Investors should be reducing the duration risk in their bond portfolios even though rates could stay lower for longer, according to M&G Investments’ Richard Woolnough. 
The FE Alpha Manager said there are clear reasons for central banks, and in particular the Bank of England, to raise interest rates but that we could be in a low-yielding environment for some time.
“The macro view is the most important thing to us and it is the most appropriate given the discussions and changes in monetary policies that seem to be on the horizon,” the manager of the £20.8bn M&G Optimal Income fund said.
While these shifts away from monetary policy is expected, he noted that it is important for investors to realise that it has worked.
“Cutting interest rates worked,” Woolnough (pictured) explained. “The UK has got the lowest unemployment rate in 40 years – we are at full employment.
“Economic policy has worked. We haven’t got a great depression, we have full employment, a healthy labour market, a healthy housing market and it is very similar in the US.”
He added that even in Europe, which is often referred to as a “basket case”, cutting interest rates had worked, with economic growth beginning to come through and inflation slowly picking up.
“Monetary policy produces growth and eventually when you get to full growth and full employment it will result in inflation,” Woolnough said.
Indeed, in the UK, inflation expectations have been raised after recent figures shows the consumer prices index (CPI) rose to 2.9 per cent last month.
CPI expectations fan chart
Source: BoE
However, the manager said investors should not expect rampant inflation to come through, as there tends to be a lag between full employment and rising wages – the most common driver of inflation.
“A tight labour market does not mean that wages go through the roof. In 2008, in the middle of the recession, wage growth was 4 per cent per annum because there is a lag,” he explained.
As such, while wage growth has not yet come through this year, despite a fully employed labour market, Woolnough expects to see rises next year and beyond in both the US and UK.
The manager noted that if yields do remain lower for longer, he can attempt to forecast where they might go and take advantage of mispriced assets while waiting for interest rates and, therefore, yields to rise.
“It is our job as practising economists to take advantage of this delay between today’s headline news and the reality that is going to come tomorrow. We think we can do that and we position our fund accordingly,” the manager said.
With inflation rising but not too sharply, Woolnough said it was a good environment for investors as there is also economic growth.
“It is good deflation. It is 'efficient-ness' that is driving down inflation. We can have good growth and low inflation and that’s great,” he said.
The manager said while this has been a boost for economies, it has meant that yields have become too low and are being mispriced.
In particular, he highlighted Germany where government bonds (bunds) are yielding 0 per cent and in the UK, where gilts are yielding around 1.2 per cent.
“Even the US bond market sold off post-Trump and has stuck around those 1.80-2 per cent kind of levels. These are very low long-term levels,” he said.
“I don’t think that much has changed. We are in a low inflation world. Bond yields won’t go back to 4 or 5 per cent. So I am not going to wait for yields to get back to 10 or 8 per cent to get long duration again I just need them back to 3-3.5 per cent as opposed to being at 2 per cent.
“It is a low inflation world, it will stay a low inflation world but we are not so distressed that we need negative rates in parts of the world and zero rates elsewhere and we want to take advantage of that.”
One way the manager has tried to take advantage of this position is by taking more short duration exposure in anticipation of slow but steady rate rises.
“Unfortunately, I have had this view for a long time,” Woolnough said, noting that with hindsight this has been a mistake.
“I think where we differ from the market is [that] we have been short duration for a long period of time because we think that monetary policy will work and that inflation will come back,” he added.
Normally, the manager said the fund has an average duration of between five and six years, meaning that if interest rates go down by 1 per cent it will make a gain of 6 percentage points and if they go up by 1 per cent they will lose 6 percentage points.
Currently the fund has an average duration of two years, meaning that interest rates were to rise by 1 percentage point the value of the bonds would fall 2 percentage points.
“Within that we can be very flexible. If we find a cheap income stream we buy it and if we see a dear income stream we have permission to sell it. We don’t find any value in UK interest rates, we can find better value elsewhere,” Woolnough added.
“My view is that the Bank of England’s job is to focus on inflation and they are concerned about other things but when you have unemployment at a 40-year low and your inflation is above the inflation target and you have the easiest monetary policy we’ve ever had it doesn’t square.
“I think they are going through that process of normalising interest rates though not like the big rate cycles that we’ve had in the past – it will be very marginal and very slow.”
The M&G Optimal Income fund is the best performer in the IA Sterling Strategic Bond over 10 years, having returned 116.11 per cent compared to the sector average 62.42 per cent.
Performance of fund vs sector over 10yrs
Source: FE Analytics
Over the three years the fund is a second quartile performer but has underperformed the sector average, returning 12.86 per cent – three basis points less than the average – reflecting the manager’s slightly early moving into short duration assets.
The fund has a yield of 1.87 per cent and a clean ongoing charges figure of 0.91 per cent.