Investment Universe, Process, Strategy and Benchmark – How does the Fund Manager invest? (ISIN: GB00B1H05155)
The name ‘M&G Optimal Income Fund’ derives from the aim to purchase those assets that provide in aggregate the most attractive, or ‘optimal’, income stream for the fund. All investment assets represent streams of future income to their owners. The income streams available vary greatly in longevity and certainty; they can all be characterised, however, by the combination of duration and credit risk that they offer. The fund manager’s preferences for duration and credit risk – and hence for the income streams offered by different assets – will depend on his views on duration and credit.In selecting individual bond issues on a bottom-up approach the fund manager is supported by M&G’s public credit analyst team. We believe that the proprietary credit analysis this team provides is a key competitive advantage for M&G in fixed interest investment. The credit analyst team is structured by sector speciality, and includes a team dedicated to the analysis of financials. The work of the credit analysts focuses on business risk (such as management and strategy, market share, product development), financial risk (eg, cashflow, debt, profit margins, capital structure) and bond covenants.
When investing in a particular company, the fund manager will examine its capital structure to choose the particular ‘slice’ – for example, secured/unsecured, senior/subordinated – that best suits his requirements. At times, a company’s equity can appear cheap compared with its debt. In those circumstances, he may well buy the equity for the fund, subject to the fund’s sector restrictions. As the fund is available for distribution both in Europe and the UK, it abides by the restrictions of its respective sectors. In the UK, these stipulate that no more than 20% of the portfolio may be invested in equity. In practice the fund’s equity exposure is typically far less than this.
Whilst the fund is invested predominantly in bonds, the fund manager is also able to take advantage of the greater flexibility available under the UCITS III ‘wider powers’ regulations to make use of a significantly broader range of investment instruments and techniques. This flexibility allows the manager to use derivatives to express his duration and credit views efficiently.
Of particular relevance for the M&G Optimal Income Fund is the flexibility to invest in new instruments for a retail bond fund:
• The income stream of the fund is ‘shaped’ by the use of derivative instruments that allow the fund manager to alter exposures to changes in various market conditions. Such instruments include, for example, credit default swaps, used to reduce or increase the fund’s exposure to credit risk, and bond futures, to alter the fund’s duration.
• The fund manager may use derivatives to take out protection on an asset if he believes it represents a particularly unattractively priced income stream. In contrast to a ‘long-only’ fund – for which the manager’s only option is to avoid owning such an asset – the fund is thus able to benefit if the manager’s view proves to be correct.
• Derivatives can also be used to express views on the outlook for the yield curve, especially on the shape of the curve at different maturities; this expression can be difficult to establish using just long-only bonds.
Taking advantage of this flexibility, fund manager Richard Woolnough can hold a combination of assets and derivatives that allows him to position the M&G Optimal Income Fund exactly according to his duration and credit risk views. Graphically, this means that the fund can appear anywhere within the shaded area in the duration risk/credit risk spectrum shown in the chart below. This is in stark contrast to typical ‘long-only’ bond funds which tend to operate within tight duration restrictions of, for example, plus or minus one year against the benchmark.
Whilst the fund is invested predominantly in bonds, the fund manager is also able to take advantage of the greater flexibility available under the UCITS III ‘wider powers’ regulations to make use of a significantly broader range of investment instruments and techniques. This flexibility allows the manager to use derivatives to express his duration and credit views efficiently.
Of particular relevance for the M&G Optimal Income Fund is the flexibility to invest in new instruments for a retail bond fund:
• The income stream of the fund is ‘shaped’ by the use of derivative instruments that allow the fund manager to alter exposures to changes in various market conditions. Such instruments include, for example, credit default swaps, used to reduce or increase the fund’s exposure to credit risk, and bond futures, to alter the fund’s duration.
• The fund manager may use derivatives to take out protection on an asset if he believes it represents a particularly unattractively priced income stream. In contrast to a ‘long-only’ fund – for which the manager’s only option is to avoid owning such an asset – the fund is thus able to benefit if the manager’s view proves to be correct.
• Derivatives can also be used to express views on the outlook for the yield curve, especially on the shape of the curve at different maturities; this expression can be difficult to establish using just long-only bonds.
