market remains well supported in a scenario of low interest rates, as central banks look to stimulate the economy. In the US, core inflation is currently around 4%[1], while short-term rates are next to zero. This means there is still a very long way to go before real rates can return in line with inflation. As long as central banks lag inflation, credit should remain well supported, because in that environment we believe default rates will likely remain low. Within our strategy we have been shifting away from US dollar investment grade corporate bonds mainly into European corporates (banks) as we find the latter more attractive.

We have also been active in inflation markets - buying or selling government bonds indexed to the inflation rate (index-linked bonds or ‘linkers’) as we try to gauge the path of inflation in the coming period. For example, last year we were active in buying long-dated US TIPS (Treasury Inflation-Protected Securities) as they were pricing in a very low inflationary environment. This was inconsistent with our view on inflation. This year we have focused more on Japanese and eurozone linkers. The latter we reduced just recently as inflation in the eurozone has surprised to the upside and inflation expectations have risen significantly.

As part of our flexible and unconstrained mandate (i.e. without restrictions according to sectors or instruments or by a benchmark), we have also bought some equities issued by companies operating in cyclical sectors, which traditionally have benefited from an improving economy. This includes consumer discretionary, energy and healthcare sectors. 

Turning to our views on economic growth for the rest of the 2021 and into 2022, we remain positive. But a consequence of this strong growth and robust employment data is creeping inflation, and we believe it will end up being higher than what we have been used to in previous periods of recovery – and be more permanent. In this case, we are wary of holding too much duration because the prices of government bonds will steadily worsen as their yields rise in response to inflationary pressures. We have also remained cautious on getting caught up in overvalued corporate bond markets, although we continue to look for attractive opportunities, particularly in Europe and UK markets and in sectors such as financials. We believe banks are like the mirror of an economy: when the economy is strong, banks are well-supported, while when the economy weakens, banks will suffer. We currently are in a positive macroeconomic environment, hence we like to own banks.

Please remember that where past performance is mentioned it is not a guide to future performance.

Further details of the risks that apply to the fund can be found in the fund's Prospectus.

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

The fund allows for the extensive use of derivatives.

By M&G Investments

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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