M&G Optimal Income – one month on

I thought it would be useful to explain the key positions in the new M&G Optimal Income Fund and how I am making use of the “wider powers”, so that readers can get a better understanding of my strategy for international bond (and indeed equity) markets.

A prevailing view over the past 18 months has been that the market’s expectations of interest rates have continually been too low, and my long-only bond funds have been very short duration since summer 2005. Back in August 2005, the Bank of England had just cut rates from 4.75% to 4.5%, and the market was pricing in one interest rate cut. How wrong the market was – yesterday’s rate hike was the third since August 2005 and there are very likely to be more on the way. This duration call turned out to be spot on and the M&G Corporate Bond Fund achieved top quartile performance in 2005 and 2006, although frustratingly, the fund only just succeeded in breaking even last year. In a long-only bond fund you are always a victim to market conditions.

I believe there are likely to be at least two more rate rises in the UK, and the bond portion of Optimal Income has an exceptionally short duration of just 3 years. On top of this, I sold a significant amount of sterling interest rate futures in December and the beginning of January, which has added to performance since launch (particularly yesterday)

With wider powers, I am now able to accurately express my yield curve view for the first time. I believe global investors are being too conservative on their interest rate forecasts and expect short dated bond yields to continue rising as interest rates go up. Long dated bonds should fare much better, thanks to ongoing support from pension funds. In the US and Europe, I have sold short and medium-dated bond futures, and have bought long dated bond futures. In the UK, long dated bond futures do not exist so I have sold 10 year gilt futures and bought 30 year gilts, which still accurately reflects this view.

As for asset allocation, investment grade corporate bonds form just over 50% of the portfolio. High yield bond valuations are not overly enticing on the whole, and high yield forms 30% of the fund. This is only slightly above the 20% minimum that must be held in high yield corporate bonds in order for the Fund to qualify for the IMA UK Other Bond sector.

Equity exposure stands at just over 10%, and I expect to build this up closer to the maximum 20% limit as opportunities become available. Equity markets still look relatively cheap versus bond markets (and very cheap versus high yield bonds). The equity holdings in the fund are all where a company’s earnings yield looks very attractive versus that company’s bond yield. Equity selection is made in close consultation with M&G’s Equity fund managers and analysts, particularly with the Global Equity team.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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