The market background
The story of 2022 has been one of higher perceived risk. At the end of 2021, markets knew about rising inflationary pressures, but were pretty sanguine about it. That changed once the Federal Reserve became more explicit about the need to raise rates to fight inflation. This was sandwiched by rate rises from the Bank of England (BoE) in December 2021 and February 2022, and led to a distinct change in market expectations. Out went the ‘transitory inflation equals minimal rate increases’ assumption, and in came one that realised inflation several points above target equals multiple rate rises, and in relatively short order.
In the UK, that meant that expectations for BoE rates lifted from 0.75% by 2024, and to 1.75% by the end of 2022. Unsurprisingly, this led to a sharp increase in yields generally, but specifically at the shorter end of the yield curve as the cash market and short corporate bonds reacted to higher SONIA rates.
The second phase of this increased risk pricing started with the Russian invasion of Ukraine. The initial market reaction was a widespread ‘risk off’ move, with investors favouring government bonds over equities and credit. After the initial shock, investors are also starting to look beyond the near-term impact at the implications this would have for growth and inflation, with a consensus emerging that higher energy prices mean that growth would be lower but inflation higher. As a result, some of those rate rises priced in during January and February have not been removed but in fact added to as inflation could become more embedded.
Impact on RLAM funds
Our traditional money market exposure has performed relatively well. Coming into this year, we were much more focused on shorter dated paper, meaning that as rates increased, and to levels that we thought were overly hawkish, we had flexibility in the funds to add longer dated paper at much higher yields.
However, our RL Short Term Fixed Income Fund and RL Short Term Fixed Income Enhanced Fund (formerly Cash Plus and Enhanced Cash Plus funds) do not hold only money market instruments. These funds are designed for investors with a longer time horizon and as such contain instruments with greater interest rate and credit risk as part of a strategy aiming to provide higher returns over the medium term.
The RL Short Term Fixed Income Fund was less affected by the first phase: its non-money market exposure is focused on covered bonds, which tend to be floating rate and therefore have little interest rate exposure. In the second phase, the move wider in credit spreads accounts for most of the negative performance of the fund in recent weeks.
The RL Short Term Fixed Income Enhanced Fund was more affected by the first phase. Although it has a sizeable allocation to covered floating rate bonds, it also has an allocation to longer dated cash instruments, short-dated corporate bonds and structured bonds. These all tend to be fixed rate, and the increase in yields during this period accounts for around half of the underperformance seen recently. The increase in credit spreads during the second phase accounts for the rest of the underperformance.
It is worth reiterating that we do not hold and have not held any Russian companies in our portfolios. Some of the banks we hold will have economic exposure to Russia, but this is not material.
Prospects going forward
We remain confident in the make-up of our funds. As mentioned above, there are three key areas that have hurt returns in recent weeks, but we are broadly maintaining our positions in all of these:
- Covered bonds: these highly rated, regulated, secured instruments benefit from dual recourse protection (allowing claims on both the issuer and collateral pool), so we feel that the risk of default is low, and has not changed during the past few months. We had taken profits in some of our holdings in February after a period of strong performance, but the characteristics of floating rates and excellent credit quality mean these will remain a key element in our strategies.
- Short-dated bank bonds: banks often sell off if fears of recession increase – the thinking being that in a recession, more loans go bad and hence banks face losses. However, while the Ukraine situation means that there is a greater risk of recession, we still see this as very much an outside case. Growth may be slower, but after the global financial crisis (GFC), bank balance sheets look very good, and central banks have spent the last two years not only keeping rates low, but supporting the banking system. Our holdings are short-dated, and heavily biased towards senior bonds. A ‘normal’ upward-sloping yield curve is also historically positive for bank profitability.
- Short-dated structured bonds: These holdings can be in non-financial sectors, providing diversification for the portfolio, but are all backed by specific assets, cashflows or sometimes both. We therefore feel that these offer a degree of insulation against economic slowdown.
While one consequence of the recent market volatility is that these assets have seen mark-to-market losses, these losses are only locked in if we sell the asset. Our strategy does not tend to trade holdings – the short-dated nature of these means that we tend to hold to maturity to harvest the yield available at purchase. In general, therefore, we fully expect these holdings to repay in full realising the original yield they were bought at. When these bonds mature, we are able to recycle the proceeds into higher yielding equivalents.
The yields on both funds have now risen materially – the RL Short Term Fixed Income Fund is yielding around 1.7% and the RL Short Term Fixed Income Enhanced Fund is just over 2% (both figures as at 21 March). We believe this is an attractive proposition in a market where SONIA is around 0.65%. There may be further short-term impacts as the Bank of England and other central banks either raise rates or give their views on future monetary policy, and of course the Ukraine conflict has yet to end and its full effects become visible. However, over the medium term, we expect the funds to continue to meet their objective of SONIA plus 0.5% and plus 1% respectively over the medium term.
We also believe our funds are an attractive alternative to a fixed term deposit. These are available in the market and these can appear to offer less volatility when valued on a book cost accounting methodology. However, in reality, if yields rise further then being locked into a lower rate with no ability to trade out is also unattractive. In addition, if the deposit were able to be sold before maturity it would also crystallise a loss on a mark-to-market basis. Our funds are constructed after undergoing an ethical screen and robust ESG integration to provide significant diversification and security for our liquidity investors, the pooled nature of the funds means we offer daily liquidity as well as the prospect of more attractive medium-term returns than fixed term deposits.
Past performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio holdings are subject to change, for information only and are not investment recommendations.
For Professional Clients only, not suitable for Retail Clients.
This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change.
The RL Short Term Fixed Income Fund and the RL Short Term Fixed Income Enhanced Fund are sub-funds of Royal London Bond Funds ICVC, an open-ended investment company with variable capital with segregated liability between subfunds, incorporated in England and Wales under registered number IC000797. The Company is a UCITS umbrella fund. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037. For more information on the fund or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.co.uk.
The “SONIA” mark is used under licence from the Bank of England (the benchmark administrator of SONIA), and the use of such mark does not imply or express any approval or endorsement by the Bank of England. “Bank of England” and “SONIA” are registered trade marks of the Bank of England.
Issued in March 2022 by Royal London Asset Management Limited, 55 Gracechurch Street, London, EC3V 0RL. Authorised and regulated by the Financial Conduct Authority, firm reference number 141665. A subsidiary of The Royal London Mutual Insurance Society Limited. Ref: AL RLAM W 0013