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Credit investing in an inflationary world
11 – 13 May 2011
Sterling powered by
strong jump in inflation
Impennata del costo del petrolio
e degli alimentari si tradurrà in
agitazione
3
M&G’s Inflation Linked Corporate Bond Funds
Source: M&G Investment Information, as at 30 April 2011. „^The M&G UK Inflation Linked Corporate Bond Fund is only authorised by the FSA in the UK. The fund has not been
authorised nor otherwise approved by a financial regulator in any other jurisdiction'.
Fund facts
September 2010
Jim Leaviss Co-fund manager
Ben Lord Co-fund manager
£231m Fund size
IMA £ Strategic
Bond Sector Sector
Inception
€29.5m
Morningstar EUR
Inflation-Linked Bond
UK^ Europe
4
95
96
97
98
99
100
101
102
103
104
105
Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11
M&G European Inflation Linked Corporate Bond Fund EU Harmonised Indices of Consumer prices
MStar PE EUR Corporate Bond (PG) MStar PE EUR Government Bond
MStar PE EUR Inflation-Linked Bond
Fund performance Since inception in September 2010
Source: M&G, Morningstar as at 30 April 2011. Pan European database, Bid-to-bid, gross income reinvested, Euro A Share class
M&G European Inflation Linked Corporate Bond Fund – performance since inception
Ind
ex
ed
to
10
0
3.90%= Fund
2.48% = EU HICP
-0.11% = € IL Bonds
-0.27%= €
Corporate Bonds
-3.67%= €
Government Bonds
5
Biography
• Jim Leaviss joined M&G in 1997 from the Bank of England. He
is Head of M&G Retail Fixed Interest
• Co Manager of the M&G UK and European Inflation Linked
Corporate Bond Funds since Sep 2010
• Has 19 years experience in fixed income markets
Co-fund managers
• Ben Lord joined M&G in 2007
• Fund manager of the M&G High Interest Fund since February
2009 and deputy fund manager for Strategic Corporate Bond
and Corporate Bond funds
• Ben previously worked at Gordian Knott as a credit analyst
covering financial institutions
Credit investing in an inflationary world Ben Lord, Fund Manager
11 – 13 May 2011
7
What is the current rate of inflation in Zimbabwe?
(as at January 2011)
Inflation Quiz 1
8
What was the rate of inflation in Zimbabwe
in July 2008?
Inflation Quiz 2
9
How much was Z$100 billion worth in Euros
in October 2008?
Inflation Quiz 3
10
How much did a roll of toilet paper cost in Zimbabwe
in May 2006?
Inflation Quiz 4
11
Agenda
• Hedging against inflation
• Macroeconomic views
• M&G European Inflation Linked Corporate Bond Fund
12
Asset class sensitivity to inflation in the short term
Source: IMF, Attie, P., and Roache, S., “Inflation Hedging for Long-Term Investors”, April 2009. 12-month returns on annual inflation using overlapping observations.
The SDR-based analysis assesses the inflation-hedging properties of broadly diversified international asset class benchmarks.
Impact on returns of a 1% increase in inflation
Commodities are an effective hedge for an increase in
inflation of 1% in the short-term
-6
-4
-2
0
2
4
6
8
10
12
U.S. 3-
month T-
bills
U.S.
Treasuries
(all
maturities)
U.S.
Corporate
bonds
SDR-
weighted
gov.
bonds
(10y+
maturities)
SDR-
weighted
equities
CRB index Gold spot SDR 60-40
equity-
bond
portfolio
Impact on returns over entire history of data
Impact on returns since exchange rates were allowed to float (1973)
Impact of a 1% rise in inflation by asset class
13
Inflation hedging over the long term Asset class reactions to an unexpected increase in inflation
Cash
Source: IMF, Attie, P., and Roache, S., “Inflation Hedging for Long-Term Investors”, April 2009. A one standard deviation shock, equivalent to about 0.2 percentage points,
was applied to inflation.
Cumulative response over 20 years to a one-time inflation „shock‟
• This model assesses how different
asset classes react to unexpected
increases in inflation
• Unexpected inflation is a rise in the
consumer price index that is not
anticipated by the model
• The model estimates the impact of a
one-time inflation shock on the
cumulative total return (or change in
price in the case of commodities),
assuming all coupons and dividends
are reinvested
Cumulative change in the level of the total
return or price index over a 20-year period.
