M&G added an inflation-linked credit offering to its bond range last year, with manager Jim Leaviss acknowledging concerns about rising prices.
While predicting a short-term spike this year, the group’s head of retail fixed income is in the longer-term disinflationary camp and predicts levels could moderate in 2012 if some wage growth comes through.
Across the group’s bond portfolios, the team is less bearish on gilts than much of the market, despite yields rising from 3 to almost 4 per cent. “The setback was due to growing inflation fears and comes after the risk-on trade was dominant for most of last year, with investors piling into high yield and equities at the expense of government debt,” says Leaviss.
“However, there is plenty of spare capacity in the global economy and rising inflation is largely down to commodity prices outside the control of governments. This year will be a period of austerity and, against that, a 4 per cent yield on gilts is attractive.”
With that in mind, Leaviss has moved long duration on his government bond portfolios in recent weeks. Like much of the market, he is also positive on high yield, feeling the market is over-compensating for default risk and companies are continuing to improve balance sheets.
“Our optimal income fund – managed by Richard Woolnough – is running its highest-ever credit level at 60 per cent, overweight in high yield and lower-rated investment-grade paper.
“However, 2011 will be a year of high inflation for several reasons and with CPI and RPI above 4 per cent, the yield carry available on index-linked debt makes that the most attractive area.”
M&G’s differentiating factor is an underweight position in subordinated financial debt, with Leaviss highlighting several banks that will struggle to survive. “This call is very much on a bank-by-bank basis and there are some where we are prepared to lend money all the way down the capital structure, such as HSBC, for example,” he says.
“Many of our peers are positive on subordinated debt due to the improving regulatory environment but it is important to be oppor- tunistic following the credit crunch as banks will go bust.”
Looking at the UK inflation-linked corporate bond, Leaviss says that while RPI levels are spiking this year, markets are still pricing in average inflation levels over five years. “With Tesco’s index-linked paper yielding 1 per cent plus 5 per cent expected inflation this year, a 6 per cent carry is attractive compared with gilts,” he says.
“We did not launch the fund in expectation of prolonged higher inflation but many of our clients were increasingly concerned about rising prices following quantitative easing and wanted a credit product offering protection.”
Since launch in September, the portfolio has focused on short-dated bonds as Leaviss says longer-dated paper will sell off as inflation picks up.
Holdings include Tesco 2016, Toyota 2017 and National Grid 2018, with utility names also featuring heavily on the stocklist.
Leaviss sold gilt futures and kept duration low, saying the latter will always be significantly less than on a more traditional UK corporate bond portfolio.
Inflation-linked credit remains a small market of around $15bn debt in issuance, with utility and blue-chip names dominant and much of the paper locked up in pension schemes. However, Leaviss is confident the universe will expand as investors demand inflation protection and he compares it with the nascent high yield area back in 1997, when M&G launched one of the UK’s first funds focusing on this area.
He also stresses capacity to use derivatives on the portfolio, which allows the team to get exposure to companies that have not yet issued index-linked paper by using credit default swaps.
Leaviss is nervous about a damaging interest rate hike in April or May, believing the Bank of England’s Money Policy Committee is feeling pressurised after losing credibility on inflation. He says: “Any hikes are dependent on data and if we get negative growth in the first quarter, the country is back in recession and pressure to raise rates goes away.
“A rise in April or May is now looking increasingly likely, with high inflation baked in for 2011.”