Taking advantage of this flexibility, fund manager Richard Woolnough can hold a combination of assets and derivatives that allows him to position the M&G Optimal Income Fund exactly according to his duration and credit risk views. Graphically, this means that the fund can appear anywhere within the shaded area in the duration risk/credit risk spectrum shown in the chart below. This is in stark contrast to typical ‘long-only’ bond funds which tend to operate within tight duration restrictions of, for example, plus or minus one year against the benchmark.
Performance Review 2007
Richard Woolnough: "The main feature of 2007 between the launch of the M&G Optimal Income Fund and the end of December 2007 was the deteriorating economic environment, which became especially apparent in the second half of the year. Fund manager Richard Woolnough steadily increased the duration of the M&G Optimal Income Fund over the course of the year, to 7.5 years at the end of 2007. This was 2.5 years longer than what we consider to be a ‘duration neutral’ position of 5 years. The manager’s long-duration position was based on his view that the knock-on effects of the credit crunch were only just starting to filter through to the broader economy, with the world facing the prospect of a severe global economic slowdown. In the US, there remained a massive oversupply of houses on the market, and prices were likely to continue falling until this excess was cleared. In the UK, lead indicators suggested that the housing market would continue to weaken in 2008. A housing market collapse has tended to coincide with, or result in, a recession. Richard believed that central banks would need to cut interest rates to prevent recession, and that being positioned long duration would enable the fund to make the most of the anticipated rally in investment grade bonds.
The market was expecting interest rates to fall by 0.75% in the US and by 0.5% in the UK this year, and the manager anticipated that interest rates would need to fall by an amount larger than the market was pricing in.
During the first half of 2007, the manager had used derivatives to reduce duration to as little as 2 years by going short of UK government bond futures and German government bond futures. This strategy served to protect the fund from the environment of rising interest rates.
Since the start of the credit crunch late in the summer of 2007, the manager used derivatives to add duration to the fund. This was achieved by closing out the existing futures positions. Duration was then moved longer in August when he bought US interest rate futures, believing that the Federal Reserve would cut interest rates. This trade served to increase the fund’s duration (that is, the fund took on more interest rate risk). The position benefited performance as the Federal Reserve cut interest rates by 1%. He also bought UK government bond futures, due to his belief that UK interest rates would fall, and this increased duration further.
Richard Woolnough’s very bearish view on the economy was reflected in the fund being very cautiously positioned in terms of credit quality. He believed that after two years of being unattractive, higher-rated corporate bonds appeared excellent value. However, he still avoided poorer-rated investment grade corporate bonds and particularly high yield bonds, because spreads (the excess yield over that of government bonds) remained tight on a historical basis. The fund manager believed the default rate would rise, and high yield bonds did not offer investors sufficient yield premium to compensate for the extra risk they bore. Just 33% of the fund was invested in high yield bonds, which was close to the minimum 30% permitted by sector guidelines at the time.
Credit default swaps (CDS) allow the manager to gain pure exposure to credit risk. He can sell (or ‘write’) protection on companies that he likes and where he thinks that corporate bond spreads will tighten, or he can buy protection and make a profit from identifying unattractively priced bonds.
The manager’s very cautious approach to credit risk in 2007 meant that CDS were generally used to buy protection since the fund’s launch, which served to improve the average credit quality of the fund, thereby reducing the fund’s risk profile. The average credit rating improved to ‘single A’ by the end of 2007, which was broadly in line with the average credit quality of the typical investment grade corporate bond fund.
Profits were generated from buying protection on financial issuers. Buying protection on subordinated bonds issued by Kaupthing (an Icelandic bank) and by Wachovia (a US bank affected by the credit crisis) helped in particular."
Performance Review 2008
Richard Woolnough: "Calendar year 2008 included an extremely challenging environment for corporate bond funds, to which the M&G Optimal Income Fund was not immune. However, it performed well ahead of the average fund in its official peer group at the time, the Morningstar Fixed Income Europe High Yield sector. This strong performance against its peers in the Morningstar Fixed Income Europe High Yield sector was primarily due to a very large underweight exposure to financials and specifically a negligible exposure to subordinated or ‘Tier 1’ bank bonds. Duration positioning also proved beneficial as government bond yields fell sharply due to the threat of a severe global recession and fears of deflation.
