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Andrew: What I’d do with M&G Episode Income in a big bond market crash

12 November 2015

FE Alpha Manager Steven Andrew thinks there could be some nasty falls for fixed income around the corner but he has a plan in mind.

By Daniel Lanyon,

Senior reporter, FE Trustnet

The prospect of a significant sell off in fixed income markets is likely in the next 12 months or so, according to Steven Andrew, manager of the M&G Episode Income fund, who adds this will provide an exciting opportunity for bargain hunting.

So far in 2015, while many were expecting bonds to enter bear market territory, bonds have mostly stood up to the numerous headwinds touted as potential triggers such as the expectation that US interest rates will soon rise.

While neither gilts or credit markets are in positive territory, they are only down marginally overall year-to-date. According to FE Analytics, the IBOXX Gilts Overall Maturities index is down 0.26 per cent and the IBOXX UK Corporates Overall Maturities index by 0.42 per cent.

Performance of indices in 2015


Source: FE Analytics

However, there have been spikes in yields this year and, while these have been followed by subsequent rallies, it has meant the perceived ‘safe’ asset class has delivered some uncharacteristically large drawdowns.

Andrew is still currently overweight equities in M&G Episode Income believing they are “the best game in town” to provide income for the £331m mixed investment portfolio. However, he says should the bond market sell off hard he will use it as a huge buying opportunity to build up his fixed income holdings.

“If it sells off by 20-30 per cent and you have yields at 4 per cent at the long-end it will feel like a big bond bear market. However, I'd buy them aggressively and be asking the market ‘why are you selling these things in the current environment?’” he said.

“This is because…a big bond bear market is not justified. For a big bond bear market we would need to have a reversal for the apparent regime that we have been in for a while.”


Andrew (pictured) says his anticipation of a bargain sale for bonds hinges on the opinion we are only part way through a period of structural global disinflation. Although he says this is likely to reverse in the next year, potentially causing the market to sell off.

“In 12 months’ time inflation is highly likely to be higher than it is today when the year-on-year effect of the energy price change is no longer with us,” he said.

“If headline consumer price inflation numbers are going to come up and coincided with cyclical indicators that are telling you that most of the world is expanding then of course it will be no surprise if people extend that out and say inflation is surprising on the upside and policy makers have missed a step.”

“They [central banks] will need to tighten more than everyone expects so everyone will say ‘let’s sell off bonds’. I can see that happening but I will be the other side of it. [However] it will self-correct.”

He thinks the risks to bond markets in a rising rate environment, which he says would be the likely cause of a hard sell off, are already reflected in a current valuations and therefore any spikes in yields would quickly fall back to their current levels.

“The market has changed regime from one of low returns, low inflation and low growth to one of either two things. Either high growth, high inflation and higher rates or low growth, high inflation which is quite unpleasant.”

Andrew has been at M&G since joining the group as an economist in 2005. He launched the M&G Episode Income fund in November 2010 which sits in the IA Mixed Investment 20%-60% sector. Since launch it has performed strongly against its peers with a top decile 36.9 per cent return versus a sector average of 24.5 per cent.

Performance of fund and sector since launch

    

Source: 
FE Analytics


The manager has a large focus on income generation as capital protection with the fund paying out every month. Anyone who invested £10,000 at launch would have since earned £2,124 in income.  


Income pay outs since fund’s launch

   

Source: 
FE Analytics


Analysts at Square Mile Research point to Andrew’s focus on valuations for both fixed income and equities as being a key strength in the portfolio but that his “strong views” and high conviction plays can lead to periods of greater than average volatility.

Our data shows the portfolio has indeed been more volatile the average fund in sector since launch and his maximum drawdown – the amount you would have lost if you had bought and sold at the worst possible times – is among the largest in the peer group.

Andrews currently holds 48.5 per cent in equities mostly in the US and Europe. He has 27.5 per cent in government bonds (although no gilts), 16.9 per cent corporate bonds and 5.4 per cent in property and just 1.8 per cent in cash.

This cash weighting is relatively low and below the average weighting in the sector of 7.5 per cent, he is not preparing for any immediate sell off and so has time to build up cash.

The M&G Episode Income fund’s current yield is 3.56 per cent and it has clean ongoing charges figure [OCF] of 0.81 per cent.

 

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.