Years Years
%
Years Years
%
%
%
Suffer short term, then recover Partial hedge
Losses, no meaningful
recovery
Effective short-term hedge,
but erodes over time
Equities Commodities
Bonds
Standard error bounds
14
Agenda
• Hedging against inflation
• Macroeconomic views
• M&G European Inflation Linked Corporate Bond Fund
15
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11
UK
US
Germany
Inflation expectations are rising
Source: Bloomberg, 04 May 2011
5 year breakeven rates for US, UK and Germany
Driven by stronger growth, higher commodity prices and
taxes, and QE fears
US Quantitative Easing 2
announced
%
16
Unit labour costs less inflation 3q-moving average, (%)
-2.5
-1.5
-0.5
0.5
1.5
2.5
3.5
4.5
5.5
6.5
Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10
Workers getting richer
Workers getting poorer
It’s rare to get inflation with such weak wage growth
But a stronger labour market should ring alarm bells
Source: Bloomberg, M&G, 28 February 2011
Germany
Eurozone
Spain
Europe
17
It’s rare to get inflation with such weak wage growth
But a stronger labour market should ring alarm bells
-6
-4
-2
0
2
4
6
Jan-
00
Jul-0
0
Jan-
01
Jul-0
1
Jan-
02
Jul-0
2
Jan-
03
Jul-0
3
Jan-
04
Jul-0
4
Jan-
05
Jul-0
5
Jan-
06
Jul-0
6
Jan-
07
Jul-0
7
Jan-
08
Jul-0
8
Jan-
09
Jul-0
9
Jan-
10
Jul-1
0
Jan-
11
UK average earnings less RPI (y/y)
Workers getting richer
Workers getting poorer
Source: Bloomberg, M&G, 31 March 2011
UK
18
The demographic case for inflation is strong
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
1950
1957
1964
1971
1978
1985
1992
1999
2006
2013
2020
2027
2034
2041
2048
70.00%
80.00%
90.00%
100.00%
110.00%
120.00%
130.00%
US inflation Non-working age to working age ratio (RHS)
But the Japanese ageing experience has been
non-inflationary
Very unproductive
workforce
Very
productive
workforce
Source: Barclays Equity-Gilt Study, M&G, January 2011
19
Eurozone HICP all items and HICP ex-tobacco (YoY)
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11
%
Ex-tobacco
All items
European Inflation
Source: Bloomberg as of 31 March 2011
20
The make-up of EU HICP
15%
4%
7%
16%
7%4%
15%
3%
10%
1%
9%
9% Food & non-alcoholic beverages MoM: 0.5%, YoY: 2.0%
Alcohol & tobacco MoM: 0.2%, YoY: 3.7%
Clothing & footwear MoM: 15.1%, YoY: 1.2%
Housing & household services MoM: 0.6%, YoY: 5.1%
Furniture & household goods MoM: 0.6%, YoY: 0.9%
Health MoM: 0.1%, YoY: 1.3%
Transport MoM: 1.3%, YoY: 5.6%
Communication MoM: -0.2%, YoY: -0.6%
Recreation & culture MoM: -0.2%, YoY: -0.3%
Education MoM: 0.1%, YoY: 1.7%
Restaurants & hotels MoM: 0.2%, YoY: 1.8%
Miscellaneous goods & services MoM: 0.5%, YoY: 2.8%
HICP weightings
Source: Eurostat as at 31 March 2011
21
Agenda
• Hedging against inflation
• Macroeconomic views
• M&G European Inflation Linked Corporate Bond Fund
22
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11
DBRI 1.75%2020
DBRI 1.5%2016
OBLI 2.25%2013
Is there value in government inflation-linked bonds?
Source: Bloomberg, 04 May 2011
German inflation linked real yields
Medium dated real yields are thin
and short dated real yields are negative
%
23
A fund should be short (or negative) duration if you
expect yields to rise
• The average European government bond has a duration of 6 years
• The average European inflation-linked government bond has a duration of 8 years
• The average European corporate bond has a duration of 4 years
If interest rates rise by 1%
• The average European government bond will fall in price by 6%
• The average European inflation-linked government bond will fall in price by 8%
• The average European corporate bond will fall in price by 4%
• If a bond portfolio has a negative duration of say, -2 years, it will increase in value by 2%
Source: Barclays Capital Indices, M&G as at 31 March 2011
Innovation 1: A short duration fund with ability to go negative
24
What am I buying when I purchase an inflation-linked
corporate bond?
