M&G Corporate Bond Fund

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1 Quarterly Review M&G Corporate Bond Fund Third quarter 2015 Fund manager Richard Woolnough Overview A general risk-off tone prevailed in the third quarter amid significant volatility in risk markets, driving core government bond yields lower and credit spreads wider. The fund delivered a modest return and outperformed the fund s peer group largely due to sector allocation. Its short duration positioning and high yield exposure detracted. Duration was held steady at around 6.4 years, 1.4 years short of the iboxx Sterling Corporate Bond Index at quarter-end. Fund Manager Richard Woolnough maintains his long-held view that the US and UK will need to raise rates soon. There was very little change to asset allocation during the month. Richard continues to be bullish on spread duration, finding particular value in BBB rated credit in US dollar and sterling denominations. Fund performance 3 months 6 months 1 year 3 years pa 5 years pa Since tenure* pa M&G Corporate Bond Fund IA Corporate Bond sector average Fund quartile ranking in sector Source: Morningstar, Inc., UK database as at 30 September Sterling A class shares, net income reinvested, price-toprice basis. *Richard Woolnough has managed the fund since 27 February 2004 The quarter was a turbulent one for risk assets. Broad negative sentiment drove core government bond yields lower and credit spreads wider. In spite of this, the fund gained and outperformed both the fund s peer group and reference index. The fund s large exposure to investment grade credit added modest value to the fund. Fund Manager Richard Woolnough s decision to adopt an underweight exposure to utility companies and auto sectors drove relative outperformance. However, the fund s short duration positioning, its tilt towards lower rated investment grade credit and its high yield exposure dragged on performance. Market review The third quarter will likely be remembered for periods of extreme volatility in Asian equity markets, as major indices posted their worst quarterly performance numbers in years. However, contagion carried over to all risk asset markets globally, including credit markets, symptomatic of concerns around slowing global growth, China s faltering economy and soft commodity prices. Those concerns combined to drive credit spreads wider and core government bond yields lower, resulting in mixed performance numbers in fixed income markets. A general flight to safe haven assets pushed core government bond yields lower the 10-year German bund fell below 60 basis points (bps) at quarter-end. Credit spreads widened with higher rated assets performing best and vice versa. Sterling investment grade credit outperformed while the US high yield market significantly underperformed, owing to its energy and commodity-related exposure, which sold off.

2 In July, Greece avoided an exit from the eurozone, but government bond yields rallied due to concerns of economic uncertainty in China and extreme volatility in Chinese equity markets. US dollar assets underperformed as spreads widened on the back of record July issuance and plummeting oil prices. In August, a rout in Asian equity was sparked by the People s Bank of China s surprise move to devalue its currency against the US dollar, combined with commodity market weakness. Major markets globally saw double-digit losses, but Asian and emerging markets bore the brunt. Core government bond yields remained steady while credit spreads widened. In September, the US Federal Reserve s (Fed) decision not to raise rates was a key driver of volatility. Fed comments cited the disinflationary impact of US dollar strength and low commodity prices, but also to recent global economic and financial developments. Government bond yields rallied but credit performance was weak as spreads widened. Total returns in the third quarter of 2015 Bond category Return in local currency Gilts 3.3 Bunds 1.8 Treasuries 2.0 investment grade industrials 0.8 investment grade financials 0.6 investment grade industrials -0.9 investment grade financials 0.2 Source: Bloomberg, Merrill Lynch, from 30 June 2015 to 30 September Fund management Duration Duration was trimmed from 6.6 years to 6.4 years, 1.4 years short of the iboxx Sterling Corporate Bond Index at quarter-end. Duration from euro-denominated assets was held steady at 0.1 year while sterling and US dollar duration was 5.8 and 0.5 years, respectively at quarter-end. Fund Manager Richard Woolnough maintains his longheld view that the US and UK will need to raise rates soon. Government bond exposure fell slightly from 7.3 to 6.4. Core government bond exposure all comes from conventional gilts. The fund retains a small position (1.1) in other governments (Italy, Spain, Mexico, Portugal). Fund duration relative to Markit iboxx Corporates Index Duration (years) M&G Corporate Bond Fund iboxx Sterling Corporate Index Source: M&G, Markit iboxx as at 30 September 2015

