Quarterly Review M&G Global Macro Bond Fund Third quarter 2015 Fund manager Jim Leaviss Overview While government bonds recorded gains, riskier areas such as high yield and emerging market debt declined. Fund Manager Jim Leaviss took steps to reduce risk in the portfolio, such as by buying protection in the credit defaults swap markets to lower its exposures to US high yield and European investment grade bonds. The fund maintained substantially short duration relative to a neutral level and a large allocation to the US dollar within its currency positioning. Fund performance 3 months 6 months 1 year 3 years 5 years Since launch* M&G Global Macro Bond Fund A-H 0.2-6.3-1.0 1.0 N/A 2.1 Morningstar Global Bond - EUR Hedged sector average -0.2-2.5-0.5 1.3 2.4 2.7 Fund quartile ranking in sector 3 4 3 3-3 Source: Morningstar, Inc., Pan-European database as at 30 September 2015. Euro A-H class shares, gross income reinvested, price-to-price basis. *The hedged share class was launched on 16 December 2011. Global bond markets registered mixed performance in the third quarter, with core government bonds delivering gains while declines were recorded among riskier assets such as high yield and emerging market debt. Within US and European investment grade credit, higher rated segments of the market mostly produced positive returns while lower rated segments of the asset class fell. The relative strength of government bonds was partly driven by the safe haven status of these assets amid increased volatility in equities, where a sharp sell-off in China s stockmarket was among the main headlines. While much attention remained focused on decelerating economic growth in China, concerns also increased about the prospect of a global economic slowdown. In addition, government bond markets were helped in the final month of the period by the Federal Reserve s (Fed) decision not to raise interest rates, a possibility that had been partly priced in by investors against the relative strength of the US economy. Among other asset classes, continued price weakness in oil and other commodity markets remained a theme that weighed on the performance of high yield and emerging market bonds. Energy-related credits are heavily represented in the US high yield market, while many emerging market countries are largely reliant on oil and commodity production for their export revenues. In the emerging bond markets, local currency-denominated bonds delivered the poorest returns. The fund generated a small gain in this environment, helped by its allocations to government bonds and segments of the investment grade credit market which delivered positive returns. However, its exposures to high yield and emerging market bond debt detracted. The fund s significantly short duration also held back its performance to an extent as yields fell.
Market overview Sentiment generally became more risk averse in global financial markets during the quarter. While a significant selloff in Chinese equities in August was accompanied by increased concerns about a global economic slowdown, equity markets were also unsettled by several company-specific developments in the final month of the period. These included news that car maker VW had cheated on exhaust emissions tests in the US and broker downgrades on the outlook for global commodities group Glencore. Against this backdrop, risk aversion spread among corporate bond markets. While high yield debt recorded the poorest returns, many segments of investment grade credit also declined. Emerging market debt also generally fell, although the fund remained underweight in this area of the market. A major theme in the government bond markets during the period was the possibility that the Fed might raise interest rates at Federal Open Market Committee meeting in September as the US economy continued to perform relatively well. However, the central bank actually decided to leave rates unchanged for now, which helped to push yields lower. For the quarter, the 10-year US Treasury yield fell from 2.4 to 2.0, the 10-year bund yield declined from 0.8 to 0.6 and the 10-year gilt yield fell from 2.0 to 1.8. Fund management Duration The maintenance of significantly short duration positioning remained a conviction view for Jim during the quarter. In his assessment, low government bond yields continue to lack relative value, partly because the prospect remains open of a Fed rate hike. Several portfolio adjustments were made to shorten the portfolio s duration further in the period. This was partly achieved through sales of longer dated German government bonds as they rallied in September. Overall, the fund s duration edged down from 2.4 years to 1.6 years during the quarter, with most of the reduction implemented in the final month of the period. At the end of September, euro- and US dollar-denominated assets accounted for almost all of this duration risk in broadly equal measure, while small exposures were also derived from the Mexican peso, New Zealand dollar and Colombian peso. In addition, Jim also held short bond futures positions in French and UK government bonds to help reduce the fund s duration. Jim also retained a sizeable allocation to inflation-linked government bonds where he felt that their valuations were appealing relative to conventional government debt. This index-linked exposure was mostly held in eurozone government bond markets.