By the end of 2008 there was no doubt that the global economy was firmly in recession. Interest rates were likely to fall further from end-2008 levels and stay low for a prolonged period. However, Richard Woolnough believed that credit was likely to drive bond market performance going forward, rather than falling government bond yields. Corporate bonds were pricing in a catastrophic level of defaults because of technical, rather than purely fundamental factors. Richard believed that default rates would rise, but would not be anywhere near as high as implied by market pricing. This represented an excellent opportunity for corporate bonds and Richard therefore positioned the fund more aggressively with regard to credit, although it remained significantly underweight financials.
The fund’s duration position has moved down to around 6.0 years by the middle of 2008, which is 1.0 years longer than what we would consider a ‘duration neutral’ position for the fund. It had been longer duration earlier in the year based on Richard’s view that the knock-on effects of the credit crunch were only just starting to filter through to the broader economy, with the world facing the prospect of a severe global economic slowdown. Duration was shortened just before the summer as medium-dated bonds became more attractive than long-dated ones after a period of underperformance, and not because of a change in Richard’s view on the prospects for the global economy. UK government bond yields rose from April to June on the back of inflationary fears, and, at the start of the second half, the market was pricing in interest rate rises. However, contrary to much of the market, Richard was not worried about inflation, believing that slowing growth would create spare capacity and that, as typically happens after banking crises, inflation would fall. He therefore took the opportunity to steadily increase the fund’s duration, which peaked at around 7.5 years at the end of September, after Richard bought 2, 5, 10 and 30-year German government bond futures. Bond yields rallied strongly from September and the fund’s position in bond futures added significant value to performance.
In December, when government bond yields moved to historic lows and credit spreads were the widest they had ever been, Richard believed that there were greater opportunities in credit than in government bonds. He therefore exited the fund’s long futures positions, bringing duration down to a neutral position of just under 5.0 years.
Richard Woolnough reflected his very bearish view on the economy at the beginning of 2008 by positioning the M&G Optimal Income Fund very cautiously in terms of credit quality. However during the course of 2008, the seizing up of the credit markets and subsequent high-profile collapse of many long-established financial institutions, coupled with wave after wave of forced selling, meant that corporate bond spreads widened to record levels – higher even than during the Great Depression. Richard maintained his view that the global economy was in deep trouble, but yields widened to such an extent that investment grade bonds were offering phenomenal value. By the end of the period, for example, UK BBB rated bonds yielded 7.6 percentage points more than government bonds, having yielded 2.9 percentage points more at the end of June 2008. In Europe, BBB spreads rose from 212 basis points over government bonds, to 626. Richard, therefore, continued to add credit risk to the portfolio, as he had done during the first half of the year.
By the end of the year, the fund’s exposure to A and BBB rated bonds, combined, was 54%, up from 50% at the start of the period. The fund’s weighting in AAA assets declined from 7.7% to 3.0%. High yield corporate bond spreads also widened sharply from 6.9 to 21.6 percentage points more than government bonds by the end of the year. Richard selectively added to the fund’s high yield holdings during the period."
Performance Review 2009
Richard Woolnough: "The M&G Optimal Income Fund significantly outperformed the average government bond and investment grade corporate bond fund over the course of 2009, although the continuing high yield rally meant that the fund’s performance lagged the average high yield corporate bond fund.
Despite the rally, corporate bond spreads remained at historically wide levels and fund manager Richard Woolnough consequently believed that there was still value to be found in corporate bonds. However, he was concerned about UK government bond yields rising in the future and therefore moved to protect the portfolio by selling UK government bond futures, retaining a short position. He also closed the position in German government bond futures. Richard remained positive on the direction of credit spreads and therefore continued to add credit to the fund via a combination of new issues and secondary market purchases.
The fund had moved to a short duration position by the middle of 2009. This was achieved through a short position in UK government bond futures, as well as short positions in German five- and 10-year government bond futures. Richard maintained the short duration position throughout the second half, although he increased duration slightly in December, as government bonds sold off sharply. This was achieved through buying long-dated credit, as well as closing the fund’s position in German government bond futures. By the end of the year the fund’s duration stood at 3.7 years.
