Bonds are no longer boring

An expanding investment opportunity set

The Optimal Income strategy was introduced in 2006 and since then the investable universe for bonds has grown significantly. This, we suggest, has presented investors with a much larger pool of fixed income opportunities to explore (see Figure 1). The M&G team behind the Optimal Income strategy has also grown – more portfolio managers, investment specialists, and expert analysts support the Optimal Income franchise. We now have one of Europe’s largest credit desks, too.

While expansion is one thing, it is fair to say the benefits of accessing a greater opportunity set (more bonds to invest in, typically greater liquidity, and more granular research behind issues) have been somewhat offset by years of near-zero interest rates. It has certainly been challenging for investors to be constructive on bonds in an ultra-low rates environment.

However, the market environment has changed: yields are higher – both on government and corporate bonds - and the bond market is looking perceptively more attractive. We think fixed income is no longer that boring asset class investors would consider for diversification purposes only. For us, it is an exciting and diverse asset class (with investment risks, of course) that can allow clients to grow their capital over the long term.

Figure 1. Optimal Income’s global investment universe – not including company shares*

Information is subject to change and not a guarantee of future results. *Optimal Income can invest in equities, subject to a limit of 20% of fund assets; historically, allocation has been under 5% and is c0.3% today.

Source: M&G Investments, 29 February 2024. 

Rates (sovereign bonds): why we favour long duration

We believe that the sharp increase in money supply during the Covid pandemic was the initial cause of inflation. As central banks have reversed course and reduced liquidity in the system, inflation has started to decline. We believe inflationary pressures will continue to ease this year, reflecting a more restrictive monetary policy. However, we expect growth to remain positive, driven in part by sustained consumer spending supported by a strong labour market and rising real wages (as inflation falls).

Nevertheless, economic growth is likely to remain subdued due to factors such as full employment, increased regulatory burdens, and higher government interventions. This contrasts with the current pricing in the bond market, where real interest rates have returned to pre-2008 levels, instead indicating an environment of higher economic growth. We continue to believe that real rates should be lower, reflecting lower potential growth. Consequently, despite the recent significant movement in nominal rates, we maintain an overweight/long duration positioning as we believe there is still potential for yields to decrease further. Current portfolio duration is around 7.1 years at the end of February, as shown in Figure 2 (overleaf) - the longest the fund has been 2008 and the Global Financial Crisis.

Figure 2. Duration evolution for M&G (Lux) Optimal Income Fund since 2006 

On 8 March 2019, the non-sterling assets of the M&G Optimal Income Fund, a UK-authorised OEIC, merged in the M&G (Lux) Optimal Income Fund, a Luxembourg authorised SICAV, which launched on 5 September 2018. Data prior to the 8 March 2019 refers to the OEIC.

Source: M&G, 29 February 2024. Information is subject to change and not a guarantee of future results.

Today we favour a long rates view, similar to the Optimal Income strategy during 2007-2008 and the onset of the global financial crisis. Throughout the period we have been active and often against the wider market consensus.

Our long duration view is also backed by what we see as a favourable risk-reward trade-off offered by bonds, particularly in the case of core government bonds (eg US Treasuries). Not long ago, rates were close to zero, leaving investors with very limited upside compared to a large downside risk. Today, it is the other way around, particularly as we now know central banks are at the end of their hiking cycle and are expected to cut interest rates in 2024-25. Figure 3 below -- which is based on M&G’s own internal scenarios of expectations for total returns of 10-year US government bonds --  illustrates our belief that the risk-reward for these assets is improving.

Figure 3. Risk-reward scenarios for 10-year US Treasuries 

Source: Bloomberg, 29 February 2024

Past performance is not a guide to future performance. 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. 

Credit: currently neutral but with some interesting opportunities in IG

Turning to corporate bonds (‘credit’), we continue to view valuations as generally ‘fair’ and consistent with an environment of positive, if subdued growth. We favour higher quality companies (eg investment grade credit at c40% of fund assets) issuing in the short-to-middle part of the credit yield curve. At the same time we have been reducing exposure to longer-dated corporate bonds due to considerable flattening of the credit yield curve. In terms of sectors, we are becoming more selective with financials and have a preference for European banks over US banks due to their lower leverage, stronger regulation, and generally limited impact from regional banks. The credit research team have been instrumental in supporting our selection.

Within high yield, we have been trimming since 2022-23, mainly because some of the physical bonds held have performed well and we took profits here. Currently, valuations across the asset class look a little expensive and we are happy being about 22% versus 33% neutral weighting.   

In summary, we began 2024 in a significantly different position compared to the previous decade. While we had previously positioned ourselves with short duration and long credit, we now have adopted a long duration stance, while we remain relatively more cautious on credit, but within some differences across quality (investment grade over high yield – see Figure 4, below) and maturities (shorter-dated over longer-dated names).  

Figure 4. We have been very active within investment grade and high yield since fund inception

* Neutral weight is 33%. Internal limits are subject to change.

Source: M&G, 29 February 2024. Information is subject to change and not a guarantee of future results.

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

Positioning

• The risk-reward profile from owning duration remains attractive, in our view. The downside risk (higher rates) seems limited as central banks have already tightened significantly and are not in a position to raise rates much further. On the other hand, if inflation and growth unexpectedly disappoint, the potential upside (lower rates) could be significant.
• Within credit, we remain close to neutral. This is not a fundamental view. If anything, we think companies' balance sheets still look healthy while growth is stable. This is more of a valuation view. Spreads are historically tight, and as a result, we prefer to be more defensively positioned than we have been in the past. 

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