Quarterly Review M&G Global Macro Bond Fund Fourth quarter 2017 Fund manager Jim Leaviss FOR INVESTMENT PROFESSIONALS ONLY Overview Central banks in the US and UK raised interest rates in the final quarter of 2017. While government bonds delivered mixed returns, credit markets generally recorded gains. We maintained a significantly short duration stance versus a neutral level for the portfolio. Risks associated with this fund: For any past performance shown, please note that past performance is not a guide to future performance. The value of investments and the income from them will rise and fall. This will cause the fund price, as well as any income paid by the fund, to fall as well as rise. There is no guarantee the fund will achieve its objective, and you may not get back the amount you originally invested. The fund may use derivatives with the aim of profiting from a rise or a fall in the value of an asset (for example, a company s bonds). However, if the asset s value varies in a different manner, the fund may incur a loss. Changes in currency exchange rates will affect the value of your investment. The fund may use derivatives in a limited way to gain exposure to investments exceeding the value of the fund (leverage). This may cause greater changes in the fund s price and increase the risk of loss. The fund will invest in emerging markets which are generally smaller, more sensitive to economic and political factors, and where investments are less easily bought and sold. In exceptional circumstances, the fund may encounter difficulties when selling or collecting income from these investments, which could cause the fund to incur a loss. In extreme circumstances, it could lead to the temporary suspension of dealing in shares in the fund. Further risk factors that apply to the fund can be found in the fund s Key Investor Information Document (KIID). Things you should know: The fund may invest more than 35% in securities issued by any one or more of the governments listed in the fund prospectus. Such exposure may be combined with the use of derivatives in pursuit of the fund objective. It is currently envisaged that the fund s exposure to such securities may exceed 35% in the governments of Germany, Japan, UK, USA although these may vary subject only to those listed in the prospectus. The fund allows for the extensive use of derivatives. Past performance is not a guide to future performance.
Performance and fund positioning While global credit markets delivered positive returns in the fourth quarter, the themes of monetary tightening and the possibility of firmer inflation again provided a more challenging backdrop for government bonds. In the UK, for example, the Bank of England announced a 0.25% interest rate rise in November, while the US Federal Reserve (Fed) confirmed a hike of the same size in the following month. The latter move was the Fed s third rate increase of 0.25% in 2017. In the corporate bond markets, however, synchronised global economic growth continued to support sentiment as the year drew to a close. Investment grade and high yield credit generally registered gains in the final quarter, while emerging bond markets also delivered decent returns. Despite interest rate increases in the US and UK, the European Central Bank (ECB) left rates unchanged in the eurozone. However, further signals that the region s economic recovery was gaining traction upheld expectations that ECB would soon scale down its monetary stimulus measures. In currency markets, the US dollar fell against the British pound and euro during the quarter despite higher US interest rates. The euro s decent performance, largely supported by the region s economic upturn and the prospect of reduced stimulus activity from the ECB, proved to be among the key highlights in foreign exchange markets during 2017. The fund s currency positioning detracted from the returns of its unhedged sterling and euro share classes during the fourth quarter. This effect largely stemmed from the depreciation of the US dollar against these currencies, which provided a headwind for performance as a sizeable exposure was maintained to the greenback. In addition, the fund s relative returns were held back to an extent by an underweight exposure to corporate credit, which performed relatively well. 2017 performance The weakness of the US dollar also weighed on the performance of the fund s unhedged sterling and euro share classes in the 12-month period to 31 December. While we increased the fund s exposure to the euro during the year, this allocation remained underweight. In turn, the fund s underweight exposures to both the euro and sterling weighed on its relative returns. Among other factors, the fund s relatively short duration stance was modestly helpful for its performance. For example, support was provided to the portfolio where government bonds sold off against the firmer interest rate/inflation outlook, such as in the core German market. However, the fund s relative performance was hampered where longer dated government debt outperformed, including in the US Treasury market. Amid mixed performance in the core government bond markets, shorter dated German government debt and US Treasuries declined modestly to deliver the poorest returns. However, gilts registered gains across maturities, despite the UK s interest rate rise in November. In the 10-year segments, bund yields edged lower from 0.5% to 0.4%, while 10-year US Treasury yields ticked up from 2.3% to 2.4%. The 10- year gilt yield declined from 1.4% to 1.2%. In the corporate bond markets, investment grade issues generally delivered positive results, with UK credit outperforming its counterparts in the US and Europe. Most segments of the high yield market also produced gains. In the emerging bond markets, amid decent performance in the hard and local currency sub-asset classes, hard currency sovereigns generated the best returns in the quarter. Duration Throughout 2017, our conviction views in the fund included the maintenance of a significantly short duration level relative to a neutral position, and we kept this stance in the fourth quarter. Going into the quarter, this level of interest rate risk stood at 2.4 years, which was shortened slightly in October to 2.3 years. This mainly resulted from a reduction to the fund s US dollar duration via activity that included selling some long-dated US credit exposure. While remaining at a significantly underweight level relative to a neutral position, the fund s interest rate risk lengthened moderately from 2.3 years to 2.7 years in November. This largely followed our purchases of local currency emerging market government bonds on a selective basis, including in Brazil, Mexico, Turkey and Uruguay. The fund s overall level of interest rate risk was broadly unchanged in December. However, we slightly reduced its euro duration, while adding some interest rate risk in Colombia and Chile, which again stemmed from buying local currency government bonds.
