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Corporate bond investing in an inflationary environment
Ben Lord, Fund Manager October 2013
2
Five years of sticky cost-push inflation
(2007-2012)
3
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
RPI Target
UK RPI
UK CPI
CPI Target
Five years of sticky cost-push inflation
Source: Bloomberg, M&G, 30 September 2013
UK RPI and CPI
UK inflation has been above target 54 out of 60 months
over the past 5 years
4
1
1.2
1.4
1.6
1.8
2
2.2
Sterling has lost around 20% since 2007
GBP/USD
GBP/EUR
Ra
te
Five years of sticky cost-push inflation
Source: Bloomberg, 30 September 2013
Sterling depreciation
A weaker pound has driven up import costs
5
9.0
10.0
11.0
12.0
13.0
14.0
Price
, £
/ K
w
UK electricity and gas prices
Five years of sticky cost-push inflation Higher energy bills and fuel costs
Source: Bloomberg, 31 December 2012
Energy and gas prices have risen over 35% since 2007
6
Five years of sticky cost-push inflation
Source: Bloomberg, 30 September 2013
Rising food prices
And UK food bills shot up by 3.8% in the past year
Ind
ex
0
50
100
150
200
250
UN Food and Agriculture World Food Price Index
7
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
2007 2008 2009 2010 2011 2012 2013
UK real wage growth has been negative
Five years of sticky cost-push inflation
Source: Bloomberg, 30 September 2013
Negative real wage growth
Putting household budgets under pressure
8
Time for demand-pull inflation?
9
40
42
44
46
48
50
52
54
56
58
60
Ind
ex v
alu
es
UK all-sector PMI
PMI data hits record highs
Source: Bloomberg, 30 September 2013
All sectors moving in the right direction
Recent data points to further acceleration in growth
10
100
120
140
160
180
200
FFL scheme
LSL Acadametrics Nationwide HBOS
UK house price indices
UK housing market showing signs of life
Source: Bloomberg, 31 July 2013. Rebased to 100 at 28 February 2002
Reb
as
ed
to
10
0
11
-100
-50
0
50
100
150
Ind
ex v
alu
es
Surprise Index
Data above
expectations
Data below
expectations
Citi Economic Surprise Index
Economic recovery appears to be taking place
Source: Bloomberg, 30 September 2013
What does this hold for inflation?
Recent economic data has been surprising on the upside
12
Months from start of recession
6 12 18 24 30 36 42 48 54 60 66
1990/93
1973/76
1930/34
1920/24
1979/83
2008/?
Change in real GDP
15%
10%
5%
0%
-5%
-10%
-15% 0
GD
P:
ch
an
ge
fro
m p
ea
k
UK economic slump is worse than Great Depression
Source: ONS, NIESR, September 2013
UK economic growth compared with previous recessions
The UK is no safe haven
13
UK employment is well above previous recession levels
Source: Bank of England Inflation Report, May 2013
Level of whole-economy employment compared with previous recessions
Quarters from pre-recession peak in GDP
20 18 16 14 12 10 8 6 4 2 0 2 4 6 8
102
100
98
96
94
92
+ -
2008/09
1980/81
1990/91
Ind
ices: p
ea
k o
f G
DP
= 1
00
14
10,000,000,000,000
1,000,000,000,000
100,000,000,000
10,000,000,000
1,000,000,000
100,000,000
10,000,000
1,000,000
100,000
10,000
1,000
100
1
0
-10
10
Germany
Italy
France
Japan
Spain
UK
US
Switzerland
1971 1913
Global inflation series
Source: Deutsche Bank, GFD , 12 September 2011
Re-based to 1 as at December 1899 on a log scale
What lessons does this hold for 21st century investors?
