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 - Year-to-Date
Richard Woolnough: "The M&G Optimal Income Fund once again lagged behind the average high yield fund over the first half of 2010, though it outperformed both the government and corporate bond fund sector averages in the earlier part of the year. The return of risk aversion to the financial markets in the second quarter of the year affected the fund’s relative performance.
Fund manager Richard Woolnough moved the duration of the fund longer towards the middle of the year. This increase was made against a backdrop of steep yield curves, ongoing uncertainty both over global economic prospects and Europe’s debt crisis, and the expectation that government bond issuance was likely to remain high. Credit spreads remain wider than their historic averages before the collapse of Lehman Brothers and fund manager Richard Woolnough consequently believes that corporate bonds offer value. He believes that credit spreads can continue to tighten. As such, he has continued to add credit risk to the portfolio.
Richard Woolnough gradually lengthened the fund’s duration since February and the fund’s average maturity edged up to 5.4 years as at the end of June. There were divergent forces in government bond markets in the second quarter. On the one hand, the fund manager expected to see large amounts of government bond supply to come on-stream in capital markets in 2010, which suggested that yields on government debt would move higher. On the other, the ’safe-haven’ status of government debt, combined with low interest rate and inflation expectations, suggested a dampening force on yields. Richard believed that in the near term, given the continuing uncertainty over global economic prospects and Europe’s debt crisis, investors’ preference for core government bonds was likely to persist, driving government bond yields lower. He therefore lengthened the portfolio’s duration to take advantage of this scenario, by buying US Treasury 3.5% 2020 as well as doubling the exposure to US Treasury 3.625% 2019 and US Treasury 3.625% 2020. Richard also significantly increased the fund’s long position in 30-year US Treasury bond futures and reduced a short position in 10-year UK government bond futures. In addition, he bought a UK government bond issue maturing in 2020 yielding 3.75%.
Richard retained his bias for credit within the fund despite corporate bond spread widening. He believed that spreads were wider than they should be given the outlook for the UK economy and corporate default rates. Within the credit rating structure, he believed BBB corporate bonds were the most attractive on a risk-return basis. Exposure to BBB rated credit within the fund was 29% at the end of the first half.
The fund manager maintained exposure to high yield corporate bonds. Richard continued to prefer the better-quality end of high yield on both a fundamental and valuation basis. The metrics on high yield companies were looking attractive and investors in these types of bonds were being compensated with a good yield. Of course, when investing in high yield companies bottom-up analysis is key in order to identify those companies that are prone to decline. In terms of country exposure, Richard retained a preference for companies operating in core, rather than peripheral, European economies.
Within the investment grade universe, Richard took advantage of attractively priced new issues from retailer Tesco, UK bank Standard Chartered and Mexico-based telecommunications provider America Movil. In other transactions, he participated in a new €205m issue of bonds from wine and spirits company Remy Cointreau. The company will use the proceeds from the 5.18% senior notes, which are due in 2016, to repurchase the €200m of its outstanding notes due in January 2012. This will also extend its debt maturity. The M&G credit research team has given the issue a BB rating."
Performance since 2007
Richard Woolnough: "The M&G Optimal Income Fund has delivered exceptional performance since its launch in Europe on 20 April 2007, with a total return of 30.3% to the end of June. This performance ranks the fund first in its sector, the Morningstar Asset Allocation EUR Defensive sector, where the average total return was 1.3%. The M&G Optimal Income Fund has also beaten the average government bond fund, corporate bond fund and high yield fund over the period, as the chart shows.
The fund’s first-rate returns are made possible by its flexible mandate, which allows manager Richard Woolnough to invest across the fixed interest spectrum wherever he sees the most compelling value. This allows him to hold the optimal blend of government, investment grade and high yield corporate bonds according to his views. Additionally, he is able to invest a portion of the fund in equities where he believes the shares of a company are priced more attractively than its debt.
This flexibility allowed Richard to increase the fund’s exposure to corporate credit as the economic recovery unfolded throughout 2009. In 2010 he has continued to raise the proportion of the fund that is invested in high yield, as he sees less likelihood of companies defaulting on their obligations.
Unlike traditional bond funds, the M&G Optimal Income Fund offers Richard considerable freedom to take duration views, with a wide theoretical duration range of zero to 30 years. This has enabled him to alter the fund’s duration in response to a changing economic and financial market environment and enhance returns during periods of falling yields and protect performance in times of rising yields.
The M&G Optimal Income Fund has produced the strongest returns in its sector since launch. However, these returns have not been delivered with a correspondingly high level of risk. The fund’s volatility has been only slightly higher than the average corporate bond fund and has been about half the level of risk exhibited by the average high yield fund. High yield funds have shown levels of volatility close to that of the global equity markets (as shown by the FTSE World Index and MSCI World Index), while the M&G Optimal Income Fund’s volatility has been more comparable with conventional bond funds, as the chart shows. The combination of extremely strong returns without correspondingly high levels of risk means that the M&G Optimal Income Fund has the highest risk-adjusted returns in its sector since launch to the end of June 2010, as measured by the Sharpe ratio (0.71 for the fund, compared with -0.6 for the average fund in the sector)."
Investment Process and Strategy – How does the Fund Manager Invest?
Richard Woolnough: "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, with several members of the 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 and the maximum level would likely only be reached in extreme circumstances.
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 me 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, I can hold the combination of assets and derivatives that positions 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."
Investment Outlook
Richard Woolnough: "Richard Woolnough continues to have a positive view on corporate credit as the current economic environment remains supportive for corporate bonds. The asset class is still priced for a recessionary scenario and a much higher level of defaults than it has experienced historically – despite many companies being in good financial health. Additionally, he does not believe that inflation is likely to pose a threat to either the corporate bond market or government bonds, as the output gaps present in developed economies are unlikely to close for some time. If the developed economies do enter recession again, in his view corporate bonds should not come under significant pressure. This is due to the fact that corporate bond spreads are already pricing in a downturn.
Lastly, he expects economic growth to remain weak but positive. This is an environment in which investment grade corporate bonds in particular have traditionally performed well. If economic growth is too high, they suffer from inflation fears and outflows of investor money to equities. But if growth is too low, they suffer from increased default risk."
