British Fund With $32 Billion Makes Lurch Into Treasuries

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(Bloomberg) -- The U.K.’s biggest bond mutual fund is shifting money to the other side of the Atlantic as the interest-rate gap between Europe and the U.S. widens to record levels.

M&G Limited has boosted U.S. holdings in its 23.4 billion pound ($32 billion) Optimal Income Fund this year to more than a third at the expense of positions in French, Italian and Spanish bonds. To cushion inflation risks and the impact of rising U.S. rates, it’s gorging on short-term Treasury bills and paring credit risk.

“If you look at the relationship between the front end in Europe and the front end in the U.S., we’re multi-year wide,” M&G portfolio manager Stefan Isaacs said in an interview. “The front end of the U.S. curve looks like good value to us. You’re getting a positive real yield there.”

The M&G Optimal Income fund, which Isaacs helps oversee with lead manager Richard Woolnough, is the biggest actively-managed open-end bond fund domiciled in the U.K., according to data compiled by Bloomberg.

The allocation shift underscores overseas demand for U.S. securities, despite elevated currency-hedging costs, with short-dated yields higher than inflation, effectively for the first time since the crisis.

Bond investors cut exposure to all regions outside the U.S. in the week ending May 2, according to EPFR Global data, while exchange-traded funds that track U.S. government bonds have attracted more than $17 billion so far this year.

M&G is striking a different note to Pacific Investment Management Co. bond investor Andrew Bosomworth, who suggests shunning 10-year Treasuries in favor of Italian, Danish and Swedish debt, citing dollar-hedging expenses for money managers in Europe. Pimco estimated last month that the cost for euro investors could rise closer to 4 percent next year from just below 3 percent.

Isaacs said that while the high price of offsetting dollar exposure had put the fund off Treasuries over the past few months, the recent selloff has pushed yields on short-dated bonds to levels that outweigh that cost. The yield on benchmark five-year Treasuries has jumped about 60 basis points since the start of the year to trade at 2.84 percent.

Defensive Strategy

As the U.S. Treasury curve flattens to 2007 levels, Isaacs’ strategy is defensive. The paring of the Federal Reserve’s balance sheet and "relatively robust" economic data raise the prospect of a slow but sure rise in long-dated U.S. bond yields. As such, the M&G Optimal Income fund has a modest duration -- a measure of the sensitivity of bond prices to changes in interest rates -- at just 2.4 years.

The firm took profits on European bonds earlier this year after spreads narrowed versus Germany, while cutting exposures to high-yield debt. The fund’s flexible mandate allows it to take a position in equities, which now stands at 5 percent, said Isaacs.

While the fund is sitting on a loss of 0.2 percent so far this year, it outperformed more than 80 percent of peers over the past two, according to data compiled by Bloomberg.

“The trade has been out of the riskiest end of U.S. credit markets into the front end of the least-risky part of the market,” Isaacs said. “Why take the additional risk when you can earn the vast majority of that income at the front end of the market?”

©2018 Bloomberg L.P.

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