15
US
D t
rln
3
6
9
12
15
USD
+10
trillion
Central banks have printed almost $10 trn since 2007
Source: DB Research, February 2013
Sum of major central bank balance sheets
…larger than the combined GDP of the UK, Germany and
France
US, UK, ECB, Japan, China and Switzerland
16
BoE’s Carney offers some forward guidance
Source: Bank of England, Quarterly Bulletin-Q2, June 2013
BoE Inflation report – August 2013
Mervyn King focused on quantity of money. Carney is
now focusing on velocity of money
“We are introducing forward guidance as part of a mixed strategy which includes
bank rate at historic lows, asset purchases and the funding for lending scheme”
Forward guidance Focus on money
velocity
Repair transmission
mechanism (FFL scheme)
Return confidence to
business and households
17
Inflation and credit views
18
Inflation expectations
Source: Bloomberg, 30 September 2013
Valuations support inflation protection
Inflation protection looks cheap
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
UK (RPI) US Germany
Five-year breakeven rates for the UK, US and Germany
19
80
84
88
92
96
100
104
108
112
Oil shocks analysis
Source: Fathom Consulting , Bloomberg, 30 September 2013
Effect on inflation measures of an oil price increase
Oil price ($/barrel) Oil Price
$/Barrel UK RPI
EA CPI
ex-tobacco US CPI
40 -1 -1.2 -3
50 -0.8 -0.9 -2.4
60 -0.6 -0.7 -1.8
70 -0.4 -0.5 -1.2
80 -0.2 -0.2 -0.6
90 0 0 0
100 0.2 0.2 0.6
120 0.4 0.5 1.2
130 0.6 0.7 1.8
140 0.8 0.9 2.4
150 1 1.2 3
160 1.2 1.4 3.6
170 1.4 1.6 4.2
180 1.6 1.9 4.9
20
1% 0.4% 1%
2% 2%
2% 3%
6%
13.4%
7.3%
10.4%
18.3%
0%
5%
10%
15%
20%
IG Non-Fin AA A BBB
Actual Average Actual Worst Implied Defaults
Five-year implied default rates, UK non-financials
Source: Implied defaults calculated using 40% recovery rate. Deutsche Bank and Merril Lynch Indices, 30 September 2013. * Bps
Implied vs actual default experience
Default risk premiums are very high vs. experience since
1920s
21
Source: M&G as at January 2011
Conclusions
• Economic recovery and current policy responses may be laying the
foundations for higher future inflation
• Markets are pricing in a very low level of inflation
• A strategy of short duration, inflation protection and high quality credit
that delivers a positive real yield has to be a wise strategy
22
M&G UK Inflation Linked Corporate
Bond Fund
23
M&G UK Inflation Linked Corporate Bond Fund
Source: M&G, 30 September 2013
Fund facts
• Co-fund manager Ben Lord
• Co-fund manager Jim Leaviss
• Aim To protect the value of capital and income
from inflation by generating a return
consistent with or greater than UK CPI over
the medium to long term
• Launch date September 2010
• Size £775 million
24 Please note that guidelines are subject to change
M&G UK Inflation Linked Corporate Bond Fund
• Minimum 80% Sterling (or hedged back to Sterling)
• Minimum 70% exposure to investment grade credit (including derivatives)
• VaR limits
– Upper limit: 10%
– Lower limit: 0.0%
• Restrictions by corporate issuer rating
– AAA - BBB 5%
– BB & below 3%
– Structured credit (inv grade) 2.5%
– Structured credit (high yield) 1.5%
Regulatory
Internal
Sector
25
Effect on capital value if
Why low duration matters
Source: M&G, 30 September 2013
Less exposed to a rise in interest rates
Duration Yields +1% Yields +3 %
M&G UK Inflation Linked Corp Bond Fund 2.5yrs -2.5% -7.5%
Iboxx £ Corp Bond Index 8yrs -8% -24%
BofA ML UK Gilt Index 10yrs -10% -30%
26
Yield Inflation 3% Inflation 4%
5Y UK Gilt +1.5% (nom. yield) -1.5% -2.5%
5Y UK IL Gilt -1.7% (real yield) -1.7% -1.7%
5Y UK IL Gilt + Credit “UKIL”
-1.7% (real yield)
+ 1.0% (IG credit)
- 0.7% (real yield)
-0.7% -0.7%
Inflation expected to return
Source: M&G, 30 September 2013
How might the fund perform in an inflationary environment?
