Re-thinking fixed income investing by Alex Sullivan

re-thinking fixed income

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CONTENTS

THE BUSINESS OF UNCERTAINTY

WHERE NEXT FOR CORPORATE BONDS?

FUND MANAGER SPOTLIGHT INTERVIEWS

IFA Magazine is published by IFA Magazine Publications Limited, The Tobacco Factory, Loft 3, Bristol BS3 1TF Full subscription details and eligibility criteria are available at www.ifamagazine.com Â©2016. All rights reserved.

Telephone: 0117 953 2003 Editor: Michael Wilson, Editor in Chief editor@ifamagazine.com Publishing director: Alex Sullivan alex.sullivan@ifamagazine.com Design: Fanatic Design

May 2016 IFA Magazine

The business of uncertainty Examining the global economic backdrop and its impact on fixed income investing A hawkish Fed, monetary easing by the European Central Bank and interest rate uncertainty in the UK have cemented the need for a flexible approach to bond investing during uncertain market conditions. Flexibility is key in the face of changing and uncertain markets and for the US, UK and Europe uncertainty is not over. Last year was a weak market for UK and US government bonds as yields increased by around 20 to 30 basis points in general but in contrast, European bond yields hit record lows due to the ECB’s monetary policy stance.

Negative interest rates Despite the difference in the performance within government bonds, one trend has been notable – negative interest rates. Although negative interest rates are not a new phenomenon – 4

IFA Magazine May 2016

Switzerland set interest rates below zero for foreigners in 1970 in a bid to stem flows in the Franc – but the proliferation of negative interest rates is more widespread. It is not just the Eurozone that has set negative interest rates but also Denmark, Switzerland, Sweden and Japan. Setting rates below zero results in cheaper borrowing for households and businesses. This in turn boosts economic activity and has a portfolio rebalancing effect as low rates encourage investors to sell low yielding assets and buy riskier assets. Jim Leaviss, Head of Retail Fixed Income for M&G’s mutual fund range, said this has the knock on effect of reducing costs for companies and ‘controversially, reducing the attractiveness of an economy’s currency in a world in which competitive devaluation is seen as desirable’.

While all of these outcomes may be intended, Leaviss said there were also unintended consequences of negative interest rates. Negative interest rates make it expensive for companies to sit on large sums of cash and insurers have been known to encourage late payment of premiums in order to reduce their cash pile. Leaviss said negative rates may also encourage the purchase of safety deposit boxes and cash hoarding as households stash their cash ‘in order to avoid paying to save’. ‘If storing physical cash disrupts the transmission mechanism, what can central banks do to make it difficult to do?’ asked Leaviss. One solution from the European Central Bank (ECB) has been to stop printing the €500 note, which accounts for 30% of cash in circulation. Mario Draghi, President of the ECB,

Annual return on cash after inflation and tax 10

‘In reality savers can get around this by holding physical cash,’ said Woolnough. ‘Negative and low nominal interest rates are new, low and negative real returns both pre and post-tax are not.’ This in-depth understanding of the complex and shifting backdrop of monetary policy means Woolnough has successfully managed changes in the markets — especially through the tumultuous times of the financial crisis and the boom created by quantitative easing (QE) — in order to generate consistent returns over the long term for M&G Optimal Income Fund investors.

% -5

-10

-15

-20

BONDVIGILANTES

has previously noted the high value banknote’s connection to crime and tax evasion, but there is suspicion that printing has been cut because households tend to hoard cash in large denominations, disrupting the transmission mechanism of monetary policy at negative rates. The €500 note will, however, continue to be legal tender and demand is expected to remain strong. Central banks have also tried to minimise the impact negative interest rates have on banks’ profits by introducing tiered interest rates. ‘Different levels of rates apply to different portions of the banks’ reserves,’ said Leaviss. ‘In Japan’s case, reserves held before rates went negative would still earn 0.1% for example. Banks are generally incentivised not to convert reserves into banknotes as any such reduction is taken from the highest interest tier, rather than the most deeply negative.’ Negative interest rates have been criticised as a tax on savings and as such can distort economic behaviour.

Source: M&G, IFS.org http://www.ifs.org.uk/uploads/publications/ ff/income.xls 30% rate assumed from 1965–1973

‘Fortunately, holders of cash have traditionally been compensated for depositing it in a bank account by receiving interest payments. But is this something that is now at threat with negative rates? ‘If you take the Bank of England rate as a proxy for the interest earned on cash and adjust for inflation – subtract Retail Prices Index from base rates – although negative nominal interest rates are a new phenomenon, real negative rates are not.’

Negative interest rates have been criticised as a tax on savings Woolnough said by including historic rates of basic income tax, it better depicts what could be considered the ‘real rate of return on cash’.

Richard Woolnough, Fund Manager of the £16 billion M&G Optimal Income Fund, said negative interest rates are not a ‘new phenomenon’.

‘This gives a more accurate reflection of what savers have actually earned in real disposable income per annum… [and] this has been negative in the UK for much of the past 10 years.’

‘Let’s not forget that money has always been effectively clipped by the traditional enemy of savers – inflation,’ he said.

In order to manage the risk of negative interest rates, and in effect negate the impact of a zero rate, savers can hold money in physical cash.

The fund aims to provide a total return to investors based on exposure to optimal income streams in investment markets through the combination of income and growth of capital. The fund invests in a broad range of fixed income assets which the manager identifies as good value. The investment approach starts with a topdown assessment of the macroeconomic environment, including the trajectory of growth, inflation and interest rates. This insight is used to inform the fund’s duration positioning and allocation to various bond asset classes. Bottom-up analysis is provided by the M&G in-house team of credit specialists to enable individual credit selection, with no restriction on the amount of government bonds, investment grade bonds or high yield bonds that can be held in the portfolio.

