M&G UK Inflation-Linked Corporate Bond fund - research update

Richard Troue | Mon 16 May 2016

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Our view

Despite interest rates being kept at ultra-low levels, and almost unimaginable amounts of money being created via quantitative easing (QE), UK inflation remains low. We don't see a catalyst to send it sharply higher in the short term, but that does not mean it can be dismissed entirely. Central banks have made it clear they will use every tool at their disposal to stimulate demand and inflation, including more QE.

Inflation shocks are inherently difficult to predict. This fund is managed by an experienced team which we hold in high regard. We believe it could offer some shelter against short-term inflation shocks and the potential for inflation-beating returns over the medium to long term.

The fund is invested differently to most conventional bond funds. The capacity to perform well if inflation or interest rates rise means it could offer diversification to a bond fund portfolio and the potential to perform well when other bond funds struggle, although this is not guaranteed. The fund retains its position on the Wealth 150 list of our favourite funds across the major sectors.

Portfolio update

Ben Lord and Jim Leaviss, the fund's managers, invest partly in a portfolio of index-linked UK Government and Corporate Bonds. In addition, the managers use derivatives to add an element of corporate bond exposure alongside the index-linked government bonds, effectively giving the portfolio exposure to corporate bonds with some inflation protection built in. Companies are seen as more likely to default on their debt than the UK or US government, so investors demand a greater return for the additional risk involved. This additional flexibility gives the managers greater scope to achieve an inflation-beating return. Derivatives are also used to reduce the sensitivity of the fund to rising inflation or interest rates, although this does add risk.

Since early 2015 the managers have maintained a 'negative duration' position. A bond fund's duration measures its sensitivity to interest rates. A positive number indicates the fund would be likely to fall in value if interest rates rise (or are expected to rise); a negative number indicates it could benefit.

The managers have held a broadly positive view on the global economy. They suggest the potential for interest rates to rise and inflation to increase is being underestimated by many investors. This has been, and continues to be, their rationale for the slightly negative duration.

Performance review

Over the past 12 to 18 months the negative duration position has not paid off. Inflation has remained stubbornly low and expectations for an interest rate rise in the UK have been continually pushed back.

In this environment 'longer-dated' bonds, i.e. those with a long time to maturity, have performed well. These bonds are more sensitive to higher interest rates (and expectations for higher interest rates) because the interest they pay becomes less attractive compared with higher rates available on cash deposit, and the payments are fixed for a long period of time. When interest rates are expected to remain low they are more attractive.

On the whole, UK government bonds (gilts) and conventional bond funds have continued to perform well, particularly those with a bias to longer-dated bonds (i.e. with a higher duration). Funds invested more in short-dated bonds, and those with a negative duration have struggled in comparison and M&G UK Inflation-Linked Corporate Bond is no exception.

Specialist funds invested in a concentrated area of the market with the aim to achieve a specific goal can be prone to such setbacks, particularly over the short term. Since the fund launched in September 2010 it has achieved its objective to deliver an above-inflation return. Please remember past performance is not a guide to the future.

Performance of M&G UK Inflation-Linked Corporate Bond Fund since launch over managers' tenure

Source: Lipper IM, correct at 03/05/2016

Source: Lipper IM to 03/05/2016. Past performance is not a guide to future returns.

Find out more about this fund including how to invest

Please read the key features/key investor information document in addition to the information above.