Ben Lord of M&G talks to Will Jackson about asset allocation, hedging against inflation and fiscal policy
Q. M&G UK Inflation Linked Corporate Bond was launched on September 16. How is the fund positioned?
A. The major component of the fund, given that we’re trying to deliver CPI [Consumer Prices Index inflation] over the medium term, is index-linked product. We have 25% in index-linked gilts, 55% in index-linked corporates, and 4% in index-linked public finance initiatives. So more than 80% is in true index-linked product, where your principal and coupons adjust for RPI [Retail Prices Index inflation].
Q. How much are you likely to move that allocation around in response to market conditions?
A. We’d always want to have the majority of the fund in index-linked corporates, but the market is not as developed as the index-linked gilt market. So if the fund was to grow quickly, we would start having to encourage issuers to come to the market. But I believe the fund should always have index-linked product as its core holding.
The other investments that we can use are floating rate notes. At the moment we have 7% in floating rate notes, but that portion will increase as and when we expect the Bank of England to start hiking rates. We also have a small part of the fund in short-dated conventional corporate bonds. These are bonds where we feel that the spreads are too wide and prices are too low. (article continues below)
Q. You are able to use derivatives. Where do you use them?
A. Indexing-corporates are less than 5% of the total corporate bond universe. When M&G launched the first high yield corporate bond fund in the UK, there were real problems with scalability. There wasn’t a large market for high yield in sterling, but now it’s a market in its own right. We fully expect to see this market develop with the launch of funds like this. Since launch, we’ve had two banks and another corporate on the phone to us, and talk about the potential for either issuing a new index-linked bond, or tapping existing issues for it. So it feels to us that there is latent demand from corporate treasurers to tap this growing investor base.
When we were designing the fund, we didn’t want to launch on hope that the market would grow. And one of the real innovations of this fund is the ability for us to use derivatives. So we have a physical portfolio of 25% in index-linked gilts and we staple a credit default swap on top of that – which is basically us selling insurance against a credit event.
What that means is there are 30 different issuers in our physical portfolio of index-linked corporates, index-linked gilts, floating rate notes and short-dated bonds. But by selling insurance over the top of our index-linked gilts, the overall portfolio has exposure to 155 names. By doing that we’re being paid 110 basis points or so, and we’ve created a coupon stream over and above our index-linked gilts.
Q. A more traditional way of hedging against rising inflation is to diversify into equities and/or commodities. What is the advantage of your strategy?
A. Our research shows that commodities are a good protector against inflation in the short term. So if we had an unexpected pick-up in inflation tomorrow and you had a large holding in commodities, you would do very well. But if you look with a longer term view, that relationship breaks down and commodities start to do badly.
With equities, it’s a popular fallacy that they are a good hedge against inflation. It has been shown that companies are unable to increase their margins in line with inflation.
The best inflation hedge has been National Savings & Investments products, but sadly they were pulled from the market.
The other one is to take a more traditional index-linked gilt fund and we have seen good demand in that part of the market. But we are positive on credit risk and we want to give investors a boost in their yield.
Q. British inflation remained well above target in August. Do you agree with the Bank of England’s view that it will fall back below target in 2011?
A. We are not in the business of forecasting economic data but our belief is that inflation will fall steadily over the medium term. If you look at Sweden in the 1990s or at the Great Depression – every time there has been a financial crisis, there has been rampant deflation. The policy actions that have been taken may prevent rampant deflation this time, but there are going to be very strong disinflationary forces.
Another thing I am increasingly focusing on is that although we’ve had an increase in the quantity of money, that’s only one part of the equation. What you really need is the velocity of money to increase, and at the moment it’s sitting in the banks’ vaults – it’s not being on-lent into the economy. Until we start seeing the velocity of money increase, it’s difficult to expect inflation.
Q. Do you have any expectations on when lending will increase?
A. If policymakers want to get the money that has been created turning around the system more quickly, they have to go to the banks and say: ’we’ll withdraw your stimulus unless you start lending to the real economy.’ If they do that, it will be a quick turnaround before we see new lending. But because that will be driven by artificial forces, it’s difficult to predict when it will be.
Q. Do you expect the Bank to expand its quantitative easing programme?
A. My prediction is that the economic data is about to turn quite severely down again. I think the residential property markets in America and here are about to suffer another dip. And if you look back to the beginning of this cycle, that was probably the single best early warning sign for what was to come. For that reason we as a team – and myself especially – have got much more bearish on the macroeconomic outlook. We’re definitely closer to having more stimulus than having less.
Q. Would you support an expansion of quantitative easing in Britain?
A. What policymakers have done is vindicated by the fact that we’ve still got a financial system that works. In terms of whether I would support another round, the answer has to be ’by degree’. While I may support another £50 billion or £100 billion in quantitative easing, any more than that and I would start to get a bit nervous.