Fund returns are explicitly linked to RPI, while the credit
component provides an additional level of yield
27
Fund positioning
28
Ye
ars
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Ye
ars
Fund duration Fund credit spread duration
Fund positioning summary
Source: M&G, 30 September 2013
M&G UK Inflation Linked Corporate Bond Fund
Key portfolio themes Duration
Duration Low interest rate
duration: 2.5 years
29
Fund positioning summary
Index-linked government
bonds 13.0%
Index-linked corporate
bonds 16.4%
Synthetic index-linked corporates
49.9%
FRNs 8.6%
Short dated corporate
bonds 6.0%
Cash 6.1%
Source: M&G, 30 September 2013
M&G UK Inflation Linked Corporate Bond Fund
Key portfolio themes
Duration Low interest rate
duration: 2.5 years
Asset
allocation
The core of the
fund is invested in
index-linked credit
Asset allocation, %
30
0.2
13.4
15.4
59.4
3.6
1.8
0.0
0.0
6.1
AAA
AA
A
BBB
BB
B
CCC & Below
NA
Cash
Fund positioning summary
Source: M&G, 30 September 2013
M&G UK Inflation Linked Corporate Bond Fund
Key portfolio themes Credit rating breakdown, %
Duration Low interest rate
duration: 2.5 years
Asset
allocation
The core of the
fund is invested in
index-linked credit
Credit risk
We find the best
risk/reward profile
in BBB credit
31
0%
5%
10%
15%
20%
25%
30%
35%
US Credit US Banks US Insurance
Fund positioning summary
Source: M&G, 30 September 2013
M&G UK Inflation Linked Corporate Bond Fund
Key portfolio themes Allocation to US credit over time
Duration Low interest rate
duration: 2.5 years
Asset
allocation
The core of the
fund is invested in
index-linked credit
Credit risk
We find the best
risk/reward profile
in BBB credit
Geographic
exposure
We are moving
back into EU
credit
32
Key portfolio themes
Duration Low interest rate
duration: 2.5 years
Asset
allocation
The core of the
fund is invested in
index-linked credit
Credit risk
We find the best
risk/reward profile
in BBB credit
Geographic
exposure
We are moving
back into EU
credit
Value at
risk
The low VaR is the
result of high
quality credit
portfolio with little
interest rate risk
Fund positioning summary
Source: M&G, 30 September 2013
M&G UK Inflation Linked Corporate Bond Fund
30 day VaR (99%)
0%
2%
4%
6%
8%
10%
33
Fund positioning
Source: M&G, 30 September 2013
M&G UK Inflation Linked Corporate Bond Fund
AAA- AA+ AA AA- A+ A BBB+
Credit risk
-2
-1
0
1
2
3
4
5
6
Dura
tio
n (
ye
ars
)
A- BBB
Sep 2010
Jan 2011
Jun 2012
Feb 2013
Sep 2013
34
0%
5%
10%
15%
20%
25%
75
95
115
135
155
175
195
215
Ind
ex v
alu
es
Itraxx Europe 5y (LHS) Fund risk free cash level 5-day MA (RHS)
We have been flexible and taken advantage of recent
market volatility
Source: Bloomberg, M&G, 30 September 2013
35
Rank Issuer %
1 United Kingdom Gilt Inflation Linked 62.2
2 Tesco Plc 3.2
3 Verizon Communications Inc 1.5
4 National Grid Electricity Transmission P 1.4
5 Scottish Power UK Plc 1.3
6 Granite Master Issuer Plc 1.2
7 National Grid Gas Plc 1.2
8 American International Group Inc 1.2
9 Toyota Motor Credit Corp 1.0
10 America Movil 1.0
Fund positioning summary
Source: M&G, 30 September 2013
M&G UK Inflation Linked Corporate Bond Fund
Top 10 physical positions
36
Rank Issuer %
1 Itrx Europe 5Y Index 23.0
2 Cdx Na IG 5Y Index 6.0
3 Heathrow Funding Ltd 1.9
4 Electricite De France 1.9
5 Deutsche Telekom Int Fin 1.9
6 Comcast Corp 1.4
7 Ford Motor Co 1.4
8 Eon Intl Finance Bv 1.2
9 Dow Chemical Co 1.1
10 Lloyds Banking Group Plc 1.1
Top 10 CDS positions
Fund positioning summary
Source: M&G, 30 September 2013
M&G UK Inflation Linked Corporate Bond Fund
37
Risk and performance analysis
38
Value at Risk
Source: M&G, 31 August 2013
Plenty of headroom to add risk
Daily monitoring of global exposure using VaR with
methodology 99% one month with an equally weighted
observation period (history) of 250 business days
VaR limits
0%
5%
10%
15%
30 day VaR @99% Upper Limit Lower Limit
39
Credit stress tests
Source: M&G, 31 August 2013