Inflation-linked corporates are a combination of duration risk and
credit risk. Principal and coupons are uplifted by EMU HICP
Pure interest rate risk
(duration)
“Risk free” yield
= 0.4% pa (2015 OATi)
Veolia I/L 2015
Yield = 1.3%
+ inflation
Pure credit risk
= 0.9% pa
+
Source: Bloomberg, M&G 31March 2011
25
-1
0
1
2
3
4
5
6
7
Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11
Re
al
Yie
ld (
%)
Veolia 1.75% 2015
France IL 1.6% 2015
Real yields on Veolia IL 1.75% 2015 Vs. France IL 1.6% 2015
Money yield = 3.7%
Current HICP ex-
tobacco = 2.4%
YTM = 1.3%
+
=
How do inflation-linked corporate bonds perform?
Corporate bond returns plus inflation protection over
the long term
Source: M&G, Bloomberg 31 March 2011
26
Some issuers of Euro and UK inflation-linked corporate bonds
27
CDS + government linker = synthetic inflation linked corp
Synthetic Glencore linker
Credit default swap (Pure Credit Risk):
Glencore 5y = 1.7%
Source: Bloomberg, M&G as at 31 March 2011
Innovation 2: synthetic inflation-linked corporate bonds How to create one
Pure interest rate risk (duration):
UKTI gilt 2.5% 2016 “Risk free” yield = -0.17%
= 1.5% + RPI (currently 5.5%)
= Money yield of 7.0%
28
100
130
160
190
220
250
280
Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11
Bp
s
Glencore 5y SR CDS spreads (Bps)
Performance
We sold protection on Glencore senior debt in Oct 2010
Innovation 2: synthetic inflation-linked corporate bonds
Source: Bloomberg as at 31 March 2011
29
M&G European Inflation Linked Corporate Bond Fund
Fund positioning
Source: Bloomberg, M&G as at 30 April 2011
overall fund duration: 1.5 years Core of fund in index linked credit,
4.5%
1.3%
1.8%
4.4%
30.7%
39.0%
13.4%
4.9%
0% 10% 20% 30% 40% 50%
Cash
NR
B
BB
BBB
A
AA
AAA
Credit split incl. derivatives Asset allocation
IL corporates &
PFI, 41.4%
IL governments,
1.1%
IL governments
with derivative
overlay, 35.0%
FRNs, 11.5%
Short dated
corps, 6.5%
Cash, 4.5%
30
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11
% VaR Upper Limit Lower Limit
Source: M&G, as at 31 March 2011
Value at Risk
VaR limits
Plenty of headroom to add risk
Upper Limit: Greater of: 70% Euro BBB Securities 15+ year duration / 30% Euro High Yield B rated and 20 year
European Inflation Linked Govts
Lower Limit: Euro 3 Month Treasury Bill
0.96%
9.86%
0.09%
31
Summary
…then add inflation protection to your portfolio
If you or your clients fear inflation…
• Inflation expectations have been rising in 2011
• Investors need to protect their portfolios
– But traditional asset classes are an imperfect hedge
• Inflation linked corporate bonds can offer protection against inflation
• The M&G European Inflation Linked Corporate Bond Fund is an
innovative product allowing investors to protect against inflation
This document is designed for investment professionals‟ use only, not for onward distribution to any other person or entity.
For Switzerland: Distribution of this document in or from Switzerland is not permissible with the exception of the distribution to qualified investors according to the Swiss
Collective Investment Schemes Act, the Swiss Collective Investment Schemes Ordinance and the respective Circular issued by the Swiss supervisory authority
("Qualified Investors"). Supplied for the use by the initial recipient (provided it is a Qualified Investor) only.
In Spain the M&G Investment Funds are registered for public distribution under Art. 15 of Act 35/2003 on Collective Investment Schemes as follows: M&G Investment Funds (1) reg.
no 390, M&G Investment Funds (2) reg. no 601, M&G Investment Funds (3) reg. no 391, M&G Investment Funds (7) reg. no 541, M&G Investment Funds (9) reg. no 930, M&G Global
Dividend Fund reg. no 713 M&G Global Dynamic Allocation Fund reg. no 843 and M&G Optimal Income Fund reg. no 522.
The collective investment schemes referred to in this document (the "Schemes") are open-ended investment companies with variable capital, incorporated in England and Wales.