Despite having a slightly negative view on government bond yields, Richard remained positive on the direction of credit spreads. He therefore continued to add credit to the fund via a combination of new issues and secondary market purchases. For example, in the primary market he added BBB rated drinks company Campari, at a spread of approximately 250bps over UK government bonds, as well as US dollar-denominated bonds from Brazilian oil company Petrobras, also rated BBB and offering a similar spread over US Treasuries. Other examples of investment grade bonds added at new issue were EDF, BAA, BAT, Segro and senior bonds from insurance company Aegon. In the secondary market Richard added to the fund’s exposure to HSBC, Tesco and Imperial Tobacco.
The fund’s high yield exposure was moderately increased. There were a number of new issues in this market that Richard participated in, including autoparts manufacturer Hella, at a spread of approximately 450bps over five-year German government bonds, and global packaging company Smurfit Kappa at a spread of 500bps over German government bonds."
Performance Review 2010
Richard Woolnough: "Having adopted a relatively neutral duration position throughout most of 2009, in February 2010 Richard started to lengthen the fund’s duration, taking it longer than the benchmark. He positioned the fund to take advantage of the rise in US, UK and German government bond prices amid concerns over the sovereign debt crisis in peripheral Europe. This move added significant value to performance.
In the second half of 2010, the fund manager reduced the fund’s duration position, taking it short of what he regarded as a benchmark position of around five years. This was largely due to the steepness of the yield curve as well as an increase in the fund’s short position in 30-year German bund futures. In the fund manager’s view, the middle of the UK and German curves and the long end of the US curve looked most attractive. The portfolio also had a relatively large weighting in high yield bonds, which tend to be shorter duration.
Adding credit risk helped to boost the fund’s performance in 2010 as spreads continued to tighten during this period from the all-time wide levels reached in March 2009. Asset allocation was the biggest driver of the fund´s performance over second half of 2010, namely a relatively large position in credit. Approximately 80% of the fund was invested in corporate bonds, including more than 40% in high yield bonds. The fund manager sold protection on two high yield indices in the latter stages of 2010 to represent his positive view on this area of the market in the portfolio."
Performance Review 2011
Richard Woolnough: "After reducing duration in the latter stages of 2010 and in early 2011, Richard increased duration again from April 2011 onwards taking it to 5.2 years in July. He did this by closing the fund’s short position in German government bonds and buying physical German government bonds to ensure the fund was well placed amid renewed anxiety over the economy and the eurozone debt crisis and therefore a subsequent increase in demand for ‘safe haven’ assets. This move was well timed since German government bonds rallied strongly, which in turn benefited the fund.
Most recently, in Q4 2011, duration was lengthened slightly from 3.7 to 3.9 years. This was not because Richard Woolnough became more bullish on the outlook for government bonds in general. Rather, the contribution to duration from US dollar assets was increased slightly, whilst at the same time, duration from euro-denominated assets was reduced. At the start of the quarter, the fund had almost no duration from US dollar assets, because Richard felt that US Treasury yields looked too low. However, following ‘Operation Twist’ in the US, as well as continued problems within the eurozone, which Richard believed would continue to give a safe haven bid to US Treasuries, he increased the fund’s duration from US dollar assets by around 0.5 years. At the same time, he sold down his holding in 10-year bunds, thereby reducing the fund’s euro duration contribution. At the end of the quarter, the fund had 2.7 years duration from sterling assets, 1.1 years from euro assets, 0.5 years from US dollar assets, whilst maintaining the short of -0.3 years from Japanese bond futures.
Richard reduced the portfolio’s financials exposure in 2011, reflecting his longstanding bearish view of the sector. He believed financials to be in a structural bear market and that there were better opportunities to be found in non-financial credit.
The portfolio’s high yield exposure also increased in 2011, as the fund manager believed that the market was pricing in too many corporate defaults. However, while remaining bearish overall on financials and corporates from peripheral eurozone countries, the manager did add issuers on a case-by-case basis if they appeared to offer compelling value."
Performance Year-to-Date 2012
Richard Woolnough: "The fund has outperformed its sector year-to-date (to February 29, 2012). The start of the year saw improved investor risk appetite, thanks to actions by the European Central Bank (ECB) in December 2011 and February 2012 to inject liquidity into the financial markets through a long-term refinancing mechanism known as the LTRO. This lowered sovereign bond yields and eased banks’ immediate funding pressures.