Future of Europe Negative interest rates are not the only problem countries in the Eurozone have to consider and although Draghi averted a Eurozone crisis in 2012 by saying the ECB would do ‘whatever it takes’ and later embarking upon €1.1 trillion of QE in 2015 , he will have to dig deeper for more solutions. ‘ECB President Mario Draghi continues to desperately seek an answer to the deflationary malaise in which the economy currently finds itself,’ said Leaviss. The weapons in Draghi’s arsenal include expanding and extending the ECB’s asset-purchase programme, and adding to the list of assets that would be eligible for the ECB to purchase. It

May 2016 IFA Magazine

could also cut interest rates further into negative territory. According to Leaviss, ‘there is no reason why interest rates could not go deeper into negative territory’. What levers Draghi may pull in future are unclear but what is clear is that something needs to happen in order to pull the Eurozone economy out of the doldrums. ‘With the ECB likely to lower its forecast for economic growth in 2016/17, and given the extent of monetary easing that has already taken place, it is clear that the Eurozone economy is not in a healthy state despite signs of improving consumer confidence,’ said Leaviss. The economic problems have been compounded by concerns about Greece leaving the Eurozone and political risk in Spain and Portugal. Unfortunately there has been little real progress towards a fiscal and political union in the Eurozone and this will weigh heavily on investors’ minds in 2016. The trends and problems within the European macroeconomic landscape have a number of implications for investors in terms of currency, yield curve and the impact on corporate assets. Leaviss set out four implications for investors: 1. The euro is likely to come under further pressure due to the different policy biases of the ECB and the Federal Reserve. ‘A gradual decline in the euro may result over the course of 2016. A negative ECB deposit rate and higher Fed funds rates is at the core of this prospect as capital flows out of the euro area in search of a positive return.’ 2. Action by the ECB could result in support for the front end of the yield curve in the short term and possibly for yields with longerterm maturities. However, Leaviss sees little reason to own European government bonds at low yield levels ‘given the risk of an upward surprise in inflation rates and limited potential for upside capital returns’. ‘Indeed, with a third of the European government bond market trading 6

IFA Magazine May 2016

with a negative yield, it seems preposterous to lock in a negative return unless you believe that Europe is entering into economic depression,’ he said. 3. The macroeconomic conditions in Europe have also affected European

It is clear that the Eurozone economy is not in a healthy state corporate assets such as asset-backed securities and corporate bonds, and these have come into scope for ECB asset purchases, said Leaviss, as the ECB attempts to encourage banks to lend into the real economy. ‘In this type of environment, highquality corporate bonds may be the biggest beneficiary of a large buyer like the ECB stepping into the market,’ he said. 4. If the ECB chooses to cut deposit rate further this could negatively impact bank profitability as it would squeeze net interest margins. Leaviss said domestic lenders in Spain could be hit even harder as they could be forced to pay billions of euros in compensation to mortgage customers whose

contracts were found to have illegal interest rate floors.

Innovation and productivity needed The problems within the Eurozone are not just monetary but also structural. Stefan Isaacs, Deputy Head of Retail Fixed Interest at M&G, said: ‘The reality is that many of the problems holding back the Eurozone are structural in nature. And doesn’t the ECB know it. ‘I can hardly remember a press conference when Mario Draghi hasn’t mentioned the need to address these issues…The ECB is acutely aware of the moral hazard it creates in addressing the Eurozone’s troubles purely via the monetary channel. And yet with a sole mandate to hit an inflation target of close to but below 2%, they are once again finding themselves with the unenviable task of having to do the bulk of the heavy lifting.’ Isaacs said monetary policy changes aside, increased productivity and greater innovation is what is needed to drive the Eurozone. ‘Antiquated bankruptcy regimes need to be radically reformed, red tape needs to be removed and the banking system needs to own up to further loan losses that it has yet to provision for,’ said Isaacs.

‘These changes aren’t easily achieved, not least because they require the sort of short-term pain that politicians rarely have long-run incentives to deliver.’ Monetary policy will only go so far to help pull the Eurozone out of its economic slump and Isaacs fears without structural change it will continue to experience low growth. ‘Absent further structural change, I’m convinced the Eurozone will labour under a cloak of lower potential growth and struggle to encourage investment given the need to earn an attractive rate of return on capital,’ he said. ‘Yes, the ECB can likely drive riskfree rates even lower. Yes, they can depreciate the euro. And yes, they can provide ever more liquidity to the banking system. These may all help in the near term but without real reform the market will increasingly worry that we have reached the limits of monetary policy. ‘And at some point, if the market cannot be convinced otherwise, then the consequences will be significant.’

The US outlook The Federal Reserve is at a different point in its interest cycle from the ECB, having begun to raise interest rates from historic lows in December last year. Whilst some investors are doubtful that the Fed will continue to raise rates this year because of ongoing uncertainties in the global economy, Richard Woolnough believes rates will continue

Job cuts as % of working age population 0.16% 0.14% 0.12% 0.10% 0.08% 0.06% 0.04% 0.02% 0.00%

BONDVIGILANTES

Source: M&G, Reuters_Datastream, November 2015

to rise as the labour market continues to strengthen.

points to a continuing trend of healthy employment numbers.’

In fact, the labour market figures should bring cheer to investors.