M&G UK Inflation Linked Corporate Bond Fund
-0.05%
0.05%
-4.73%
5.31% 4.00%
-6.24% -8.19%
9.08%
-0.08%
0.08%
-7.21%
8.23%
5.31%
-9.17% -10.39%
12.61%
-15%
-10%
-5%
0%
5%
10%
15%
Fund
Benchmark
40
Interest rate stress tests
Source: M&G, 31 August 2013
M&G UK Inflation Linked Corporate Bond Fund
-0.02%
0.02%
-1.02%
1.03%
-2.03%
2.08%
-0.73%
0.79%
-0.08%
0.08%
-3.72%
3.98%
-7.21%
8.23%
2.64%
-5.41%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
IR +1bp IR -1bp IR+50bp IR-50bp IR+100bp IR-100bp IR CurveFlatteners
IR CurveSteepeners
Fund
Benchmark
41
Performance since inception in September 2010
Source: Morningstar. Inc., UK database, 31 August 2013, sterling A class shares, net income reinvested, price to price. Rebased to 100, 17 September 2010
M&G UK Inflation Linked Corporate Bond Fund In
de
xe
d to
10
0
95
100
105
110
115
120
125
130
135
140
M&G UK Inflation Linked Corporate Bond Fund
IMA UK Index Linked Gilts sector avg
CPI Indexed
11.7%
25.0%
10.1%
42
M&G Global Corporate Bond Fund
43
M&G Global Corporate Bond Fund Fund at a glance
An active fixed income fund consisting primarily of investment grade
corporate bonds diversified across industries, issuers and regions
Designed for investors who want access to investment grade corporate
bonds and to benefit from global macroeconomic trends
The fund manager is empowered to take conviction views and aims to
maximise total returns for investors
Backed by a team with an excellent track record* in managing fixed income
portfolios
A blue-chip global investment grade bond fund that is designed
to capture relative value opportunities across markets
*Range of 10 fixed interest funds managed over past 5 years: 4 ranked first quartile, 4 ranked second quartile
(Source: Morningstar, Inc., UK database, 31 August 2013, sterling shares, net income reinvested, price to price, rankings in IMA sectors)
44
M&G Global Corporate Bond Fund
• Unconstrained investment approach allows a high degree of selectivity
• Global investment grade is not a new asset class for us
– London-based research team covers approx 1/3 of global index
– We manage significant US investment grade corporate bonds in existing
portfolios ($5.8bn across 142 names in USD bonds/$7bn across 69 names in
US-based corporates)
• Fund manager has experience as US financials analyst
• Deputy fund manager has experience as a US credit analyst
• Access to US-based credit research via PPM America, an affiliate of M&G
Source: M&G, October 2013
Designed to be a best relative value opportunities fund
Why we can run a global fund
45
• PPM America, Inc., an affiliate of M&G, is a well-resourced and
established fixed income manager based in Chicago
• Approximately $89 billion of fixed income assets under management
as of 31 March, 2013
• M&G fund managers have access to views and proprietary research
generated by 22 analysts “on-the-ground” in Chicago
• M&G fund managers visit Chicago up to 4 times a year to meet with
the PPM America, Inc., credit analysis team
Access to credit research in the United States
Source: M&G, 31 July 2013
46
M&G Global Corporate Bond Fund
M&G Corporate
Bond
M&G Strategic
Corporate Bond
M&G European
Corporate Bond
M&G Global
Corporate Bond
Sector £ Corporate Bond £ Corporate Bond EUR Corporate Bond Corporate Bond
Fund type Blue chip, investment
grade corporate bond
fund
More focused
investment grade
corporate bond fund
European investment
grade corporate bond
fund
Global investment
grade corporate bond
fund
Typical currency
exposure 95-100% GBP 90-100% GBP 95-100% EUR 95-100% USD
Typical asset allocation
Investment grade
High yield
Government bonds
90-100%
0-10%
0-20%
80-100%
0-20%
0-20%
90-100%
0-10%
0-10%
80-100%
0-20%
0-20%
Typical duration 6-9 years 4.5-11 years 3-6 years 4-8 years
Source: M&G, 13 August 2013. The inclusion of this fund information is for illustrative purposes only. Please note that guidelines are subject to change
.