Renewed risk appetite was widely evident, with equities, high yield bonds and emerging market assets delivering positive returns. In this environment, the portfolio’s relatively large exposure to high yield bonds was the main reason for its outperformance.
Richard Woolnough made a number of significant changes to the portfolio since the start of the year. He reduced the fund’s duration, from 3.9 years at the end of December to 2.3 years at the end of February, approaching its shortest ever duration position, as he believes that current government bond yields do not look attractive. He achieved this by selling 10-year gilt futures, as well as five- and 10-year Treasury futures, and five- and 30-year bund futures. As a result, the fund now has almost no duration derived from US dollar assets, as Richard believes that the US housing market is beginning to show signs of a pick-up, indicating a wider economic recovery.
He also began to increase the fund’s exposure to financials, although the portfolio remains underweight the sector relative to its peers. The two rounds of the ECB’s LTRO significantly lowered sovereign bond yields and has eased bank funding, resulting in a substantial supply of new bank bonds. The decision to increase exposure to financials does not mean that problems and risks within the banking system have gone away. It remains uneconomical for many banks to borrow on an unsecured or subordinated basis. This has led to a large amount of covered bond issuance so far this year.
The increase in financials holdings has been achieved mainly through buying covered and senior bank bonds, as well as some lower Tier 2 bonds from some preferred institutions. The fund manager has bought AAA-rated covered bonds from issuers including Lloyds, RBS and Barclays as well as new unsecured bonds from some of the stronger banks, such as HSBC and Rabobank. "
Performance since 2007
The fund has outperformed its peer group, the Morningstar EUR Cautious Allocation sector, since launch and in each of the major reporting periods, year-to-date, 12 months and three years (as at 29 February 2012).
The fund manager has achieved this strong long-term performance by actively managing duration and credit risk (the two main drivers of return in a fixed interest fund).
Duration management is extremely important in bond funds as it can be a key source of performance. This is particularly the case for the M&G Optimal Income Fund, which has very wide theoretical duration limits compared with most funds. This flexibility enables the fund manager to move the fund very short duration (although the fund’s duration may not be negative) in an environment of rising bond yields and high inflation, or to move the fund very long duration if he believes bond yields will fall. Over the past three years, the fund manager has been very active in adjusting duration and this has been a key driver of performance.
The fund’s duration was as low as 2.3 years shortly after its launch as economic growth was strong, the housing market was booming and the fund manager believed that the Bank of England would continue to raise interest rates beyond the market’s expectations. As the bank moved rates from 5.0% at the fund’s launch to 5.75% in May 2007, UK government bond yields sold off into the summer of 2007, peaking at around 5.5% in July, and the fund’s short duration position boosted performance.
Given the fund’s flexibility and ability to make use of derivatives, the fund manager was able to quickly move the fund from a very short duration to a very long duration position. Duration was approximately 8 years in the summer of 2008 as the credit crunch broke and it looked likely that economic growth would slow and interest rates would have to be cut. This duration position was achieved by buying German and UK government bond futures. Government bond yields then tumbled as investors sought safe-haven assets and began to price in interest-rate cuts. But for a brief move shorter in early summer 2008, the fund manager maintained the fund’s long duration position as UK 10-year government bond yields fell to an historic low of 3.0% by the end of 2008.
At the start of 2009, the fund manager moved the fund to a more neutral position (estimated to be around the 5.5-year duration mark) and then sold government bond futures in the spring when it became apparent that there would be a large volume of new issuance. This helped performance as yields rose from March 2009 onwards (despite the downward pressure from the Bank of England’s quantitative easing programme) on fears of oversupply, as well as improved economic data and risk appetites.
Then in February 2010, the fund manager started to lengthen the fund’s duration, taking it slightly longer than the benchmark in July 2010. He positioned the fund to take advantage of the rise in US, UK and German government bond prices amid concerns over the sovereign debt crisis in peripheral Europe. This move added significant value to the fund.
After reducing duration in the latter stages of 2010 and in the first part of 2011 to capture profits following this good performance, Richard increased duration again from April onwards taking it to 5.2 years in July 2011. He did this by closing the fund’s short position in German government bonds and buying physical German government bonds to ensure the fund was well placed amid renewed anxiety over the economy and the eurozone debt crisis and therefore a subsequent increase in demand for ‘safe haven’ assets. This move was well timed since German government bonds rallied strongly, which in turn benefited the fund.