Graph above shows US job cuts as % of working age population

‘If the outlook from an economic and industrial output perspective were grim then companies would be shedding labour in the most traditional manner, by firing people,’ he said.

With oil, mining, commodities and the Chinese market all struggling, Woolnough said there would have been some sign by now that the US was heading into recession. He also pointed out that the Fed’s rate rise was fully anticipated thanks to the careful signposting by the committee.

‘The private sector is firing the lowest percentage of the working age population in the past 15 years. This is a sign of continued labour market strength and the low level of job cuts

One to watch The make-up of the Federal Open Market Committee (FOMC), which meets eight times a year, has changed this year and there could arguably be a move to a more hawkish Fed position. The FOMC is made up of 12 members, each of whom casts a single vote on the US interest rate policy. It includes seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve

‘The economic reality is that falling oil prices help the economy, falling commodity prices are a supply rather

Bank presidents, who serve one-year terms on a rotating basis. As of 1 January 2016 the four bank presidents rotated. Four ‘dovish’ presidents, known for keeping rates on hold, are leaving the voting pool and are being replaced by four more presidents, three of whom are known ‘hawks’, who are bullish on the US economy and concerned about inflation. ‘On face value, one could surmise that this hawkish swing will result in a more definite and quicker pace of interest rate hikes in 2016,’ said Jim Leaviss, Head of Retail Fixed Income for M&G’s mutual fund range.

May 2016 IFA Magazine

than a demand issue, the Chinese economy is not a significant input into the US economy, and interest rates and Fed policy remain exceptionally accommodative,’ he said. ‘The stock markets, commodity markets, and the economy do not always move in tandem. The Fed should not focus on these indicators. Its mandate is not to support the stock market or the commodity market, but to support the labour market. The Fed should therefore remain vigilant, and not get side-tracked by noise that has little effect on the long-term outlook for inflation, or the short-term outlook for the labour market.’

The Bank of England Whilst a more hawkish Fed is predicted to increase rates at a quicker pace in the US, the same cannot be said of the Bank of England Monetary Policy Committee (MPC) approach to interest rates. ‘The timing of a rate hike from the Bank of England is more difficult to call, given the uncertainty surrounding the referendum on Britain’s membership of the European Union,’ said Leaviss.

If Britain votes to leave the EU on 23 June it will have a large impact on UK assets and investor fear about this impact is not irrational.

to be too relaxed about the impact of an ‘out’ vote…it’s probably rational to be nervous about UK assets as the referendum date nears.’

‘Would Brexit matter?’ asked Leaviss. ‘Eurosceptics point to the fact that

Investors are feeling the squeeze from low income growth and higher prices, government bond yields sit at historic lows and long-dated government bond prices suggest investors believe inflation will stay low for some time.

The Bond Vigilantes blog aims to promote discussion on a wide range of marketrelated topics European companies need the UK more than the UK needs them, given that Britain is a large net importer from the Eurozone. ‘They also point to the success of nonEU European states such as Switzerland and Norway, which have free trade agreements with the Union. But with a third of the UK’s gilt market owned by foreign investors, a record current account deficit needing to be financed, and ratings agency Standard & Poor’s suggesting that a two-notch downgrade could follow a Brexit vote, it’s difficult

Global macroeconomics, encompassing negative interest rates, inflation, growth and what the Fed, ECB and Bank of England may do, is a confusing landscape but the Bond Vigilantes are helping advisers to navigate the ups and downs with their regular blogs which are posted on the M&G website www.bondvigilantes.com The Bond Vigilantes blog aims to promote discussion on a wide range of market-related topics. As Leaviss says, “It’s for us to share our views on the things that matter to bond investors – inflation, interest rates and the global economy – as well as to talk about the bond markets themselves. Over the past few years we have blogged about value in high yield bonds, the outlook for emerging market debt, and new developments in the inflation-linked bond markets. We also share our views on the traditional investment grade corporate bond markets – being a good bond vigilante should also be about identifying deteriorating trends in corporate behaviour, as well as that of governments.”

www.bondvigilantes.com

IFA Magazine May 2016

Where next for corporate bonds? With so much going on in global markets, there is much for advisers to consider when reviewing fixed income investments and overall asset allocation strategies for client portfolios. Here we look at some of the key issues affecting bond markets at the present time. These are challenging times for fixed income markets. The Federal Reserve has switched direction on monetary policy, raising US interest rates in December – the first upward move in nearly a decade. At the same time, economic statistics are mixed and variable, making it difficult to build a clear picture of the likely direction of global economic growth. There has already been significant fluctuation in financial markets since the start of 2016 and many believe this is poised to continue. According to the assessment of the M&G fixed income team, valuations in the developed government bond market currently look extreme. The income available from developed market government bonds is at extremely low levels, while in those areas more exposed to the economic cycle, the income is still relatively high, reflecting investor fears over the pace of global growth.

A new direction from the ECB The decision by the European Central Bank (ECB) to expand its asset purchase scheme to include corporate bonds is already having the desired effect. On 10 March this year, the ECB launched a new stimulus package, the Corporate Securities Purchase Program (CSPP), as a way to address the problems that have dogged global markets.