Corporate bond range at a glance
47
- Sub vs senior financials
- Long end USD telcos
- High coupon USD credit
- CDS single name +ve basis
- CDS broad IG indices
- Synthetic vs physical
in Europe
(+ve basis opportunities)
- Hybrids
CR
ED
IT
- Bullish credit
- Euro cash bond
valuations very rich
- Financials vs HY
- US/UK vs EU
financials
- USD TMT
Portfolio themes
MACRO ASSET TYPE SECTOR INDIVIDUAL CREDIT
- Hedging duration via
GBP & USD futures
- Preference for $
FRNs over € & £
RA
TE
S
- Short duration (5.3y
vs 5.7y for index)
- Yield curve too steep
- EU rates poor rel val
- Euro macro tail risks
underpriced
- € corp hybrids (low
rate sens, high yields)
- Fix to float yield
- 20-30y USD credit
Top down Bottom up
Source: M&G, 30 September 2013
48
M&G Global Corporate Bond Fund
• Maximising cross-currency swap adjusted z-spreads amongst top credit relative
value picks across $, £ and € to exploit:
– Home bias (names trading cheaper in foreign currency)
– Market’s preference for funding in one currency over another
– Other inefficiencies
• High coupon, high priced $ bonds present an opportunity to earn substantially
higher z-spreads in those cases where we are comfortable with the credit
Opportunities across global bond markets
49
Cross currency relative value opportunities
Source: Bloomberg, 7 October 2013
100
150
200
250
300
350
400
DT 8.75 06/15/2030 USD
DT 7.125 06/15/2030 GBP
DT 4.5 10/28/2030 EUR
Exploiting spread differentials across markets
bp
s
Deutsche Telekom Z spreads
50 Source: Bloomberg, M&G, 30 September 2013.
Barclays Capital Global Corporate Index, BofA Merrill Lynch Sterling Corporate & Collateralised Index, BofA Merrill Lynch Euro Corporate Index
Asset allocation
M&G Global Corporate Bond Fund Fund positioning
Country allocation
6.8%
81.5%
11.7% Index-linkedgovernmentbonds
Investment grade
High yield
5.2
4.5
17.4
61.2
8.5
3.2
AAA
AA
A
BBB
BB
B
Credit rating breakdown Currency allocation
0%
10%
20%
30%
40%
50%
60%
70%
Fund Benchmark
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Fund Benchmark
51
M&G Global Corporate Bond Fund
Source: M&G, 30 September 2013
3.5
1.0
0.8
5.3
3.7
0.6
1.1
5.7
0.0
1.0
2.0
3.0
4.0
5.0
6.0
USD GBP EUR Total
Fund Benchmark
Ye
ars
Slightly short duration
Duration positioning
Fund Barclays Global
Corp
ML £ Corps ML € Corps
YTM 3.8% 2.9% 4.0% 2.2%
Duration 5.3 years 5.7 years 8.0 years 4.4 years
Duration contributions
52
20.2
17.9
8.8
6.8
6.2
5.1
4.6
4.1
3.9
3.8
3.7
3.5
2.9
2.0
2.0
1.8
1.4
0.8
0.6
Telecommunications
Banking
Basic Industry
Sovereign
Index
Asset Backed
Utility
Consumer Non-Cyclical
Insurance
Media
Mortgage Backed
Energy
Consumer Cyclical
Commercial Mortgage Backed
Technology & Electronics
Capital Goods
Healthcare
Automotive
Financial Services
%
Sector exposure
Source: M&G, 30 September 2013
M&G Global Corporate Bond Fund
53
www.bondvigilantes.com
www.twitter.com/bondvigilantes
54
Appendix
55
Population over 60 by region
0
500
1000
1500
2000
2500
Mill
ion
s
More developed regions Less developed regions
Today
810 million
2050
2.4 billion
2012
12%
