How bond funds are facing the inflation threat

Commonly dubbed 'the enemy of the bond investor', the prospect of inflation has sparked remarkably little fear among fixed-income markets of late. Having sold off fiercely in the first quarter of 2021, US Treasuries have rallied substantially in recent months. Yields, which move inversely to prices, rose to around the 1.7 per cent mark at the time of the sell-off but have more recently dropped below the 1.3 per cent mark. This suggests a stalling of the reflation trade and a consensus that recent high readings of inflation will prove to be short-lived.

Yet the arguments about whether price rises will be transitory or something more structural and permanent do continue to divide some investors, and this is not restricted to equity specialists. Bond fund managers have differing views on the prospects for inflation, with big consequences on how they run portfolios. This matters when it comes to the more flexible bond funds that can move in and out of different parts of the fixed-income market. To give a sense of how different portfolios are prepared for rising prices, we have assessed 10 of the largest strategic bond funds available to investors in light of the inflation debate.

 

A moment of calm

What’s striking is that of those six funds in the list that tend to extensively look beyond the world of corporate bonds, half of the investment teams seem notably relaxed about the outlook for inflation.

The team behind Jupiter Strategic Bond (GB00BKSFXX05), led by Ariel Bezalel, have consistently argued for some years that structural factors including ageing demographics and high levels of national debt will depress the outlook for growth and any prospect of serious long-term inflation. They continue to stand by this. As they put it in a note from late May: “In the short term, inflationary pressures will fluctuate but as investors who seek to balance risk and reward, we look to longer-term trends. Structural inflation everywhere is being kept in check by the combined drivers of too much debt, ‘zombification’ of the corporate sector, ageing demographics and disruption from globalisation, technology and low-cost labour.”

They have warned about the risks of taking big bets on the prospect of inflation proving to be structural and maintain a flexible approach. At the time of the note, the team continued to maintain a “barbell” investment approach designed to get the portfolio through different market conditions. This involved holding select corporate bonds alongside US and Australian government bonds, while high-yield exposure came with a limited level of duration or interest rate sensitivity.

 

Where teams behind the biggest strategic bond funds sit in the inflation debate
Fund	Recent view on inflation
Jupiter Strategic Bond	Structural inflation is being kept in check by several factors, from debt to ageing populations.
Janus Henderson Strategic Bond	Investors have been distracted by the "siren call" of inflation worries.
Allianz Strategic Bond	No signs yet of longer-term inflationary pressures.
Invesco Monthly Income Plus	Fund tends to focus on corporate bonds.
Muzinich Global Tactical Credit	Fund tends to focus on corporate bonds.
M&G Optimal Income	Higher economic growth and eventually higher inflation will put pressure on government bonds.
TwentyFour Dynamic Bond	It is not at all clear that all price increases currently arising will prove fleeting
Royal London Sterling Extra Yield Bond	Fund tends to focus on corporate bonds.
Artemis Strategic Bond	Inflation could be more deep-rooted due to shrinking working populations and the costs of decarbonisation
Baillie Gifford Strategic Bond	Fund tends to focus on corporate bonds.
Source: Fund manager commentaries

 

The Jupiter fund is the biggest in its sector but the team is not alone in its stance, with managers behind the next two biggest funds widely available to retail investors sharing similar views. Mike Riddell, manager of the highly flexible and defensively minded Allianz Strategic Bond fund (GB00BJ1DZT42), expects inflation to move much lower in future.

“Inflation has been a bit stickier than we thought six months ago for a few reasons that have been well-covered (supply bottlenecks and a leg higher in commodity prices) but we don’t see any signs yet of longer-term inflationary pressures, where inflation should move lower again in the first half of next year,” he said. He adds that growth and inflation are very likely to fade at the end of this year.

Others have made a strident case that investors have become preoccupied with the inflation debate. Jenna Barnard and John Pattullo, managers of Janus Henderson Strategic Bond (GB00BLCYFX43), warned in a recent update that investors had been distracted by inflation concerns, adding: “The common mistake when bond yields rise is to confuse a timely cyclical rise in bond yields with the beginning of a structural bear market in bonds.” They ran a relatively high level of duration, or interest rate sensitivity, in the fund during the second quarter of the year, although the managers suggested they may take profits on government bond exposure in the wake of a fall in yields.

 

Spotting a threat

There may be some consensus among the biggest three names in our list, but a relaxed view of inflation is not shared by all. The managers on the M&G, Artemis and TwentyFour funds have all warned that inflation could become more of a threat.

Artemis managers James Foster and Alex Ralph have argued that inflation could be more deep-rooted than market moves suggest, leading them to limit duration in the strategic bond fund they run together. They plan to reduce duration further if government bond yields fall much lower and more evidence emerges of inflationary pressures being stoked.

“The [inflation] debate is whether this is just a short-term impact associated with economies opening up after Covid or the long-term consequence of more deep-rooted inflationary concerns,” they said in a recent update. “Our current thinking is that the problem is more deep-rooted.

“Firstly, demographics have been a significant factor in keeping inflation down. Labour markets are now getting tighter across the world as working-age populations shrink. Clearly robotics should counter this, to some degree, but we would be surprised if they do so entirely.

“Secondly, decarbonisation of the economy is a fundamental shift, which will be expensive. The trend has only just begun but has a very long way to go as consumers swap their gas boilers for dearer hydrogen boilers or electric heat pumps. Cars, similarly, will gradually swap to electric vehicles, which will be more expensive than petrol or diesel alternatives.”