The CSPP allows the ECB, from June, to purchase European corporate bonds of ‘non-bank corporations established in the euro area’ in co-ordination with six national Central Banks. On launching the CSPP, the ECB said: ‘The ECB pursues a symmetric definition of price stability – high inflation is as dangerous to our economy as deflation. In the current period of weak growth and low inflation, the interest rate instrument alone has not been sufficient to steer inflation closer to 2%. To fulfil its

mandate, the ECB needs to make use of all instruments at its disposal.’ Although there has been little detail about the particulars of the policy, it would seem the ECB’s announcement is already having an impact. Wolfgang Bauer, Deputy Fund Manager of the M&G Global Corporate Bond Fund and European Corporate Bond Fund, said in the first month since the announcement ‘credit spreads on euro-denominated investment grade

May 2016 IFA Magazine

Bond screening has been done taking into account the information on the CSPP released by the ECB. This screening is second nature to Isaacs and Bauer who invest in European investment grade corporate bonds through the M&G European Corporate Bond Fund. The fund also has the flexibility to invest in high yield or government bonds with a total return focus. Bauer suggests that returns from this fund are driven by a combination of macroeconomic, asset, sector, geography and stock-level factors. A dynamic investment approach is followed that allows for a blend of duration and credit exposure based on the management team’s outlook. The fund does not strictly follow a benchmark so can be flexible and pursue a high-conviction investment approach. It is highly diversified across issuers, sector and geographies with independent credit analysis being performed consistently.

What will the ECB buy? In analysing the corporate bonds on offer, the management team have implemented a ‘common sense’ filter of euro-denominations and non-bank bonds. When it came to credit rating the corporate bonds had to be investment grade from at least one of the three main rating agencies – Moody’s, Standard & Poor’s, and Fitch. The ECB’s method of defining investment grade bonds is very lenient. One investment grade rating by a single rating agency is sufficient, which includes DBRS ratings, even if all the other agencies classify a bond as ‘high yield’. When it comes to the issue around what is defined as a ‘European’ company, legal technicalities matter as incorporation in the Eurozone will make it eligible, even if the company itself is non-European in origin or geographical focus. The ECB’s intention was to remain flexible and to be able to access a very broad investment grade bond universe by refraining from imposing overly strict regulations on themselves. The participation of the ECB in the primary market is also very interesting. There is a bit of a grey area here as when 10

IFA Magazine May 2016

Sterling corporate bonds issuance has collapsed, with issuance half of what it was in 2012 and as a share of global corporate bond debt issuance it is at its lowest ever lever.

the ECB buys government bonds, traditionally they are excluded from purchase at issuance as otherwise they would effectively subsidise the sovereign’s funding plans. Yet in the case of a corporate which has, for instance, a 20% stake from a particular government, it could be argued that the ECB is effectively subsidising a sovereign, albeit indirectly.

Jim Leaviss, Head of Retail Fixed Income for M&G’s mutual fund range, said the ECB’s announcement that it would buy euro-denominated corporate debt made the euro a ‘cheaper’ currency to borrow in.

What does this mean for investors in European bonds?

However, he also pointed to three other main reasons that could be hitting sterling corporate bond issuance set out in the Bank of England blog ‘Bank Underground’.

The ECB may have set itself up as a new buyer with deep pockets but that does not mean investors should be snapping up euro-denominated credit where they can.

‘The three main factors, however, might be mergers within the UK asset management industry making the investor base more concentrated; the reduced flow of cash into credit heavy annuities following pension reforms; and competition from euro issuance as that market finally got critical mass.’

‘While euro-denominated credit does look good value relative to governments, spreads of euro-denominated corporate bonds, both investment and speculative grade, have been tightening since midFebruary,’ said Bauer. ‘The rally noticeably accelerated due to market euphoria around the ECB’s announcement. At this point a large portion of the expected benefits could be priced in. Valuations are arguably already stretched for certain issuers, when comparing underlying credit risk fundamentals and current spread levels.’

In the US, the anticipation of more rate rises from the Federal Reserve, which increased rates by 0.25% in December 2015 after a decade of nearzero rates, saw investment grade bond spreads underperform as yields were expected to rise. The US market has also seen some ‘fundamental deterioration in credit quality’, according to Leaviss, as leverage increased partly as a result of share buybacks and mergers and acquisitions funded by borrowing.

Outside the Eurozone The impact of the ECB’s announcement has not only been felt in the Eurozone but arguably has had a knock-on effect in the UK sterling-denominated corporate bond market.

‘US high yield bonds were the underperformers of 2015,

Dissecting the EUR IG non-bank corporate bond universe – tickers and credit ratings Top 10 tickers

Composite credit rating profile

Issuer

EUR bn

350

EDF

23.4

3.7%

300

Anheuser Busch InBev

23.0

3.6%

Volkswagen

17.0

2.7%

Daimler Finance

15.3

2.4%

BMW

13.6

2.2%

Eni SpA

13.6

2.1%

Enel SpA

12.8

2.0%

Telefonica

12.3

1.9%

Deutsche Telekom

11.8

1.9%

GDF Suez Energy

11.5

1.8%

Rank

Outstanding (EUR bn)

corporate bonds have tightened by around 20 basis point on average’.

250 200 150 100 50 0 AAA

AA Minus

BBB

Flat

Source: Bloomberg, M&G, 21 March 2016

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BB Plus

continuing the damage started at the end of 2014 as energy-related bonds started to discount a prolonged fall in oil prices,’ he said. ‘And as other commodity prices hit their lowest level for years, bonds exposed to metals and mining also sold off. Outside of energy and commodity names, however, default expectations remain very low.’

