M&G’s star bond manager Richard Woolnough, who runs the huge £20bn M&G Optimal Income Fund which is sold widely across continental Europe, is explaining to International Adviser the opportunities to find value amid the bearish consensus out there about this asset class.
“When you’re very bearish there’s a chance that people will be surprised as the market moves in the opposite direction to what everybody thinks. So, it’s a typical contrarian type move we’ve had so far this year, everybody went into the start of the year thinking bonds were a terrible place to be.”
But long duration bonds are very cheap from a historical viewpoint, he says, “so, you’re getting paid a lot more yield for taking that duration risk on board, and these two things are intertwined because everybody’s bearish, which is why the prices are where they are”.
He is waiting for the market to get to a level that makes him comfortable about having a neutral position in the portfolio on duration. The trigger point here for when the bear market has been priced in is when yields get up to 4%, which he argues is still a possibility.
First among peers
The outperformance of the M&G Optimal Income Fund against the peer group over the past three years is notable, and explained by Woolnough in part due to being “better able at picking the value out of market distortions” as they occur, “and providing positive returns when the market returns to normal from a panicky mode”.
A key advantage to this approach is that the mandate is exceptionally flexible, which at the start of the year allowed the portfolio to go down to two and a half years duration making it “pretty protected” from the bond bear market. At the same time the portfolio has lots of credit risk.
“We positioned the portfolio accordingly, through selection of sectors and stocks, and being at the right part of the yield curve we took advantage of that. It’s great having an international stage to do it on, so that when you do get a situation where the market gets in distress, you can decide where you want to buy.”
The best example of that last year, he recalls, was when the quantitative easing wobble occurred in the US and it was possible to buy five-year treasuries very cheaply, as that bond market got “more out of whack” than any other in the world.
He says the team works hard to take lots of little different views, all the time, with all sorts of presentations to clients, for example giving a history of where the portfolio’s credit risk has been.
“We’re as transparent as possible so clients understand why we’ve done something, and if it goes wrong, they understand why we’ve done it.”
There is also equity exposure, with an upper constraint of 20%, which has ranged between 2% and 12.5% since the fund was launched in December 2006.
“For this fund a neutral position in equities is to own no equities. If I believed everything in the world was perfectly priced, the fund would be a third government bonds, a third in investment grade, a third high yield.”
The principle of the fund is to try and find the best income stream and sometimes these will appear in the equity part of the capital structure, not the debt part.
Apple is one of the company shares that Woolnough has bought and sold a few times, by looking at the equity earnings of the stock and seeing how cheap it was in relation to its debt.
The highest exposure he has got to for Apple in the portfolio is 0.4% to 0.5% of net asset value, which would equate to around £100m of the fund’s £20bn.
“We’re very much a tourist to equities – we go there when they’re attractive but we don’t live there. Other people’s job is to live there, they have some great equity funds and that’s what they do.”
The size of the fund clearly puts limitations on the range of stocks and shares which can be purchased in order to get a sensible level of exposure.
Woolnough acknowledges that stock selection becomes more difficult, but that there are lots of other ways to add value, through asset class allocations, yield curve duration across sectors, and as between different credit rating levels.
“As the fund has got larger then it is harder to add value at the stock selection level. You do pick up things to counteract that. If I was running a £100m fund it would be me and nobody else.
Running a £20bn fund, the people around us in terms of analysts, and others on the team including investment support, are very high. That gives me other things to do, as a lot of the high yield decision-making processes are delegated out to our very strong high-yield team and our analysts.”
The bonds team of 10 people, including Woolnough and the other two main fund managers Jim Leaviss, and Stefan Isaacs, is being added to “all the time”.
“We’re very good at keeping a reasonably flat structure, and generally the people who are recruited seem to fit in that bracket. People are given flexibility and freedom in their work.”
A point of interest
Turning to macro issues, Woolnough says central banks are keeping interest rates too low because they are wrongly fearful of deflation.
“If I was running a central bank I would have put rates up a long time ago, just a little bit, just to have that emergency measure of being able to cut them again.
“I’d argue that even if they keep rates low you won’t get inflation to the extent that you have historically.
So I’m a firm believer that the new normal interest rate is for short-term interest rates being in the range of 0-4%, not 3-6%.
“I think the central banks are being too dovish – my view is that they are keeping interest rates lower for longer than they should do.”
He says there is a risk “you get anchored to the history of where interest rates have been” and that fortunately he has been through a number of cycles when, in one case, rates went through 10% against expectations.
His view on deflation is different to others, he adds: “I think falling inflation and low inflation is good, so if you get a scenario where inflation is low, my analytical view is that central banks should let it be low and if you have deflation in the economy then so be it, because you can have deflation with reasonable growth.”
As for where the markets go from here, he paints a picture of market sentiment responding to central banks saying they are going to put interest rates up.
“The market will not behave rationally, the market will take that as a headline, so the headlines in the paper will read something like ‘Base rates go up, sell all your bonds’.
That’s the natural, knee-jerk reaction that will occur because people think short rates and long rates are completely intertwined.
“So, you’re sat with those kinds of forces at the moment, with the prospect of a global, quite dramatic reaction to this and other pieces of news.”