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Woolnough moves to 'negative duration' on UK bonds

Unusual move sees manager Richard Woolnough protect £15 billion M&G Optimal Income fund from high bond prices and rising inflation.

Woolnough moves to 'negative duration' on UK bonds

The country’s leading bond manager, Richard Woolnough, has moved to ‘negative duration’ on UK debt for the first time in response to the rising threat of inflation and the surge in bond prices since the EU referendum.

Expressed in years, duration is the measure used to show a bond fund’s sensitivity to interest rate changes.

The overall duration for Woolnough’s £15 billion M&G Optimal Income fund is currently at a low 2.6 years, reflecting the view that interest rates in the developed world are expected to slowly rise following the first increase in US rates at the end of last year.

Rising interest rates are bad for fixed interest bonds as they make their returns look unattractive. Rates also tend to rise when inflation is increasing, which erodes the fixed returns from bonds. An inflation or interest rate ‘shock’ can cause bond prices to fall quickly, as in 1994 when an unexpected series of US interest rate rises caused the bonds market to temporarily collapse and hit confidence in broader stock market.

High bond prices

Within the UK portion of his fund, however, Woolnough has moved duration to -0.2 years, the first time it has been negative since he launched the fund in 2006.

This is in response to the post-Brexit decision by the Bank of England to cut interest rates from 0.5% to 0.25% and to revive bond purchases under its policy of 'quantitative easing' which aims to lower longer-term interest rates.

As bond prices move in the opposite direction of their yields, or interest rates, last month's cut in the Bank's base rate to a new record low has made all UK bonds across a range of maturities more expensive.

From a pre-financial crisis level of 5.6% in 2007, yields on benchmark ten-year UK government bonds, or gilts, slid to 1.376% just before the referendum on 23 June. They tumbled to a record intra-day low of just over 0.5% in mid-August, but have since increased to 0.8%, just ahead of consumer price index inflation of 0.6%.

Low return

Anthony Doyle, a fixed income specialist at M&G, confirmed the changes to Citywire and said Woolnough (pictured) believed that UK government bonds currently offered poor prospective returns.

He said the fall in the pound since the EU referendum suggested inflationary pressures will build in the UK economy over the medium term.

Doyle added: ‘Richard believes that yields will likely increase in this environment. Because of these views, the M&G Optimal Income fund has a low duration of 2.6 years.

‘Given the flexible nature of the M&G Optimal Income fund, Richard has the ability to focus the fund’s duration by currency to implement his views.

‘Currently, most of the fund’s duration comes from USD (the US dollar market) (2 years), with the EUR (euro market) contributing 0.8 years, and GBP (pounds sterling market) -0.2 years,’ Doyle said.

Sold 'linkers'

Woolnough shortened the fund’s UK duration in August by selling long-dated inflation-linked government bonds, or gilts, which have surged in value and been among the top-performing assets this year.

One of the ‘linkers’ Woolnough sold was the 2044 index-link gilt which had shot up 34% this year. Cutting linkers reduced the fund’s exposure to gilts by around 2%.

Woolnough also sold UK credit, or corporate bonds issued by companies when they borrow, which had also performed well, reducing their allocation by around 3%.

‘Richard switched assets out of sterling credit to parts of the market where the credit curve looks more attractive - purchases in August focused on USD [dollar] credits, particularly at the long end given the higher yields on offer.’

QE bubble

Woolnough's move is not without precedent. In September 2013, he moved the fund to negative duration on European bonds for the first time. This was in response to perceived ‘mistakes’ by the European Central Bank which Woolnough believed was over-reacting to the threat of deflation or falling prices.

Early last year the ECB launched its first quantitative easing programme, buying bonds in an effort to cut long-term borrowing costs and boost the flagging eurozone economy.

ECB president Mario Draghi disappointed markets yesterday by not announcing an expansion to the policy although M&G believes further stimulus is inevitable in face of weak economic data.

QE policies by central banks in the UK, US and Japan have helped push up bond prices since the financial crisis, fuelling what many fear is a bubble that has lifted global share and property prices beyond what is justified by the underlying economy.

Between its launch in December 2006 and the end of August the fund delivered a total return of 111% compared to the 71.7% from the average fund in the IA Sterling Strategic Bond sector (source: Lipper). Statistics on this website show that over five years to the end of July it ranked 33 out of 51 strategic bond funds with a 35.2% total return. It yields 2.1% in annual income. Woolnough last received a Citywire A-rating for his performance on all his funds two years ago.

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