M&G Optimal Income (GB00B1H05155) managers Richard Woolnough and Stefan Isaacs have argued that “higher growth and eventually higher inflation” will pressure government bonds, leading them to position accordingly.

Finally, the managers behind the TwentyFour Dynamic Bond fund (GB00B5VRV677) have warned that while the inflationary pressures witnessed from January until May this year were mainly influenced by "transitory issues", the prospect of structural changes cannot be dismissed. "It is not at all clear to us that all price increases currently arising will prove fleeting," they said. "There is enough evidence that some of this inflation could prove to be more persistent and that makes us take a more respectful view around future inflation. We are also a little bit worried of the rather loose usage of the word transitory when it comes to inflation."

As such, they have limited duration in the fund, with more of a focus on credit and financial debt in particular. As we have noted in the past, the fund tends to have a broad mix of fixed-income exposures, from asset-backed securities to bank debt, high-yield bonds and government bonds.

The Invesco, Muzinich, Royal London and Baillie Gifford funds in the table are included due to their size but tend to make less use of the broad fixed-income universe than the others. Instead, these four tend to focus largely on high-yield and investment-grade corporate bonds.

That does not excuse them from the inflation debate, however. Even when funds do without government bonds, it is worth monitoring the credit quality of the corporate debt they invest in. High-yield, which is riskier, more sensitive and more closely correlated to equities than other bonds, has been more resilient amid inflation concerns this year. Both developed-market government bonds and investment-grade corporate bonds have struggled amid inflation scares.

 

How the funds are positioned

Strategic bond funds tend to disclose their asset allocation decisions in different ways, making it difficult to accurately compare them in a like-for-like manner. While it can be worth monitoring their allocations, manager commentaries can actually be more informative about what might be going on in the portfolio.

The first chart shows the levels of government bond exposure in each portfolio. Generally speaking, such bonds are more vulnerable at times of inflation fears, given their sensitivity to interest rate increases. 

A problem here is that such disclosures can be misleading. The chart suggests that the Allianz team has simply loaded up on government bonds, whereas the investment approach tends to be much more flexible. The team often uses derivatives and currency positions to express views. On the government bond front, it should be noted that the managers have recently been reducing duration following price gains.

Other nuances can be important. In the M&G fund, the managers have made use of floating rate notes within their government and investment-grade bond allocations. Floating rate notes come with variable, short-term rates of interest tied to particular benchmarks, meaning they should tend to pay out more as interest rates and yields rise elsewhere. This offers some protection in an inflationary or rising interest rate environment.

Duration is also an important metric, but not one always disclosed by strategic bond funds. Among those less concerned about inflation, the Janus Henderson team ran a duration of more than seven years in the second quarter. The Jupiter fund had an effective duration of 5.6 years at the end of June. The TwentyFour fund had a duration of just 3.24 years.

As noted, some of the funds tend to have a closer focus on corporate debt, although the risks taken can vary. If investment-grade has a correlation to government debt, high-yield is less affected by inflation and interest rate expectations. Instead, high-yield corporate bond performance often depends on the state of the economy and the company issuing the debt. Fundamentals can be much more important here. While high-yield is not immune to rising interest rates, it can perform well in periods of decent growth.

As the second chart shows, the Jupiter, TwentyFour and Invesco funds have substantial allocations to debt with lower-quality ratings. That said, disclosures can again be misleading, given that quality rating breakdowns could apply to a whole portfolio rather than just its corporate bond exposure. While the same caveats apply, it is interesting that the M&G fund, among others, has a high allocation to BBB-rated debt. This is the lowest rung of investment-grade and in the corporate space such bonds can be at risk of a de-rating in times of economic difficulty. Going down the quality spectrum will generally offer higher yields.

Given its high stated allocation to government bonds, the Allianz fund is not included in the chart. The Baillie Gifford fund, which does not break down the quality ratings of its portfolio in factsheets, is also absent.

All of these allocation decisions can be important in different conditions. While not all funds break out the granular details of their approach, it can be worth checking factsheets alongside manager commentaries.

 

Views on credit and performance

It should be noted that some managers have expressed caution on corporate debt, warning that the difference in their yields versus that of government bonds (the spread) has grown too tight. Jupiter’s Bezalel and Mike Riddell of Allianz have both argued that developed market corporate bonds look expensive. There are, of course, counterarguments. TwentyFour’s bond team has argued that the fundamentals behind corporate bonds continue to look strong.

The Artemis team offered its own upbeat take in an update published in mid-July, noting: “We have increased our weightings to credit, with a mix between high-yield and investment-grade bonds. High yield is now 46 per cent of the portfolio, a steady increase. Over the past quarter we have focused on Covid recovery names. This includes companies such as Center Parcs [holiday parks], Dufry [airport duty-free[ and Jaguar [car manufacturer[.”

Performance across the sector has been mixed this year. Some of the biggest funds took a hit in the first quarter, a time that saw government bonds sell off heavily. All funds posted gains in the second quarter.

Even those strategic bond funds with hefty government bond exposures have fared better than funds specifically dedicated to this area. The average fund in the Investment Association's UK Gilts sector lost some 7.4 per cent in the first quarter of the year. The recovery has not been so stark since then, with the average fund making a gain of just 1.5 per cent in the second quarter.