A bond fund offering protection from rising inflation and interest rates

Kate Marshall | Tue 17 October 2017

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• This defensive fund aims to provide some shelter from rising inflation and interest rates
• Recent concern over inflation has increased speculation of rising interest rates
• We favour the knowledge and experience Ben Lord and Jim Leaviss bring to the portfolio

Our view

We recently met Ben Lord for an update on his views on inflation and the M&G UK Inflation-Linked Corporate Bond Fund. In our view, he is a highly experienced bond investor and remains on top of the key issues relating to the inflation-linked bond market. He manages the fund alongside Jim Leaviss, who brings his knowledge on wider economic issues, such as economic growth, interest rates, and inflation, to the portfolio.

We believe this fund could offer some shelter against short-term inflation shocks, and inflation-beating returns over the longer term. The fund has produced an inflation-beating return since its launch in September 2010, although please remember past performance is not a guide to future returns.

The fund is invested differently to most conventional bond funds. We feel it could be used to form part of a more defensive portfolio, or one that aims to shelter capital from the impact of inflation. 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. The fund remains on the Wealth 150 list of our favourite funds across the major sectors.

Past performance is not a guide to future returns. Source: Lipper IM 30/09/17

Is inflation on the rise?

Ben Lord and Jim Leaviss are broadly positive in their outlook for the global economy. After years of subdued interest rates and huge rounds of quantitative easing (QE), there are signs economic growth is finally accelerating, and inflation rising, in some parts of the developed world.

Inflation in the UK now stands at 3.0% and the managers believe it could remain elevated over the coming months. While sterling has recently strengthened against the world’s major currencies, the influence of currency depreciation takes time to feed through fully to inflation figures, which means earlier sterling weakness continues to feed into consumer prices. A weaker pound makes goods imported from overseas more expensive, which increases costs for manufacturers and retailers, and in turn the prices of goods and services often rise.

Low unemployment and a shortage of labour is also putting pressure on wages, which means companies may be forced to pass on rising labour costs to their customers through rising prices. Indeed, recent data suggests average weekly earnings rose 2.1% on an annual basis in the three months to June 2017.

That said, Ben Lord and Jim Leaviss believe inflation could fall back towards the Bank of England’s target level of 2% next year, especially if further wage growth fails to come though and amid a possible consumer slowdown.

Overall, rising inflation concerns has led to increasing speculation over whether central banks across the globe will withdraw QE and raise interest rates. Rising interest rates are typically bad for bonds as the interest available on cash deposits looks commensurably more attractive to savers, which reduces the appeal of bonds. However, the M&G UK Inflation-Linked Corporate Bond Fund has the flexibility to take steps to shelter investors in this environment.

How have the managers positioned the portfolio?

The managers invest partly in a portfolio of short-dated, index-linked government and corporate bonds. In addition, they use derivatives to add an element of corporate bond exposure alongside the index-linked bonds. 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, although it also adds risk. The managers can also invest in higher-risk, high-yield bonds should they see fit.

Derivatives are also used to reduce the sensitivity of the fund to rising inflation or interest rates. In anticipation of a rising rate environment, Ben Lord and Jim Leaviss have kept the fund’s ‘duration’ short. This lower duration stance affords some shelter against rising interest rates, as the prices of short-duration bonds fall to a lesser extent than long-duration bonds when interest rates rise, or are expected to rise.

In the US, the managers expect interest rates to rise faster than expected. They have therefore reduced the fund’s exposure to US TIPS (Treasury inflation-protected securities) from 25% to around 11% of the portfolio.

The managers believe other parts of the US bond markets are starting to look overvalued following several years of strong performance. They have therefore recently reduced exposure to US corporate bonds, including bonds issued by US banks such as Bank of America. Proceeds have been reinvested in financials bonds issued in the UK and Europe, where they see greater value.

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.