M&G (Lux) Optimal Income Fund
5 min read 23 May 23
With fixed income markets in recovery mode, adding value through active credit selection may prove crucial in the coming months – especially as macro volatility looks like being something of a permanent feature. Carlo Putti, an investment director dedicated to the Optimal Income strategies, provides key insights on latest fund positioning and finding investment opportunities across the fund’s flexible mandate.
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.
It has been a steady start to 2023, following a really challenging 2022 for the vast majority of fixed income markets. March aside, most periods to date have been fairly consistent and positive for bond markets. As a result, against a backdrop of a reasonable economic outlook (peak inflation, labour data still robust) those important determinants of fund return – our active view on duration and credit selection – have been beneficial. Overall, credit spreads have largely gone sideways during the first months of the year, while yields on core government bonds have been generally lower because inflation could be on a downward trajectory.
Through our active credit selection - and our team of global credit analysts have been instrumental here - many corporate bonds we hold have done well so far. Corporate fundamentals remain strong, in our view, and we expect bond default rates to stay lower than expected by the market. Currently, our fund positioning is close to neutral. Duration is 5.7 years vs 6.0 years of our benchmark, while overall asset allocation is also close to its neutrality of 33.3% government bonds, 33.3% investment grade corporate bonds and 33.3% high yield bonds.
However, relative to our benchmark, we tend to carry more credit risk, as we believe the market remains dislocated, providing us with different opportunities to add value. We currently find most of these opportunities within the investment grade space. Generally, this is the area where most of the positive performance has come from year to date, and it’s been a key alpha-generator for us.
Within corporate bonds, dispersion across sectors has been at very elevated levels. Credit valuations can differ quite dramatically – for example, between sectors such as real estate and financials, where credit spreads remain quite wide, and other sectors such as health care and capital goods, where spreads are significantly tighter. Within financials, we have a preference for larger, more liquid and well-capitalised banks, which we believe are in a good position to withstand recent sector stresses and also potentially benefit from any fallout, such as we witnessed in March. As a result, top-down asset allocation will remain important, but it is likely that bottom-up security selection will also have an important role to play.
As central banks have now moved to quantitative tightening (QT) – as oppose to quantitative easing (QE) – we think this has created some really interesting pricing. For instance, we have added some interesting UK sterling bonds as our analysts noticed cheap prices on select bonds, with the Bank of England’s unleashing of its QT programme.
In general, we continue to focus our purchases on US dollar and UK sterling markets. Also, we continue to find what we think are some good relative value opportunities as the market remains particularly dislocated, in our view. Back to sectors, we also quite like utilities at the moment because they are trading with relatively cheap valuations, from our estimates, and tend to operate in very stable businesses.
A key lever for the fund is to use its interest rates risk positioning. During the past 12 months, we have increased the duration (the level of interest rates risk) of the portfolio from around 4.2 years to 5.7 years, and actually it has been steady at this level for most of 2023. The key upward shift was during 2022, when we began to see pockets of value in certain types of government bonds. Most of the duration comes from European assets (around 2.7 years’ worth) and the reasons for this bias are worth stating.
First, valuations are important: European assets have underperformed in recent months and we think they are now looking more attractive. Secondly, we believe inflation will fall faster in the eurozone countries, as their inflation basket is mainly skewed towards volatile items. In the US, the inflation basket is mainly skewed towards ‘sticky’ items. Finally, the Federal Reserve has a dual mandate of managing inflation and maintaining a healthy labour market. If inflation falls while the labour market remains strong, the Fed will struggle to cut rates, as low unemployment means the economy is running above potential, putting upward pressure on inflation. On the other hand, the European Central Bank has only one mandate – tackle inflation. So if inflation continues to fall, the ECB will likely have to cut rates sooner than expected.
A pattern this year has been to rotate away from buying US Treasuries and into both European and UK government bonds. For the latter, we have noticed that UK gilts have underperformed recently because of higher-than-expected inflation, and they are now looking relatively more attractive from our perspective. Within US Treasuries, we have moved some of the higher-priced bonds into lower-priced tranches because of the ongoing uncertainty around the country’s debt ceiling or limit (which is due to expire at the start of June unless the US Congress agrees to raise it). In the very unlikely (though not impossible) event of a default, lower-priced bonds will outperform higher-priced ones in our view, as they are already trading closer to the recovery value.
There are reasons why there could be light at the end of the tunnel in terms of recent peak inflation. We have seen this already in the US with April’s CPI (consumer prices index) report showing annual inflation dropping to 4.9% (core inflation also moderated to 5.5% year-on-year). Inflationary pressures are easing, a wage-price spiral seems to have been avoided for now and rent inflation – the biggest component of the CPI basket – appears to have peaked and will likely be on a downward trajectory for the next few months. Importantly, money supply (as measured by M2) also continues to trend lower, reflecting central banks’ efforts to remove some of the excess liquidity in the system. That, in turn, will likely serve to contain inflationary pressures. So while inflation around 5% is clearly still high, things are moving in the right direction.
It might take a little longer than expected to return to target, but we believe things are definitely on the right track and disinflation will likely remain the theme for some time. Having said that, getting back to target is one thing, remaining around that target is a completely different story. Inflation usually comes in waves as it causes issues which tend to be resolved with more money being created – such as in the 1970s, when the world experienced three waves of inflation, each of them following an increase in the money supply -- and this in turn will cause inflation to reaccelerate.
In summary, we are expecting a very interesting macroeconomic environment ahead, with more volatility to come. In this context, we believe a flexible bond strategy with active credit selection could be particularly relevant for investors in the coming, uncertain period.
Past performance is not a guide to future performance
Main risks when investing in this fund:
Other important information
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.