The reason is that medium dated gilts are very closely correlated to global government bond yields. In fact the 10-year gilt yield is actually slightly closer correlated to the US government bond market than to the UK base rate. This week the US government bond market has performed reasonably well, with the 10 year US Treasury yield falling from 4.74% to 4.66% on the back of some slightly weaker than expected industrial production and jobless numbers.
I have positioned my corporate bond funds to benefit from an inverting UK yield curve, and this has had a large positive impact on fund performance. My view of the last 18 months has been that UK interest rates will rise by more than the market has expected, global government bond yields will rise, and pension fund demand will support long dated bonds. Both the M&G Corporate Bond Fund and the M&G Strategic Corporate Bond Fund have consistently held:
– over 20% in floating rate notes, which benefit from rising interest rates
– a large underweight in short and medium dated bonds, which I have expected to perform poorly due to the background of rising global interest rates
– a market weight position in long dated bonds
At various stages in the past three years both the M&G Corporate Bond Fund and the M&G Strategic Corporate Bond Fund have had large overweights in long dated bonds, but in a long-only fund it’s not possible to have a large overweight in long dated bonds while still being short duration.
Within the M&G Optimal Income Fund, I am able to create a duration-neutral yield curve view by using derivatives, so it doesn’t matter what direction the market as a whole moves. This has been achieved by:
– selling interest rate futures to benefit from UK interest rates rising
– selling medium dated gilt futures to benefit from medium dated UK gilt yields rising
– buying long dated gilts to benefit from pension fund demand
This position has made money for the M&G Optimal Income Fund, despite the very difficult environment for government bonds over the past few months.