In the latter stages of 2011 and into 2012, Richard reduced duration in the fund, as he believes that believes that government bond yields are unattractive at current levels. The portfolio’s duration at the end of February 2012 stood at 2.3 years, close to its shortest ever level since inception.
The fund was launched at a time of tight credit spreads, when the average sterling BBB rated corporate bond yielded just 1.1% more than government bonds and the average high yield bond just 2.6% more (this compares with 2.3% and 5.7%, respectively, at the end of June 2011). The fund manager did not believe that he was being paid enough to take credit risk in many cases, so the fund held the minimum weighting in high yield of 30% (at that time the fund had a restriction on its high yield exposure as it was to be included in the Morningstar Fixed Income Europe High Yield sector). As the credit crunch broke and spreads began to widen, the fund manager initially increased the credit quality of the fund by purchasing government bonds. At the same time he began to decrease the fund’s exposure to financials.
In 2008 as spreads widened considerably from their 2007 lows, the fund manager began to add credit risk to the fund, increasing exposure to BBB rated debt, reducing government bond exposure and maintaining the minimum high yield exposure. He continued to maintain the fund’s very low weight of around 10% in financials. The fund’s net exposure to financials as a whole was actually as low as 5% and net exposure to banks was almost zero, as the fund manager had also bought protection on several names (using CDS), representing approximately 5% of the fund’s value. Despite having the lowest possible high yield exposure, this hurt performance in late 2008 as the asset class sold off heavily and spreads widened, falling 20% in October alone.
However, the fund’s sector positioning helped to offset this weakness as investment grade non-cyclical industrials, utilities and senior financials outperformed considerably. The fund manager continued to add to the fund’s corporate bond exposure in 2009 mainly via the raft of A and BBB rated new issues. These were generally offered at extremely attractive levels, as issuers were desperate to get deals done after the banks were all but closed as a source of financing. As the economic data began to improve and banks started to tender for their subordinated debt, the fund manager increased the fund’s exposure to financials (by rotating out of non-cyclicals), moving from around a weighting of around 10% in February to about 26% by the end of August 2009. As at the end of April 2010, financials accounted for just below 20% of the portfolio, while 12 months later, the weighting in financials had fallen slightly and was approximately 18%. By the end of August 2011, the fund’s total financials exposure had fallen to 13.1%.
Adding credit risk and financials helped to boost the fund’s performance in 2009, 2010 and in the earlier stages of 2011 as spreads continued to tighten from the all-time wide levels reached in March 2009. That said, the fund’s conservative positioning – that is very little money in the lowest rated high yield bonds and no money in Tier 1 bank bonds, has helped to protect performance during those months of heightened risk aversion most notably June, July and August 2011. In the same way, the fund manager’s conservative stance also means that he has avoided investing in sovereign debt from the peripheral countries and this has also helped performance.
The fund manager’s decision to build up the fund’s credit exposure, while maintaining a focus on the best quality names, that is businesses with strong balance sheets and sound fundamentals, had a positive effect on the portfolio in 2011. In general, however, the fund’s relatively large high yield position held back performance throughout the summer when risk appetite was very low. That said, being in the best quality companies and avoiding those businesses rated CCC and below, as well as having a relatively small position in financials, has helped to protect the portfolio from the heaviest losses suffered by corporate bonds in recent months.
Since early 2012 Richard Woolnough has begun adding financials exposure to the portfolio, although the portfolio remains underweight the sector relative to its peers. The European Central Bank’s decision to inject a record amount of liquidity into markets in December and February significantly lowered sovereign bond yields and has eased bank funding, resulting in a substantial supply of new bank bonds. The decision to increase exposure to financials does not mean that problems and risks within the banking system have gone away. It remains uneconomical for many banks to borrow on an unsecured or subordinated basis. This has led to a large amount of covered bond issuance so far this year.
The increase in financials holdings has been achieved mainly through buying covered and senior bank bonds, as well as some lower Tier 2 bonds from some preferred institutions. The fund manager has bought AAA-rated covered bonds from issuers including Lloyds, RBS and Barclays as well as new unsecured bonds from some of the stronger banks, such as HSBC and Rabobank.