The future for investment grade bonds According to Leaviss, there are two significant supports in place for credit markets this year, which will help both investment grade, or high grade, and high yield bonds. There is a difference between high grade and high yield bonds. High grade bonds are securities issued by corporates rated BBB- or above by credit rating agencies. High yield bonds are rated BB+ or below and, as the name suggests, compensate investors for taking on the risk of a lower credit rating by offering a higher rate of interest. ‘First of all, credit spreads in both investment corporate bonds and in high yield are likely to overcompensate for expected default rates – so hold-tomaturity credit investors are likely to outperform investments in government bonds,’ he said. ‘Secondly, in a world of low or negative yields in government bonds, investor demand for credit remains firm.’ Leaviss said there is a perception that credit is expensive but over the past 20 years global corporate bonds spreads ‘have been tighter than they are now 73% of the time’ and following a widening in spread ‘my global bond strategy was to add credit risk, both in investment grade and high yield’.

Corporate bond challenges Investing in credit isn’t just a one way street and there are challenges, particularly around liquidity risk. Leaviss said: ‘We think a good portion of the ‘overcompensation’ that credit investors get for investing in the asset class isn’t about credit risk, but liquidity risk. ‘Managing liquidity risk in a portfolio is equally as important as choosing the companies you lend to: this might mean running with more cash or

government bonds than you might like ideally, it might mean avoiding smaller or complex bond issues, and the use of credit default swap indices is important as an extremely liquid way of adding or removing credit risk from a fund.’ There are also more nuanced risks that need to be taken into account when investing in corporate debt, including investor sentiment and sectorspecific problems. Leaviss said that investors are put off by what they see as ‘increasingly poor behaviour’ from the issuers of corporate bonds.

The M&G Optimal Income Fund was designed to be adaptive ‘Bond investors don’t like debtfinanced M&A that results in ratings downgrades, or bonds being issued to do share buybacks – or to buy the business owner a third yacht,’ he said. ‘This kind of issuance is coming back to the market, and corporate leverage is edging up. So the tailwinds of improving corporate fundamentals are no longer with us, and there’s also been a pick-up in idiosyncratic risk – the VW emissions scandal, for example, which saw its 10-year bonds fall by around 10%. There is a silver lining to the problems within the high yield corporate bond market. ‘Defaults will pick up from the 2.5% global high yield annual rate, but with high yield spreads at 6% over government bonds there is room for the asset class to outperform,’ said Leaviss.

A broader mandate managing flexibility Nevertheless, fixed income still has an important role in any investment portfolio in this environment, both as a source of income and as an alternative to equities. For advisers questioning whether to put more or less risk into client portfolios, the unpredictability of the current climate means that holding a blend of assets in those portfolios

with an eye on flexibility is more important than ever. The M&G Optimal Income Fund was designed to be adaptive. It has a flexible strategy to invest across a variety of different bonds. Manager Richard Woolnough recognises that different parts of the market perform at different stages of the business cycle. For example, corporate bonds may perform best during periods of stronger economic growth, particularly at the higher risk end. Developed market government bonds, in contrast, may help to protect capital at times of economic weakness. By having the flexibility to invest where he sees the best value at any point in time, Richard seeks to provide a stronger performance than each of the mainstream bond sectors over the course of the economic cycle (around five years). At times of market volatility in the past, this flexibility has proved crucial in minimising the negative impact on investors’ capital. Notably, it meant the fund was able to run with very low holdings in financial bonds moving into the Financial Crisis of 2008, and also to limit investor exposure to the sharp swings in bond markets following the Federal Reserve’s decision to slow its asset-buying programme in 2013.

Longer-term opportunities Today, it means that the fund can capitalise on the recent state of flux, using short-term fluctuations in prices to invest in longer-term opportunities. Since launch in December 2006 the fund has, on a cumulative basis, outperformed key sectors, while taking lower levels of risk. From here, we believe the uneven global economic recovery will present both opportunities and threats to bond investors. The M&G Optimal Income Fund is an opportunity to invest in a fund that can adapt as markets change, managed by a longterm, value-driven fund manager with a proven track record, who is unafraid to question the consensus view. The fund allows for the extensive use of derivatives.

May 2016 IFA Magazine

Fund Manager Spotlight Claudia Calich, highlights the value of flexibility when it comes to investing in emerging market debt. The M&G Emerging Markets Bond Fund is designed to maximise longterm total returns (the combination of income and growth of capital) by investing mainly in emerging market (EM) sovereign and corporate debt. The fund’s flexible approach begins with Claudia’s top-down assessment on macroeconomic factors such as global risk appetite and structural global growth catalysts. This is followed by analysis on a regional and countryspecific level of monetary and fiscal policies, capital flows, and political and regulatory environments. Based on this, Claudia decides the fund’s country and currency allocations as well as its duration. The fund is unconstrained by a benchmark, being diversified globally across a range of EMs and having no restrictions on the currencies to which it may be exposed. This flexibility allows Claudia to construct a ‘best-ideas’ portfolio with the freedom to invest in any EM debt security as well as in any EM currency. Importantly, she is also unrestricted in allocating the fund’s assets between the three EM bond sub-asset classes: • Local currency-denominated emerging market sovereign debt • Hard currency (external) emerging market sovereign debt, which is primarily US dollar-denominated • Hard currency (external) emerging market corporate debt, also primarily US dollar-denominated Claudia splits the portfolio between these sub-asset classes and blends 12

IFA Magazine May 2016

high-conviction macro calls with fundamental credit analysis. In doing so, she actively manages three levers that drive the fund’s performance, namely credit risk, duration sensitivity, and currency positioning. In Claudia’s view, determining the right asset allocation between government and corporate issues denominated in local and ‘hard’ currencies, together with careful country and security selection, are key factors in seeking to maximise returns. Advantageously, the fund has a much bigger opportunity set with EM corporate debt potentially enhancing its risk/return profile compared with portfolios restricted to the much smaller number of EM sovereign bond issuers. Indeed, the EM corporate bond subasset class has been a particularly fastgrowing segment of the fixed income universe over the past decade, and now offers widely diversified investment choices across geographies and industry sectors. EM corporate credit also allows for investments in countries that the fund would invest in but where the sovereign does not issue investable debt. In addition, Claudia may consider there are attractions of investing in bonds issued by companies that are domiciled in an EM country but have revenue streams from developed markets or from multiple regions. The fund allows for the extensive use of derivatives.

