There can be little doubt that 2022 was one of the most turbulent and difficult years on record for bond investors. However, the outlook for bonds in 2023 is much more positive – with opportunities opening up for those who know where to find them.
In that light we thought it was an appropriate time for a quick catch up with Matthew Rees. Matthew is Head of Global Bond Strategies at LGIM, and lead manager on the LGIM Strategic Bond Fund. We wanted to find out how he and the LGIM team are gauging the current economic and bond market conditions and whether the worst really is behind us.
You won’t need me to remind you that, in 2022, fixed income investors learned the critical importance of understanding what’s driving interest rates and their impact on risk assets. Investors had a painful reminder of the power of ‘duration’.
As fixed income investors, LGIM are anticipating more volatility in the foreseeable future. However, rather than be spooked by it, as active managers they believe they can aim to add value in this environment and take advantage of market dislocation.
So, is 2023 likely to be the year for bonds? “Yes,” said Rees “We think it will be. “You have to go back a long way – before 2012 – to get more than 4% on sterling corporate bonds for example. At times, many people took the view that bonds weren’t really that interesting. However with the resurgence of inflation and central banks increasing rates to combat that, there is some yield in bonds now. It’s definitely a lot more interesting.
What does this mean for asset allocation?
Given his positive stance, we proceeded to ask Rees to outline some of the highlights of the allocation strategy that he and the LGIM team are taking within the Strategic Bond fund. His belief is that when it comes to bond fund management, “the most important part at the moment really is your view on interest rates, where they’ll go and therefore how much interest rate risk do you want to take? This really caught many people by surprise last year. It was quite a reminder of how bad the negative returns can be in bonds when inflation comes back and you’re not prepared for it.
He proceeded to outline three fundamental assessment criteria that he and the team use and shared his view on their relative importance at the current time commenting:
“So, firstly, for us, the level of interest rate risk we want to have is crucial. The fund can’t go net short interest rate risk, but we we can go long. But generally last year we went between zero years of interest rate risk and seven years. We ran with very little interest rate risk last year – it was one of the main reasons why we had very good relative performance compared to our peers. This year is very different. We’ve seen so many interest rate rises as the central banks and the market foresaw the amount of inflation that may be coming.
“Of course, during recessions interest rates are your friends again. So generally interest rates do rally when there’s a recession, even in the high inflation environments of the seventies that happened. We see some value in taking some interest rate risk. At the moment we’re relatively cautious, so we have about three years of interest rate risk, which is still, I think, less than some of our peers.
“Our view is that there is still a good chance of recession out there, much more so in the UK than the US. But in that recessionary environment, you still do want to have some of that duration.
“Secondly, in terms of asset allocation we operate a very flexible approach. The global strategic bond sector is amazingly wide in terms of the scope of where you can invest. Our approach is to make sure we get we take the best opportunities with the best people – which is where the strength and depth of our team here at LGIM really comes into its own. For example, Martin Reeves and his team are our high yield managers, myself, I’m an investment grade credit guy. By combining our expertise with lots of other sector specialists, we can ensure that we have a very robust coverage of all aspects of the bond markets. That extends to areas such as emerging markets too.
“We can move our risk according to our view points on the world and where valuations are at a particular point in time. For fixed income, it’s simple. It’s all about fundamentals. If we’re going to recession we think the default rates are going to be lower this time around than previous recessions. What other risks are out there? When it comes to valuations, where are they in the context of history? Well, in our view high yield is okay, particularly in European high yield, it’s much more attractive than U.S. high yield. emerging markets are still relatively cheap and sterling and Euro investment grade there is some value there.
“Overall valuations are still okay. They’re not brilliant. They were much, much better in September, October last year of course.
“Finally, with fixed income technical analysis really matters. Basically, we have to look at whether there are more buyers than sellers. Just now there are a lot more buyers than sellers because there is some yield in fixed income.
“When we wrap all of that together, those fundamentals, technicals and valuations, there are certain areas out there that are still interesting. In particular, we’ve increased our allocation towards investment grade because with the uncertainties over recession, we think that taking more risk with either high yield or emerging markets doesn’t give us the best risk adjusted return. We still have about 25% the portfolio in those areas, but investment grade is more interesting.
“When assets got hit quite badly in the gilt crisis of September-October last year, we picked up some really cheap, short-duration bonds there and that just sits in the portfolio, producing really good yields for the fund.
Want to find out more? Join LGIM team for the webinar on 1st March 2022.
IFA Magazine readers are invited to join LGIM for their webinar, ‘The duration game: solutions from a strategic bond fund’.
The first webinar in this three-part series, snappily called ‘Bonds, Barks and Bites’ – takes place on Wednesday 1 March at 15.00. In this first episode, the focus will be on duration and how the LGIM team manage it within the Strategic Bond Fund.
About Matthew Rees – Head of Global Bond Strategies
Matthew was appointed Head of Global Bond Strategies in September 2019. He was previously co-head of the Euro credit portfolio management team, and joined LGIM in March 2009. Prior to this Matthew spent three years as a Partner at Banquo Credit Management (a multibillion euro absolute return investment manager) and has worked at UBS, Merrill Lynch and the rating agency Fitch IBCA. Matthew has more than 25 years’ experience in financial services and qualified as a chartered accountant with Coopers & Lybrand in 1996.