3 Credit risk There was very little change to asset allocation during the month. Richard continues to be bullish on spread duration, finding particular value in BBB rated US dollar and sterling-denominated credit in long-dated and medium-dated tenors, respectively. At quarter-end, investment grade was 84, up from 83, with three quarters in sterling credit, 11 in US dollar assets and the remainder in euro assets. BBB rated bonds account for 47.4 of the fund, the largest exposure by credit rating, followed by A rated bonds (21). High yield exposure fell slightly from 5.2 to 4.8, including 1.6 exposure to high yield financials. Fund rating breakdown () Physical CDS short CDS long Net AAA AA A BBB BB B CCC CC C D No rating Cash Source: M&G, as at 30 September The columns may not always add up when reading across as physical bond holdings and/or cash are sometimes used as collateral for CDS exposure. Fund exposure to financials Capital ranking Q Q Q Q Senior Lower Tier Upper Tier Tier Source: M&G, as at 30 September 2015 The fund s financials sector holdings were held steady and remain underweight relative to the fund s comparable index. Richard continues to prefer subordinated bonds over senior bonds, because they offer a better risk/reward profile in many cases.

4 Fund sector breakdown () Sector breakdown of physical assets since June Source: M&G, as at 30 September 2015 Outlook Richard has long held the view that the growth outlook for the global economy is positive, driven by the US and helped by the stimulative effects of a weak oil price. China s economic slowdown will likely not have a significant effect on global growth. Meanwhile, Europe looks to be stabilising. The fund is positioned to benefit from this recovery. Richard believes that central banks in the US and UK will need to respond to improvements in their respective economies shortly, given the strength of employment data and the delay with which monetary policy changes can take effect. He expects to see a rate rise in the US in the short term, followed by the UK. In Europe, he believes that the economy is in better shape than the market thinks and that the economy may be turning a corner following years of easy monetary policy. Europe s policy response was slow post-crisis, and some eurozone members face significant challenges, where debt and unemployment rates are still high, particularly in the Peripheries. The European Central Bank only started quantitative easing this year and monetary policy typically takes months before it feeds through into the real economy. However, economic data has improved since the end of 2014 and there are clear signs that the economy is stabilising. In light of these views, we are cautious on interest rate duration and bullish on spread duration. As the global economy continues to improve, particularly in the US and UK, we will likely see a rate rise in those economies very soon. We believe that government bond yields, now at historically low levels, will rise from here and we therefore hold a short duration position, particularly on euro-denominated assets. We believe this normalising environment is supportive of corporate credit fundamentals, fundamentals will improve as the economy improves and spreads will compress. Spreads in some parts of the US investment grade market have only been wider in times of crisis and we don t think we are heading into a crisis, particularly with the low oil price providing further support to growth.

5 In addition, historically, investment grade spreads have tended to tighten in a rate tightening cycle. In our view, this is the right time to have credit exposure, although we remain cautious on interest rate duration given the very low levels of government bond yields. In investment grade, we have a preference for US dollar and sterling assets over euro-denominations, and see especially good value in BBB rated, long-dated US dollar bonds. The credit curve in the US is the steepest it has ever been, and long-dated investment grade corporate spreads have widened to very attractive levels on the back of corporate activity and large issuance volumes. In high yield, we remain constructive on a selective basis and are slightly underweight. We prefer US over European high yield due to a more favorable economic environment. However, we are cautious of energy exposure as we believe there may be a number of defaults in the sector going forward if the oil price does not recover materially. The fund may invest more than 35 in securities issued by any one or more of the governments listed in the fund prospectus. Such exposure may be combined with the use of derivatives in pursuit of the fund objective. It is currently envisaged that the fund s exposure to such securities may exceed 35 in the governments of Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, Netherlands, Singapore, Sweden, Switzerland, UK, USA although these may vary subject only to those listed in the prospectus. 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 investment products. The registered office is Laurence Pountney Hill, London EC4R 0HH. Registered in England No _84306

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