2050
26%
Elderly dependency ratio1
Global population
Demographics
Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2008
Revision; Elderly dependency ratio = ratio of population 65+ per 100 population 15-64 based on a medium fertility variant
Increasing elderly dependency ratio
With more people consuming goods and services, and
fewer people producing them, prices will tend to rise
Population over 60 by region
56
10% 25% 0%
5%
10%
15%
20%
25%
30%
2011 2050
22% 34%
2011 2050
15% 24% 0%
5%
10%
15%
20%
25%
30%
2011 2050
6% 10% 0%
10%
20%
30%
2011 2050
11% 24%
2011 2050
19% 27%
2011 2050
Demographics: ageing population
Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2008
Revision; http://esa.un.org/unpp. Assumes medium-fertility variant, 2010-2050
Not just a developed world phenomenon…
The number of old people worldwide is growing faster
than any other age group
% of population aged 60 years or older
57
Pure interest rate risk
(duration)
“Risk free” yield
= -0.2% pa (2024 gilt linker)
BT I/L 2025
Yield = 1.4%
+ inflation
Pure credit risk
= 1.6% pa
+
What am I buying when I purchase an inflation-linked
corporate bond?
Source: Bloomberg, M&G, 30 September 2013
An inflation-linked corporate bond is a combination of
duration risk and credit risk, plus inflation
58
Some issuers of UK inflation-linked corporate bonds
Source: M&G, June 2013
59
Synthetic France Telecom linker
Credit default swap
(Pure Credit Risk):
France Telecom 5y = 1.0%
Pure interest rate risk
(duration):
UKTI 2022 “Risk free” yield = -0.5%
Yield = -0.5% + RPI + CDS premium
Synthetic inflation-linked corporate bonds
Source: Bloomberg, M&G, 30 September 2013
How to create one
CDS + government index linked bond = synthetic inflation
linked corporate bond
60
Ben Lord
• Ben Lord joined M&G in 2007 and was appointed
fund manager of the M&G Global Corporate Bond
Fund from launch in September 2013. Since
launch in September 2010, he has also been the
co-manager of the M&G UK Inflation Linked
Corporate Bond Fund and the M&G European
Inflation Linked Corporate Bond Fund. Additionally,
Ben is deputy manager of the M&G Short Dated
Corporate Bond Fund
• Ben previously worked at Gordian Knot as a credit
analyst covering global financial institutions
• He obtained an MA (Hons) from the University of
Edinburgh and is a CFA charterholder
Biography
61
Jim Leaviss
• Jim Leaviss joined M&G in 1997 from the Bank of
England. He is Head of M&G Retail Fixed Interest
• Manager of the M&G Global Macro Bond Fund
since September 1999
• Manager of the M&G Gilt & Fixed Interest Income
Fund since April 1998
• Co-manager of the M&G UK Inflation Linked
Corporate Bond Fund and M&G European Inflation
Linked Corporate Bond Fund since September 2010
• Has 21 years of experience in fixed income markets
Biography
62
The value of stockmarket investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount
you 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
investment products. The registered office is Laurence Pountney Hill, London EC4R 0HH. Registered in England No. 90776