What’s your role at M&G? What did you do before you joined the team? I joined M&G in October 2013 as a specialist in emerging markets debt and was appointed fund manager of the M&G Emerging Markets Bond Fund in December 2013. I was also appointed fund manager of the M&G Global Government Bond Fund and deputy fund manager of the M&G Global Macro Bond Fund in July 2015. Prior to M&G, my career has spanned over 20 years of experience in emerging markets, most recently as a senior portfolio manager at Invesco in New York, with previous positions at Oppenheimer Funds, Fuji Bank, Standard & Poor’s and Reuters. I’m a BA graduate in economics from Susquehanna University and have an MA in international economics from the International University of Japan in Niigata.

How are you feeling about the Emerging Market Bond markets at the moment and what do you think advisers should be looking out for when looking to gain exposure to the sector? A flexible investment approach remains key, given that the dispersion of returns between hard and local currency-denominated bonds and sovereigns and corporates is much higher than in the past. It’s therefore important to have the ability to move between these asset classes and chose the best ideas within the universe.

on average, so even if the price return slows going forward, there is still the prospect of the carry return. In terms of the economic outlook, I believe that some of the larger economies will finally start bottoming out in terms of growth. The IMF recently released its updated World Economic Outlook and, for the first time in a long while, it has not materially lowered its forecasts for emerging market (EM) growth.

What’s your investment philosophy with the M&G Emerging Markets Bond Fund? The fund is designed to maximise long-term total returns by investing mainly in EM sovereign and corporate debt. I believe that determining the right asset allocation between government and corporate issues denominated in local and hard currencies, together with careful country and security selection, are crucial factors in seeking to deliver this goal.

currency-denominated EM sovereign debt, hard currency EM sovereign debt, and hard currency EM corporate debt. I split the portfolio between these sub-asset classes and blend high-conviction macro calls with fundamental credit analysis. In doing so, I actively manage three levers that drive the fund’s performance, namely credit risk, duration sensitivity, and currency positioning. The outcome is that I allocate the fund’s assets to those areas where I see the best relative value and avoid exposure to those emerging market bonds and currencies whose outlook I do not like. Indeed, avoiding the worst performing issuers and/ or defaulters is critical at this point of the cycle. Within M&G, I receive valuable input from deputy fund manager Charles De Quinsonas, who has a solid

How do you manage the fund? What support do you get from the team at M&G? Importantly, I am unrestricted in allocating the fund’s assets between local

What is your outlook for the EMB sector in Q3 and Q4 2016? For the rest of the year, I see returns consolidating at a slower pace than so far year to date. Still, the asset class is providing yields on the range of 6-7%

May 2016 IFA Magazine

background in EM corporate credit. Charles’s focus for the fund is on EM corporates, helping to shape its strategy and uncover additional opportunities on this ever-expanding universe. I can also draw on the skills and experience of M&G’s large credit analyst team, which researches all types of debt securities across the spectrum of government and corporate bond sectors. However, I retain ultimate responsibility for all portfolio construction decisions.

issuers among oil- and commodityimporting countries, with examples in Asia and eastern Europe on a selective basis. In addition, my investment activity earlier this year included adding exposure to oil-exporting plays such as Azerbaijan and local currency Russian sovereigns on the view that oil prices had bottomed in the low US$30s and that assets in these countries were attractively valued if there was a price rebound.

How is the fund positioned at the moment? Where do you believe the biggest opportunities exist going forward and why? How are you planning to exploit those opportunities?

In Latin America, I participated in Argentina’s recent return to the sovereign new issues market, believing it represented a favourable development

As at the end of Q1 2016, around 50% of the fund was invested in hard currency EM sovereigns, with 20% in local currency sovereigns and 29% in hard currency EM corporates. Going in to 2016, I felt that the sharp underperformance of local currencies in the previous year had priced in enough bad news to start offering attractive local currency entry points. As a result, I increased the fund’s local currency exposure during the first two months of this year, while retaining a sizeable exposure to the US dollar. Among other themes, against some of the ongoing key challenges in the asset class, I believe there will be winners and losers among EM bond issuers. For example, while oil exporters lose from cheaper prices, oil importers may gain from such lower costs. As a result, my preferred allocations in the fund include both government and corporate

IFA Magazine May 2016

As always, my investment strategy will seek to take advantage of the fund’s flexibility on a number of counts. The move helps to normalise the country’s financial relations with international markets and should also promote an increase in its foreign exchange reserves, which had fallen worryingly after being excluded from markets for some years. Looking ahead, Argentina seems on course to deliver positive reform momentum, managing its economy with more orthodox policies and continuing to improve its relations with the West. Elsewhere, my favoured investment themes include holding exposure to select smaller markets in Central America and the Caribbean that

have strong ties to the US economy. Relevantly, for example, certain countries should gain from increased remittances from their citizens based in the US who are employed in its robust labour market. Partly based on these considerations, the fund holds sovereign bond positions in Honduras, Guatemala, and the Dominican Republic. As always, my investment strategy will seek to take advantage of the fund’s flexibility to build a ‘best ideas’ portfolio and stay away from those assets towards which my outlook is pessimistic.

