A high yield fund for a rising rate environment

18/10/2018

The M&G Global Floating Rate High Yield Fund is designed for investors seeking an attractive level of income, but who are concerned about the negative impact of rising interest rates. Drawing on M&G’s long-running expertise in high yield investing, the fund gives investors access to a globally diversified portfolio of high yield floating rate notes (FRNs), a sub-set of the high yield market that has seen significant growth in recent years.

The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.

Floating rate notes (FRNs) are a type of bond that pays a variable coupon, which is regularly adjusted in line with short-term interest rates. These instruments not only minimise the negative effects of rising interest rates, but also offer a way to benefit from any future rate rises. This is in contrast to conventional bonds, which typically suffer in a rising rate environment because their fixed coupons become relatively less attractive.

Generating income without undue interest rate risk

How high yield floating rate notes work

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Source: M&G, 2018. Euribor - is the interest rate at which a prime bank is willing to lend funds in euro to another prime bank.

As well as providing a natural hedge against rising interest rates, high yield FRNs may also appeal to investors who are looking for a less volatile alternative to conventional high yield bonds. This is because of their relatively high concentration of senior-secured bonds. In the event of default, senior-secured bonds have a stronger claim on a company’s assets than unsecured bonds and, as a result, tend to be less volatile.

High Yield Floating Rate Notes (FRNs) – holding up well during volatile markets

2018 has been a challenging and eventful period for high yield bond markets. Following a sustained rally that persisted throughout much of 2016 and 2017, sentiment deteriorated in the early months of 2018. Several factors lay behind this reversal, including the potential impact of rising US interest rates, escalating trade tensions between the US and China and political instability in Italy and Turkey.

As a result, returns have been mixed across global high yield markets. On the one hand, US high yield has held up relatively well, with the robust economic backdrop and the rising oil prices providing support for these assets. However, it has been a more difficult environment for European and EM high yield, with political turmoil and slowing economic momentum holding back returns.

Performance of high yield indices in 2018

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Past performance is not a guide to future performance .

Source: BofA Merrill Lynch Indices, rebased to 100 on 31 December 2017. As of 30 September 2018.

Against this backdrop, high yield FRNs have proved resilient in 2018, delivering modest positive returns along with relatively low volatility. This has been partly due to the significant proportion of senior secured issues in the HY FRN universe.

Steady performance in 2018

The fund itself has delivered a positive return over the year, returning +2.6% in the year to the end of September. This is ahead of the Morningstar Global High Yield Bond Sector (+0.9%) although slightly behind the high yield floating rate notes index (+3.1%).

Performance as at 30.09.18 YTD 2017 2016 2015 2014 2013
M&G Global Floating Rate High Yield Fund USD A Acc. +2.6% +3.7% +7.8% +0.1%
High Yield Floating Rate Notes Index +3.1% +4.8% +12.7% -0.2% +2.2%
Morningstar Global High Yield Bond Sector +0.9% +6.9% +11.6% -2.3% +1.3% +6.7%

Past performance is not a guide to future performance.

Source: Morningstar Inc., Pan European database, 30 September 2018, USD A class shares, gross income reinvested, price to price Index returns shown from 1 January 2014 to 31 March 2016 is the ICE BofAML Global Floating Rate High Yield (USD Hedged) Index. Index returns shown from 01 April 2016 is the ICE BofAML Global Floating Rate High Yield 3% Constrained (USD Hedged) Index.

Well positioned for a rising rate environment

We are currently seeing healthy levels of activity in the primary high yield floating rate notes market. This is a welcome development which brings additional liquidity and diversification to this asset class, which in turn has enabled us to increase the fund’s physical FRN exposure from 43% at the end of 2017 to above 50% at the end of September. Primary market valuations also remain attractive, with new issues typically offering an additional yield compared to an equivalent bond trading on the secondary market. That said, we remain disciplined and have pushed back on several deals where we felt weak covenants failed to protect the interests of bondholders.

While volatility is likely to become a more common feature in the coming years, we maintain a positive assessment for the global economy which we believe will ultimately provide further support for high yield bond markets. However, at this stage of the economic cycle we believe a defensive approach is warranted and, following the tightening in high yield spreads since July, we have recently started to dial back spread duration (spread duration is a measure of how sensitive a bond, or bond fund, is to movements in credit spreads).

We believe the optimum strategy right now is to keep capturing the attractive coupons that can be found in this market, but without taking too much credit risk. In our view, the fund remains well placed to generate further steady returns in an environment of rising interest rates and heightened market volatility.

The Fund allows for the extensive use of derivatives.

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The value of the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.