Looking at risk-reward at the front end of the yield curve

• In light of rising bond yields continuing to impact bond portfolios, we believe short-dated corporate bonds continue to show their resilience and defensive qualities
• Short-dated corporate bonds coupled with high-quality credit exposure to boost alpha generation could offer an attractive risk-reward route for those seeking to reinvest their portfolios at higher yields
• The M&G Short Dated Corporate Bond Fund utilises a clear, defensive short-dated proposition, with a low duration range of 0-3 years designed to protect against the sort of higher interest rates we’ve experienced since early 2022; we are fully backed by a global credit analysis research team, supporting our active views

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.

Bond yields remain at elevated levels, for now

Currently, the yields available on bonds with different maturities (short, medium, or long-dated) all have something in common: They remain at relatively elevated levels because of central bank action in hiking interest rates as economies attempt to cool inflationary forces. This has started to work, with inflation falling, and there are signs we could be at the peak of the rate-hike cycle. But as things stand, rates are still historically high, and this is a challenge for bonds.

October saw the European Central Bank keep deposit rates at 4% - their highest since the launch of the euro in 1999. Meanwhile, the Bank of England kept rates at 5.25% (a rate akin to February 2008 levels), while the Federal Reserve maintained rates at a two decade high in its October meeting (5.25/5.50%).

Short-dated’s unique risk-reward opportunity set

Naturally, high quality corporate bonds issued at the shorter end of the yield curve are an asset we like, and we have been selectively active in this growing space since 1993 (when the this fund was launched). But we also believe the scenario of elevated bond yields mentioned above has altered short-dated corporate bonds’ risk-reward opportunity set. If we look at the chart in Figure 1 overleaf – and this is a very simple representation of different types of investment grade indices’ all-in yield* - we are seeing quite different risk characteristics, yet yields on offer are broadly similar. (*A corporate bond’s ‘all in’ yield comprises the ‘risk-free’ interest rate, plus the credit spread).

 In a nutshell, and based on the simple graphical representation in Figure 1, yields on short-dated high quality bonds were similar to longer-dated high quality bonds, but there was less sensitivity to rising interest rates in the former. Interestingly, in 2022, maximum drawdown losses were also smaller for short-dated credit compared to longer-dated credit, regardless of where they were issued (US, Europe etc.). So while last year was very tough for investment grade bonds, lower-duration solutions had stronger loss-limiting qualities compared to investment grade bonds with longer maturity horizons. We therefore believe it is possible to take lower rates risk within bonds, but without sacrificing too much yield in compensation.

Figure 1: The contrasting risk characteristics of investment grade bonds, but there could be a similar ‘all-in yield’ on offer!

Past performance is not a guide to future performance

Source: M&G Investments and Bloomberg indices – data extracted 11 September 2023. Please note - indices are not investible.

Why take lower interest rate risk?

Because of the relative drawdowns between short-dated and longer-dated assets, as shown on the chart (see Figure 2). This is a simple representation of the index values of European investment grade corporate bonds compared to the values of similar, good quality bonds but with a shorter duration exposure (in this case 1-3 years; the blue line appears smoother). We suggest this chart shows that, since the advent of high rates uncertainty to deal with high inflation - which has been a big problem for bond investors - there has been less drawdown volatility in the case of low duration bonds, matched by a better total return profile.

Past performance is not a guide to future performance

Figure 2: The power of (low) duration - European IG index vs the short-dated European IG index

Source: Bloomberg, ICE BofA, 31 August 2023

Active management in short-dated credit

Having a clear, defensive proposition to attempt to limit losses to capital value when rates are high is fine, but what are we doing to try to improve the risk-reward profile of a short-dated credit strategy during volatile periods, or when rates may have peaked (as some commentators argue)? Within our fund, there are three key ways we try to add value: 3 M&G Short Dated Corporate Bond Fund: Risk-reward at the front end of the yield curve

Global credit analysis

One area where we believe we can try to add value is being active within the global corporate bonds market – and in the process drawing on the expertise of M&G’s in-house credit research team as we seek to identify the most compelling opportunities across global credit markets. In a more volatile market environment, with increasing dispersion between individual credit valuations, we believe the current backdrop can provide a rich source of alpha generating opportunities for active managers such as ourselves. A good recent example is adding financial bonds from the senior part of the capital structure (eg covered bonds) after some in-depth analysis by our London team of researchers.