What’s your message to existing investors at the moment? EM debt is an asset class that has faced challenges on the past years, mainly including falling growth, weak commodity prices, political uncertainty in some countries, and rising corporate defaults. However, I believe that the rate of credit deterioration will start slowing as commodity prices seem to have stabilised (particularly oil prices) and the economic activity in some key countries that have been in recession should start stabilising in the second part of the year. Russia and Brazil are examples. This cyclical recovery should start helping to slow the pace of deteriorating debt dynamics and credit quality in some of these key countries. In my view, the question is not if the asset class is improving in quality, which it is not, but are you getting paid for owning it if the pace of deteriorating is slowing? My view is yes, particularly in light of the search for yield given low or negative yields in a large part of the global bond markets. As noted earlier, the risks need to be managed carefully at this point of the cycle but provided that’s done properly, there are opportunities to be found in the asset class.

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Fund Manager Spotlight Wolfgang Bauer shares his thinking on what’s happening in the European and global bond markets and where he sees the best value going forward. 1. What is your role within M&G? How does that link within the retail fixed income team? I am the deputy fund manager of two retail fixed income funds – the M&G Global Corporate Bond Fund and the M&G European Corporate Bond Fund.

2. Looking ahead, where are the best opportunities you’re seeing for returns for investors in those two funds? Although credit spreads have tightened from their crisis-like levels in the middle of February, appealing riskreward characteristics can still be found in various pockets of the investment grade bond universe. There is potential for further spread compression, and thus capital gains for corporate bond investors. Even if spreads do not tighten significantly going forward, they still offer decent carry which is especially attractive in times of record-low interest rates in large parts of the world. We find interesting opportunities in the European insurance industry. The whole sector trades at relatively wide credit spreads, reflecting business risks in the low interest rate environment and regulatory uncertainty. But there are diversified, well-capitalised insurers which currently offer attractive bond valuations. Inflation protection is another interesting topic for us at the moment. Even after the recent rally in inflation break-even rates in the US and the

IFA Magazine May 2016

UK, inflation-linked bonds offer compelling valuations, considering the upside potential for inflation rates in these markets.

3. How are you positioning the two funds to make the most of those opportunities? In both funds we have a preference for credit risk over interest rate risk. Both portfolios carry higher spread duration than their respective comparative indices. In the European fund we are around half a year longer, in the global fund even one and a half years longer than the index. All else being equal, the funds should perform well if credit spreads tighten from current levels. In the global fund we also have a meaningful position of 12% of net asset value (NAV) in inflation-linked bonds and would benefit from rising inflation expectations in the US and UK markets.

4. What are the main challenges you’re seeing in the sector? Particularly in the US we are seeing some late-cycle phenomena. Companies by and large have increased leverage, which in many cases means that credit profiles have been deteriorating. Event risk, mergers and acquisitions in particular, are another area of concern. We believe that corporate bond investors get well compensated for these risks at current credit spread levels, though.

Elevated supply levels are another headwind. Last year, many US companies rushed to the primary bond market to get their bonds launched prior to the rate hike of the Federal Reserve. This lead to heavy bond supply volumes, which contributed to spread widening. The announcement of the ECB to buy investment grade corporate bonds might lead to another surge in new bond issuance this year.

5. Should it happen, do you think that Brexit would spark volatility in the fixed income markets for UK investors? If Brexit happens – and I am not convinced that it will – market volatility would most likely rise, at least in the short term. The strongest moves would probably occur in the currency markets. This is another reason why we like UK inflation-linked bonds. If Sterling weakens against other major currencies if there was a Brexit vote, it would get more expensive to import goods into the UK, which should drive inflation expectations and increase the value of inflation linkers.

6. What’s the current asset allocation within the funds? Both funds are investment grade strategies and will always allocate the majority of their assets into this part of the corporate bond universe. At the moment, the global fund has 83% and the European fund 78% investment grade credit exposure. In the European fund, the vast majority of our corporate bond holdings are Euro denominated (75% of NAV). In contrast, in the global strategy we are strongly invested in US Dollar credit (63% of NAV). In terms of credit rating, we have a preference for

“If Brexit happens – and I am not convinced that it will – market volatility would most likely rise, at least in the short term”

BBB bonds in both funds. Securities in this rating band account for 63% of NAV in the global fund and for 45% in the European fund.

7. What is your current approach in terms of duration? If the US labour market remains strong and wage inflation gains momentum, the Fed might be forced to hike rates at a quicker pace than anticipated by the market. This risk is not fully reflected in US treasury yields. In Europe, interest rate risk in general is a lot smaller. However, rates are so low at the moment that there does not seem to be much upside potential from taking interest rate exposure in Europe. Therefore, we actively hedge interest rate risk in our portfolios. Currently, the European fund is half a year shorter and the global fund one and a half years shorter than their comparative indices in terms of duration.

8. What would be your message to existing investors at the moment? There are good relative value opportunities in fixed income markets. Particularly credit spreads in certain pockets of the corporate bond universe offer compelling risk/reward profiles.

