The implications of a flattening yield curve

Despite market volatility, the synchronised global economic recovery has continued apace, with the International Monetary Fund now predicting global gross domestic product (GDP) will grow by 3.9% in 2018. In the UK, GDP forecasts were revised up to 1.6% on the back of this stronger growth, whilst we also saw wage growth exceed inflation for the first time in twelve months. However, this dip in inflation (to 2.5%) has caused the market to speculate that UK interest rates – and therefore bond yields – will not now rise as fast as previously thought. This is, in part, reflected in the very flat yield curve we are witnessing at present. The dark blue line highlights the current yield curve, which you can see has a much flatter trajectory between 2, 10 and 30 year gilts than we witnessed 1, 3 and 5 years ago.

Yield curve steepness

Source: Bloomberg, as at 19/04/18.

This indicates that the market does not expect interest rates to rise as fast as the Bank of England has forecast. However, we would caution that although it has fallen, inflation still remains elevated. Unemployment is also now at multi-decade lows, and we are not expecting the global growth engine to ease off this year. Therefore, we still think the risks are skewed to higher rather than lower yields over the course of 2018. In contrasts, credit spreads should remain relatively stable amidst a supportive economic backdrop.

How does this impact our fixed income portfolios?

The LF Canlife Corporate Bond Fund and the LF Canlife Short Duration Corporate Bond Fund are focused on sectors that we believe offer attractive spreads – which we believe are unlikely to widen. The higher income on corporate bonds can help offset the fall in prices when yields rise. This is why we believe it is important that investors do not simply maintain an idle, passive exposure to the benchmark. If you were to buy an index tracker, you would be buying significant exposure to low spread sectors that are very vulnerable to rising interest rates and bond yields. The below graph highlights the spreads available on insurance bonds – a sector in which we are c. 10% overweight relative to the benchmark – compared to those in lower yielding sectors, such as consumer goods in which we are c. 5% underweight.

Insurance versus consumer goods

Source: Markit, as at 18/04/18. iBoxx £ Insurance Index versus iBoxx £ Consumer Goods Index.

What else are we doing?

Within the LF Canlife Short Duration Corporate Bond Fund in particular, we have also increased our exposure to floating rate notes (FRNs). These are instruments with coupons that adjust periodically (e.g. every 1, 3 or 6 months) at a specified spread above a base rate such as LIBOR. Because of the ability to reset the coupon the prices of FRN’s will remain stable even in a rising interest rate environment, indeed your income will actually increase as interest rates rise.

We have also maintained our focus on our internal credit research and selection process. Ultimately, active managers are able to add value within fixed income portfolios through good credit selection and the avoidance of defaults. This is particularly important in short duration funds, as one default can easily wipe out a year’s worth of income. At Canada Life Investments, we have always managed money with a focus on strong credits and capital preservation and our internal credit research process is central to this belief. Our well-resourced and experienced in-house team cover more than 400 issuers and adopt a bottom-up approach to stock selection, with wider macroeconomic trends taken into account when we construct the portfolio.

Currently, we are overweight financials in general given the higher spreads on offer and the insurance sub-sector in particular. It is often viewed as a more specialist part of the market, with complicated financial reporting, however we feel that the additional work is justified with attractive yields on offer relative to equivalently rated bonds in other sectors. Many of these companies are globally diverse businesses with very strong balance sheets and their financial metrics should improve as yields rise across the globe, whilst being further supported by the improving global economic backdrop.

Important Information

Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. 

The information contained in this document is provided for use by investment professionals and is not for onward distribution to, or to be relied upon by, retail investors. No guarantee, warranty or representation (express or implied) is given as to the document’s accuracy or completeness. The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice. This document is issued for information only by Canada Life Investments. This document does not constitute a direct offer to anyone, or a solicitation by anyone, to subscribe for shares or buy units in fund(s). Subscription for shares and buying units in the fund(s) must only be made on the basis of the latest Prospectus and the Key Investor Information Document (KIID) available at www.canadalifeinvestments.com

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CLI01183 Expiry 19 April 2019

Michael Count

Michael Count

Senior Fund Manager, Fixed Income

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