At the end of the period, the main contributions to the fund s duration by currency were the euro (0.8 years), US dollar (0.6), sterling (0.3), Australian dollar (0.2) South African rand (0.2), Indonesian rupiah (0.2), Mexican peso (0.2), Brazilian real (0.1), Colombian peso (0.1) and Japanese yen (-0.2). Asset allocation The fund remained globally diversified across developed and emerging bond markets during the fourth quarter. Among our positioning themes, we held an underweight exposure to credit. This was largely based on our view that valuations in the asset class had begun to look less attractive as 2017 progressed after delivering solid performance, although we continue to monitor this area of the market for better buying opportunities. During the quarter, while maintaining an allocation to investment grade credit, we held a short credit default swap (CDS) position in high yield bonds which lowered the fund s net exposure in the area to slightly below zero. Within corporate bond markets, our preferred sectors continued to include US dollardenominated floating rate notes (FRNs) from bluechip banks and financial issuers. We see this selection as a play on strengthening economic growth and the prospect of rising interest rates. At the end of the period, the fund s net allocation to investment grade credit stood at around 23%, an increase from 17% at the start of the quarter. In the high yield market, while we maintained an underweight physical exposure, the fund s net allocation was -3% given its holding of a short CDS position in the asset class. The fund s overall allocation to government bonds stood at around 64%, which included a stable weighting to index-linked debt of around 15%. The latter position continued to be held mainly in US Treasury Inflation-Protected Securities (TIPS). Currency exposure Over the longer term, active management of the fund s currency positioning is an important additional performance lever to its duration and credit risk, as well as providing a useful diversifier. During the fourth quarter, our main changes to the portfolio s currency exposures included lowering its US dollar allocation back below 50% in November. This reduction was made mainly in conjunction with an increase in the fund s exposure to the Japanese yen from 4% to around 14%, reflecting our assessment that the currency looked more attractive in relative terms. We also sold US dollars to add to the fund s local currency emerging market sovereign allocation, which increased from around 10.0% to 13.2% in November. Among other moves, the fund s allocation to sterling was reduced from around 5% down to zero in the month as the pound rallied well and we maintained a cautious view on the currency. There were no major adjustments to the fund s allocations to core currencies in December, with its largest allocation remaining to the US dollar. However, we added some emerging market currency exposure in the month, which stemmed from the fund s purchases of sovereign debt denominated in the Colombian peso and Chilean peso. Outlook Amid the encouraging synchronised global economic growth outlook, the potential for tighter central bank monetary policy remains a key theme in global bond markets. Given this backdrop, we continue to hold significantly short duration in the fund relative to a neutral level, while also keeping an exposure to indexlinked bonds in the firmer inflation environment. Elsewhere, we maintained an underweight allocation to credit as 2017 ended, most notably to high yield bonds. While we still view high yield debt as a useful contributor to returns when valuations are attractive, in our current assessment, this area lacks adequate compensation to investors for taking additional risk after performing well in recent quarters. However, we also remain unconcerned by default rates and, as always, we will continue to monitor all areas of the credit market for better buying opportunities. In terms of recent new investment, we have increased the fund s overall exposure to emerging market debt, including local currency-denominated bonds on a selective basis. Our favoured markets include those where solid real yields can be found as inflation has fallen, such as Brazil. Going into 2018, in addition to core currencies, the fund held a diversity of exposures to emerging market currencies. Its main positions were to the US dollar
(46.3%), euro (17.8%), yen (13.6%), South African rand (2.3%), Mexican peso (2.2%), Indonesian rupiah (2.2%), Norwegian kroner (2.0%), Australian dollar (1.7%) and Brazilian real (1.7%). Looking ahead, we will continue to seek what we consider the best relative value in the global bond and currency markets amid the prevailing economic conditions and avoid areas where our outlook is less favourable. Long-term performance Past performance is not a guide to future performance.
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