May 2016 IFA Magazine

Investment Specialist Spotlight Investment Specialist, Pierre Chartres, gives his view on the opportunities for investors across the fixed income universe. 1. What’s your role within M&G? How long have you been with the group and how do you work with the team? I am an investment specialist within the retail fixed income team. My role has many different facets. First and foremost, I am responsible for communicating with clients and conveying the team’s investment message and views on markets, as well as the performance and positioning of our funds. In addition, my role also has a business development aspect and thought leadership aspect, ensuring that our funds are always well supported from a commercial side and making sure our range of fixed income investment solutions are in line with the ever-changing needs of our global investors.

2. On a macro level, where do you see the biggest opportunities for the fixed income sector at the moment? Which M&G funds do you believe are best positioned to make the most of those opportunities – and why? One of the main opportunities I see in the fixed income markets lies within the corporate bond markets, particularly in the US. In the second half of last year, the significant fall in the oil price combined with the fear of a more hawkish Fed and a hard landing in China triggered a significant spike in investor risk aversion, negatively affecting corporate bonds, even for those companies with little China exposure or likely to benefit from lower oil prices. For example, we are currently able to buy long-dated BBB rated bonds from companies in the telecoms, media

IFA Magazine May 2016

and healthcare sectors at yields of close to 5%. For investors willing to take a bit more risk, the US high yield sector is in my view still attractive. Despite having generated very good returns year to date, in my opinion, yields are still very attractive (close to 8%) and overcompensate investors for the risks of company defaults — see chart below. In addition, it is my view that in the current low yield environment that we live in, investors should look to the currency markets in order to boost their fixed income returns. We view currency investing as an extension of bond investing, and currently some currencies like the Japanese Yen, the Swedish Krone, and the Norwegian Krone are in our opinion attractively priced. In addition, many emerging market currencies have significantly repriced in the past few months, to a point where some are starting to look attractive once more. I still advocate caution in this space as many emerging countries still face strong headwinds

from low commodity prices and less growth in global trade, but in some of our funds, we have started to take small positions in the South African Rand, the Brazilian Real and the Russian Rouble. In my opinion, funds like the M&G Global Macro Bond Fund and the M&G Emerging Markets Bond Fund are best positioned to capture these opportunities.

3. As a major player in the fixed income market M&G has considerable resource dedicated to the sector and significant assets under management. How does your size help you when it comes to managing the funds – but also can it be a handicap in some situations? I definitely view the growth and size of our team as an asset for managing fixed income funds. Back in 2006 when we launched our flagship M&G Optimal Income Fund, our team

included four fund managers and two investment specialists. Today it has grown to eleven fund managers and six investment specialists, as well as an additional team of three individuals providing operational support. Our growth has therefore enabled us to recruit a whole raft of talented individuals, many specialising in their

The main challenge that we face today in fixed income is the low interest rate environment own sub-components of the fixed income markets and all with their own unique ways of managing bond funds. Simultaneously, our credit analysts and risk management teams have also grown substantially. We have also been able to hire over time a dedicated team of five fixed income dealers who execute trades on behalf of fund managers and are able to find liquidity when required.

4. How much liquidity is there in bond markets at the moment? Liquidity in corporate bonds seems to be a much discussed topic nowadays, but we have been managing bond funds for many years and we have always seen it as an inherent part of managing a fixed income portfolio. It is also important to define what we mean by “liquidity” and a definition that I find appropriate defines liquidity as the “cost of immediacy of trading”. I think it’s fair to say that on the whole liquidity is probably not as good as it was before the financial crisis, as dealers (ie large banks) have become reluctant to hold large amounts of bond inventories on their balance sheets due to regulatory constraints. In addition, the size of the market has grown quite substantially, so total trading as a percentage of

market size, which is also one way to measure liquidity, has declined. But let’s not forgot that bigger markets also mean deeper and broader markets, which ultimately equate to more liquid markets. Broader markets also mean more opportunities to add value via bond selection, so in that respect, what active asset managers may have lost in terms of liquidity, we might have gained in terms of the larger amount of bonds to choose from and generate added value. Also, liquidity changes on a dayto-day basis depending on whether you are trying to sell or buy a bond, and many other factors such as that bond’s issuance size, maturity, currency, sector, and rating. Markets are now also pricing in a liquidity risk premium for many bonds, which if managed appropriately can also generate incremental returns for investors. I also think that the procedures we have in place combined with the size and experience of our fund management team means that we are well equipped to manage a liquidity crisis should one arise.

5. What are your expectations for interest rates in the UK and other major global markets?

significantly. That said, in my opinion government bond yields have fallen so much across the developed world that any return of inflationary pressures or slightly more hawkish comments from central banks could trigger a rise in bond yields and capital losses. Because of this, I think reducing duration and allocations to government bonds in fixed income funds is the right thing to do.

6. With the challenges facing fixed income at the moment, how do you think advisers should be viewing the sector? The main challenge that we face today in fixed income is the low interest rate environment which has put downward pressures on yields. First of all, this means that investors cannot expect the same returns going forward. In addition, I think that fund managers must offer more active and flexible fixed income investment solutions to clients, better capable of seizing the opportunities available in today’s markets.

Since the global financial crisis hit, there have been more than 650 rate cuts around the world, to a point where interest rates are now quite low, even negative for some countries across the developed countries. I think that interest rates are likely to stay low for the foreseeable future, because demographics and the high levels of debt that we have amassed over the past decade prevent central banks from increasing interest rates

The value of investments will fluctuate, which will cause fund prices to fall as well as rise and investors may not get back the original amount invested. For financial advisers only. Not for onward distribution. No other persons should rely on any information contained within. This financial promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Conduct Authority in the UK and provides ISAs and other investment products. The company’s registered office is Laurence Pountney Hill, London EC4R 0HH. Registered in England No. 90776.

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