Today’s value points to bonds

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.

Plummeting bond prices and soaring yields have given investors a better entry point to fixed income in years.

At the end of May, the yield to maturity on the US Investment Grade Corporate Bond index was 5.5% – close to the highest level in more than ten years and higher than the expected yield on the US equity market, which is currently 5.0% (earning yield on the S&P 500 index).

Testament to the appeal of fixed income is that M&G (Lux) Optimal Income, a fully flexible, go-anywhere bond fund with the ability to invest also in equity, had only 0.3% in company shares.

‘We favour the value signal from bonds compared to equities,’ says Richard Woolnough, the fund’s Citywire AA-rated manager.

Being the most flexible fund Woolnough manages, Optimal Income combines a top-down macroeconomic approach with rigorous bottom-up credit analysis to invest across the fixed income spectrum – government bonds, investment grade credit, high yield, emerging market debt  – as well as in equities when a company’s shares appear more attractive than its debt.

‘We are highly active with the ability to be flexible in many areas of the global bond market,’ says Woolnough.

That agility has been used to good effect in many market environments, but really shines in periods of great flux, such as today’s ‘cancel culture – a new monetary phenomena’.

Woolnough – who has more than 30 years’ experience in fixed income investing – points to the observable link between the creation of money and inflation with a monetary lag of around 18 months being commonplace. Sharp increases in the cost of living during 2021 and 2022 are probably a function of the vast amounts of monetary creation used to support the economy during the Covid crisis.

Now, with money supply having turned negative, Woolnough wonders if we should be starting to think more about deflation than inflation next year.

‘Disinflation will likely remain the theme for some time,’ he says. ‘Having said that, getting back to target is one thing, remaining around that target is a completely different story.

‘We are expecting a very interesting macroeconomic environment ahead, with more volatility to come. In this context, a flexible bond strategy with active credit selection could be particularly relevant for investors in the coming, uncertain period.’

What could be the key opportunities?

For Woolnough and M&G’s well-resourced team of global credit analysts, the switch from quantitative easing to quantitative tightening has created ‘some really interesting pricing’.

‘Credit analysis – and using the full resources of the global team here – is very important for us in trying generate active returns versus the wider market.

‘They help us unearth some key opportunities and identify some attractive bonds that other investors have ignored or failed to notice.’

The financials sector has been one area where the team’s expert analysis has identified interesting relative value trades. For example, Woolnough was able to pick up select bank bonds at prices that were considered convenient.

In fact, ‘particularly dislocated’ markets have provided a range of good relative value opportunities in UK and US, which command almost half of the fund’s assets.

‘Within corporate bonds, dispersion across sectors has been at very elevated levels,’ says Woolnough. ‘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 healthcare and capital goods, where spreads are significantly tighter.’

Within financials, he likes larger, more liquid and well-capitalised banks, which were well-placed to withstand the sector stress experienced in March.

Another favoured sector is utilities. Although overall allocations here are far lower than financials, Woolnough is attracted to the sector’s stable businesses and relatively cheap debt.

Adding alpha

The main drivers of strategic asset allocation are an informed view on interest rate risk – which informs the duration of the fund – and credit risk – which informs the allocation to corporate bonds over core government bonds.

The team then uses tactical shifts across the entire global fixed income opportunity set to try and deliver active alpha for investors.

Over the past 12 months, the duration of the portfolio has risen from around 4.2 years to 5.7 years with the lion’s share today (around 2.7 years’ worth) coming from European assets.

‘The key upward shift however was during 2022, when we began to see pockets of value in certain types of government bonds,’ explains Woolnough. At the beginning of 2022, duration was only 2.5 years.

Asset allocation is close to its neutrality with assets split roughly equally between government bonds, investment grade corporate bonds and high yield bonds. However, relative to the benchmark, the fund carries more credit risk (at around 6.1 years’ worth of credit spread duration) as the team capitalises on opportunities to add value, primarily in the investment grade space.

‘Generally, this is the area where most of the positive performance has come from year to date; it’s been a key alpha generator for us,’ he adds.

Credit spreads have largely gone sideways during the first few months of this year, while yields on core government bonds have been generally lower because inflation may be falling.

Through the team’s active credit selection, many of the fund’s corporate bonds holdings have done well this year.

And there are many reasons for continued optimism. Woolnough points to corporate fundamentals remaining strong, the labour markets being relatively healthy and his expectation that bond default rates will remain lower than the market anticipates.

All told, the M&G (Lux) Optimal Income fund is a compelling proposition for investors looking for a core bond fund that aims to outperform the major bond sectors in different market conditions.

Past performance is not a guide to future performance.