This information is not an offer or solicitation of an offer for the purchase of investment shares in one of the Funds referred to herein. Purchases of a Fund should be based on the
current prospectus. This prospectus, simplified prospectus, annual report and subsequent semi-annual report, are available free of charge, in paper form, from the ACD: M&G
Securities Limited, Laurence Pountney Hill, London, EC4R 0HH, GB, or one of the following: M&G International Investments Limited, German branch, Bleidenstraβe 6-10, D-60311
Frankfurt am Main, the German paying agent J.P. Morgan AG, Junghofstraβe 14, D-60311 Frankfurt am Main, the Austrian paying agent, Raiffeisen Bank International A.G., Am
Stadtpark 9, A-1030 Wien, the Luxembourg paying agent, J.P. Morgan Bank Luxembourg S.A., European Bank & Business Center, 6 c route de Treves, 2633 Senningerberg,
Luxembourg, Allfunds Bank, Calle Estafeta, No 6 Complejo Plaza de la Fuente, La Moraleja 28109, Alcobendas, Madrid, M&G International Investments Limited, 90 avenue des
Champs Elysées, 75008, Paris, France or from the French centralising agent of the Fund: RBC Dexia Investors Services Bank France. For Switzerland: Please refer to M&G
International Investments Ltd., Bleidenstraβe 6-10, D-60311 Frankfurt am Main. For Italy, they can also be obtained from one of the appointed paying agents, details of which can be
found by visiting the contact section on the following website: www.mandg-investments.it.
Before subscribing you should read the prospectus, which includes investment risks relating to these funds.
This financial promotion is published by M&G International Investments Ltd. Registered Office: Laurence Pountney Hill, London EC4R 0HH, authorised and regulated by the Financial
Services Authority and registered with the CNMV in Spain.
Past performance is not a guide to future performance.
Performance stats are quoted gross of Italian tax (12.5%) on capital gains.
33
Appendix
34
Fund facts
Top 10 holdings
Source: Bloomberg, M&G as at 30 April 2011
Germany
Germany
Oresundsbro Konsortiet
Severn River
BT
Tesco
Tesco
Veolia Environnement
Anglian Water
Cades
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
2.25%
1.5%
3.40%
6.125%
3.5%
4.0%
3.32%
1.75%
4.125%
1.5%
29.1%
7.1%
4.6%
3.9%
2.7%
2.5%
2.1%
2.1%
2.1%
2.1%
2013
2016
2014
2013
2025
2016
2025
2015
2020
2021
Maturity Fund % Coupon
35
Using futures to manage duration The maths…
• The fund sold 20 10yr Bund future contracts at launch 16th Sept
• Reduced fund duration by approx 1.8 years
• 10yr bund yields rose 84bps
• On a €10m fund that results in a loss of €151,200
• The value of the futures contract fell by 5.31% over the period – therefore we
gain €129,967
• Overall effect: 129,967 – 151,200 = - €21,233
• The futures roughly neutralise the movement in the yield
Source M&G, Bloomberg as at 28 February 2011
36 Source M&G, Bloomberg as at 28 October 2010 *maturity date 20/3/12
• Nov 26 the fund sold £500k 5yr protection on Glencore at 265bps*
• We receive 265bps a year = (0.0265*£500k= £13,250)
• Today priced at 170bps
• 265 - 170 = 95
• Spread change: 95 * £500k = £4,750 (+ premia received per qtr)
• PV of Spread change = value of position
• £4,750 * 4.7yrs = £22,325 (small number but adds 22bps to a £10m fund)
Synthetic inflation-linked corporate bonds The maths…
37
Oil Shocks
Source: Fathom Consulting as at 28 February 2011
Effect on inflation measures of an oil price increase
Oil Price
$/Barrel UK RPI
EA CPI
Ex-Tobacco US CPI
90
100
110
120
130
140
150
160
170
180
0.00
0.16
0.32
0.48
0.63
0.79
0.95
1.11
1.27
1.43
0.00
0.17
0.34
0.51
0.68
0.86
1.03
0.20
1.37
1.54
0.00
0.54
1.08
1.63
2.17
2.71
3.25
3.80
4.34
4.88
38
Counterparty risk
M&G European Inflation
Linked Corporate Bond
Fund
J P Morgan
BNP Paribas
Credit Suisse
Deutsche Bank
J P Morgan
UBS
AAA
Government
Bonds
Cash
AAA
Government
Bonds
Cash
Fund Custodian
Counterparty
39
What is the current rate of inflation in Zimbabwe?
(as at January 2011)
3.3%
Inflation Quiz 1 Answer
Source: Reserve Bank of Zimbabwe, as at 6th May 2011
40
What was the rate of inflation in Zimbabwe
in July 2008?
23,11,50,888.9%
Inflation Quiz 2 Answer
Source: Reserve Bank of Zimbabwe, as at 6th May 2011
41
How much was Z$100 billion worth in Euros
in October 2008?
€0.10
Inflation Quiz 3
Source: The Guardian
Answer
42
How much did a roll of toilet paper cost in Zimbabwe
in May 2006?
Z$145,750
Inflation Quiz 4
Source: NY Times
Answer
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