Fund duration over time, years 10 9 8 7 6 5 4 3 2 1 0-1 -2-3 1.6 Source: M&G, 30 September 2015 Asset allocation Within the fund s flexible investment approach, the active management of its credit risk, duration and currency are the three main drivers of its long-term performance. In the first month of the quarter, Jim sought to take advantage of this flexibility by de-risking the portfolio via short credit default swap (CDS) index positions. Given the renewed weakness in commodity prices, as well as evidence of excess supply in the US high yield market, the fund s net allocation to this segment was reduced by buying protection on the CDX North American High Yield Index. Similarly, the fund s net exposure to the European investment grade asset class was reduced via the purchase of additional protection on the itraxx Europe index, a move that Jim felt was warranted on valuation grounds. The fund s trading activity in physical bonds also included moves to reduce risk in the portfolio via sales of corporate bond holdings that included UK insurer Aviva and energy utility ENGIE (formerly GDF Suez). However, Jim participated selectively in new issues that he felt offered attractive value, such as contingent convertible notes (CoCo bonds) from banking group Royal Bank of Scotland and UK residential mortgage-backed securities from Thrones Plc. In addition, he maintained a preference for investing in floating rate notes (FRNs) from select corporate issuers, and these assets continued to represent a sizeable portion of the fund s corporate bond exposure. Elsewhere, the fund retained an underweight exposure to emerging market bonds, largely reflecting Jim s continued concerns about slower economic growth in China and weak commodity markets. While this allocation remained broadly unchanged in the first two months of the quarter, he sold the portfolio s remaining position in local currency Hungarian sovereign bonds in September as the forint had held up relatively well. In addition, the fund s exposure to local currency Mexican sovereign debt was reduced as Jim felt that the decline in emerging market currencies may not yet be over. Currency exposure Jim continued to play out several key investment themes through the fund s currency positioning, including the maintenance of a large allocation to the US dollar. While this exposure was lowered in the quarter, he still feels that the performance of the greenback should be supported by the relative strength of the US economy and the prospect of an interest rate hike by the Fed. Elsewhere, the fund s other main long exposures were more modest in size and consisted of the euro, as well as the Danish, Swedish and Norwegian currencies. To reflect Jim s caution towards emerging market currencies, small
short positions were added to the portfolio in select China slowdown -related currencies such as the Malaysian ringgit, Singapore dollar and South Korean won. Within this China theme, a small short exposure to the Australian dollar was also maintained. Outlook Despite the recent focus among investors on volatility in China s stockmarket and falling commodity prices, Jim believes that the strengthening recovery in the US economy should remain intact. Importantly, for example, conditions in the US labour market continue to improve in terms of lower unemployment and the early signs of wages growth. Against this backdrop, while the Fed left interest rates unchanged in September, Jim thinks the prospect of an interest rate rise remains open, as does the possibility that inflation trends should turn firmer in the US. In the bond markets, this view partly lies behind his assessment that low government bond yields continue to lack value and, consequently, the fund maintains significantly short duration relative to a neutral level for the portfolio. In the credit markets, Jim believes that investors are still being overcompensated for default risk, based on his expectation that default rates should stay low in the US and Europe. In terms of the fund s allocation to credit, while this remains sizeable, factors such as lower risk appetite among investors and healthy supply levels also need to be taken in to account. Given such considerations, Jim believes now is not the time to significantly overweight credit risk in the portfolio. Within the corporate bond markets, his preferred investment themes continue to include holding FRNs given the ongoing relative strength of the US and UK economies and the possibility of interest rate rises by their central banks. Against this, FRNs can offer attractive value as they pay variable interest that is adjusted in line with movements in a reference interest rate, which not only minimises the impact of rising rates on investors but also potentially allows them to benefit from higher rates. Elsewhere, Jim is wary towards emerging market bonds given factors such as the further economic deceleration in China, lower commodity prices, and the renewed weakness in emerging currency markets. While the adjustment of emerging market currencies has potentially left some more attractive value to be found, he feels that the correction may have further to go before a sustained rebound can be expected. The fund s flexible investment approach allows Jim to not only avoid exposures to assets where he does not like the outlook, but short positions may also be taken in such cases. In emerging markets, this flexibility continues to account for several short positions in currencies whose performance Jim expects to be adversely affected by the economic slowdown in China. Overall, the fund s currency positioning remains largely allocated to the US dollar, with its other long positions consisting mainly of the euro and Scandinavian currencies. Among the latter is an exposure to the Norwegian krone, which Jim considers a better way to play an oil rebound than holding high yield energy bonds. As always, he will continue to monitor closely the global bond and currency markets to determine the best relative value opportunities for the fund as he seeks to maximise its returns.
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