26.06.2018

M&G International Investments Switzerland AG

M&G Optimal Income Fund: Re-orienting towards areas of better value

• We believe the global economic recovery remains on track. Leading indicators suggest that a healthy labour market should drive wage growth.
• After strong performance from a number of the areas where we found value in 2017, we are gradually re-orienting the portfolio towards market segments that we believe offer better value now: high-quality US investment grade credit, short-dated US Treasuries and – at the margin – equities.
• As a result of this particular focus on high-quality US paper, the fund’s average credit quality now stands at its highest level since launch.

Flexibility to invest across a broad range of assets

The M&G Optimal Income Fund is a flexible strategic bond fund that has the potential to outperform the average government, investment grade and high yield sectors over the course of an economic cycle. Unlike a traditional longonly fund, it is not forced to invest in a particular part of the market, where returns may be highly correlated with what is happening in the economic cycle. Instead, the fund has the flexibility to invest across a broad range of fixed income assets, according to where we identify
value, and we are able to separate our duration and credit views. This is particularly useful in an environment such as that of today, when we are positive on credit risk but more cautious on interest rate risk. Please be reminded that when interest rates rise, the value of the fund is likely to fall. The value of the fund may fall if the issuer of a fixed income security held is unable to pay income payments or repay its debt (known as a default).

Global recovery remains on track

From a macroeconomic perspective, we believe the global economic recovery remains on track. While recent economic data have been slightly softer than expected in some cases, this is coming off a high base, and so far we see little evidence that this will be the start of a new downward trend. In the US, consumer confidence is at its highest level since the financial crisis, while a healthy labour market is expected to drive further wage growth over the coming months. Leading indicators look especially encouraging, with the recent surge in the number of people changing jobs strongly indicative of a future rise in wages (Figure 1).

Europe is also an improving economic story, in our view: its growth outlook has brightened and, while we saw significant market reaction to Italian political uncertainty in May, overall political risk has receded. As the European Central Bank slowly continues to reduce the amount of support it provides to bond markets, this may have an impact on bond prices. While the current period of economic growth may appear long compared to historic standards, we believe we are witnessing an unusually elongated economic cycle and so this slow and steady expansion is likely to persist. As a result, we want to remain long credit, while keeping modest levels of interest rate duration.

Re-orienting towards new opportunities

In 2017, we found particular value in areas such as financials (particularly subordinated financials), eurozone peripheral government bonds and long-dated US dollar denominated bonds in the technology, media and telecommunications space. Many of these contributed strongly to returns. Please be aware that past performance is not a guide to future performance.

Since the start of 2018, financial markets have seen renewed bouts of volatility – firstly in the latter stages of the first quarter, when markets were spooked by the prospect of
higher US inflation prompting the Federal Reserve to increase rates faster than previously expected, and then again in the second half of May, when uncertain Italian politics caused a flight to quality. We have not made any substantive positioning changes in response to these bouts as, in our view, the fundamental picture has not changed. However, following strong performance by a number of those segments that contributed strongly to performance in 2017 and into the early months of 2018, we are gradually orienting the portfolio towards areas that we believe now offer better value, all of which fit with our longer-term outlook as described above. Our decision to sell down our eurozone peripheral governments exposure in early May – driven by their strong performance – was particularly timely, given the political uncertainty that ensued. Today, we are particularly finding opportunities within highquality investment grade US corporate bonds, short-dated US Treasuries and, at the margin, equities. As a result of this particular focus on high-quality US paper, the fund’s average credit quality now stands at its highest level since launch. Turning to government bond markets, while we believe yields remain generally unattractive given the prospect of further rate hikes and a pick-up in inflation, we are starting to find value in certain parts. We have begun to move away from our aggressively short duration position since US Treasury yields edged towards the 3% threshold – something that we have done at the short end of the
Treasury curve. The five-year part of the curve has been in a bear market in recent months and so now looks more interesting. By contrast, we remain bearish on the long end of the curve. By the end of May, our exposure to US Treasuries had risen to nearly 11% (of which around 1.4% is in linkers). The fund’s equity exposure has also ticked up slightly since the start of 2018, although overall exposure is still small at just below 5%. The bulk of purchases have been centred around the banking sector and we have added a number of European banks whose subordinated debt in particular has started to look expensive versus their equity.

Generating value through active management

Producing attractive returns in an environment of low government bond yields and tight credit spreads is a key challenge for fixed income investors. However, the fund’s
flexible approach and wide investment universe means it is well-placed to adapt to changing market conditions, while taking advantage of relative value opportunities. These opportunities will often be found in the specific income streams of individual bonds, which would be difficult to capture in more conventional fixed income strategies. Taking
an example from 2016, we identified an anomalously wide credit spread on the Microsoft 3.7% 2046 bond; by pairing this issue with a short position in 30-year US Treasuries, we were able to capture the subsequent tightening in the credit spread, while removing the associated interest rate risk.

In 2017, we identified a similarly attractive opportunity in 30-year Spanish government bonds, where we believed yields looked too high versus 30-year bunds given the country’s much-improved economic and political situation (Figure 3). By establishing a long position in the 30-year Spanish government bond, together with a short position in the 30-year bund, we were able to capture the subsequent narrowing of this yield differential. We began closing this position towards the end of April 2018 as part of our wider move to reduce exposure to peripheral eurozone issuers following significant outperformance in recent months – something that we had completed before the Italian political turmoil of late May. 

Please note the fund may use derivatives with the aim of profiting from a rise or a fall in the value of an asset (for example, a company’s bonds). However, if the asset’s value varies in a different manner, the fund may incur a loss. The fund may also use derivatives to gain exposure to investments exceeding the value of the fund (leverage). This may cause greater changes in the fund’s price and increase the risk of loss.

Strength in calling markets

In fast-moving markets, it can be challenging to stay on top of asset allocation decisions, as we have seen during recent bouts of volatility. The flexible nature of the M&G Optimal Income Fund allows investors to delegate such asset allocation decisions to a manager with more than 30 years of investment experience, with a strong track record of calling the direction of bond markets in a variety of market conditions (Figure 4).

Since inception, a combination of the fund’s flexibility (a flexibility enjoyed by few other funds) and our willingness to use that flexibility to reposition the fund to reflect our
changing views has been key to its success.

M&G
June 2018

The fund allows for the extensive use of derivatives.
Further risks associated with this fund can be found in the fund’s Key Investor Information Document.

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