As at 31 October 2023, the fund’s credit spread duration (portfolio sensitivity to corporate bond risk) was around 2.7 years with credit risk mainly derived from euro credit (0.9 years), UK sterling (1.2 years) and some US dollar issues (around 0.6 years’ worth). The equivalent period last year, credit spread duration was broadly similar at around 2.6 years and split between euro (0.9) and UK sterling (1.1) assets, with around 0.6 years of US dollar assets. We believe this consistent level of credit risk is cautious enough given spread volatility, but contains sufficient corporate bond exposure (which we can dial down or up) based on current valuations and the mainly subdued outlook for the global economy.

Floating rate notes

The fund also has the flexibility to invest in floating rate notes – debt instruments with coupons that fluctuate with interest rates. Because coupons are made of a variable component plus a fixed spread, we suggest they can help protect investors from high rates and add upside potential. Currently over a third of fund assets are floating rate (see Figure 3). These consist mainly of floating rate notes, but also asset-backed securities and among these, mortgage-backed securities (however, not all ABS are floating rate in nature).

Within ABS, we use as much as possible the full resource of the global credit research team throughout what can be a complex process. For the most part, holdings of ABS are a combination of traditional ABS and residential mortgage backed securities. They are integral to our short-dated corporate bonds strategy. Today, our ABS exposure is mainly invested in what we call ‘national champions’, like blue-chip banks and financial companies with robust balance sheets. Regionally, the UK dominates issuance, while in terms of ratings quality, the vast majority of ABS paper held is AAA rated. The average rating of the fund is A, so still high quality, and the main theme for the portfolio currently is going up in quality given spread uncertainty and selectively picking particular names in A/BBB ratings (names that the analysts like and consider to be trading cheaply).

Figure 3. Asset allocation, % fund

*not all ABS are floating rate in nature † includes cash, government bonds and credit default swap contracts. MBS = Mortgage backed securities. Please note, portfolio data is based on internal sources, is unaudited and may differ from information as shown in the Monthly Fund Review.

Source: M&G Investments, 30 September 2023.

M&G’s ABS research premium

We consider M&G to be among the leaders in investing in European asset-backed securities (ABS), in which the fund can freely invest, as mentioned. The relative complexity of researching ABS is a key reason why this asset class offers investors a risk premium in excess of regular corporate bonds, in our view. During the summer, investing in AAA rated ABS (in the example in Figure 4, residential mortgage-backed securities) has offered a similar level of credit spread to investors as short-dated BBB rated corporate bonds - and higher than short-dated AA rated corporate bonds.

Source: JP Morgan, Bloomberg, 20 July 2023

Figure 5: Fund performance year to date (%) and five calendar years (% pa)

Past performance is not a guide to future performance

The Markit iBoxx EUR Corporates 1-3 year Index (GBP Hedged) was introduced as the fund’s benchmark on 13 March 2018.

The benchmark is a target which the fund seeks to outperform. The index has been chosen as the fund’s benchmark as it best reflects the scope of the fund’s investment policy. The benchmark is used solely to measure the fund’s performance and does not constrain the fund's portfolio construction. The fund is actively managed. The fund manager has freedom in choosing which investments to buy, hold and sell in the fund. The fund’s holdings may deviate significantly from the benchmark’s constituents.

Source: Morningstar, as at 31 October 2023, Sterling Class I Inc shares, price to price, income reinvested. Benchmark returns stated in GBP terms.

M&G Investments

November 2023

Main risks associated with this fund

• 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 may use derivatives to profit from an expected rise or fall in the value of an asset. Should the asset’s value vary in an unexpected way, the fund will incur a loss. The fund’s use of derivatives may be extensive and exceed the value of its assets (leverage). This has the effect of magnifying the size of losses and gains, resulting in greater fluctuations in the value of the fund.
• 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.

Other important information

The fund allows for the extensive use of derivatives.

Further risks associated with the fund can be found in the fund’s Key Investor Information Document.

6 M&G Short Dated Corporate Bond Fund: Risk-reward at the front end of the yield curve