Artemis Strategic Bond Fund update

• The fund returned 0.9% over the quarter versus a return of 1.7% from the IA £ Strategic Bond sector*.
• The biggest negative came from our holdings in so-called ‘AT1’ (additional tier one) bonds.
• We believe it is prudent to adopt an increasingly defensive positioning as we move into a ‘late-cycle’ dynamic. 

The first quarter was one of the more challenging periods for the fund since the change of management team in September 2021; the portfolio was not immune to the stresses in the banking sector that appeared in March. 

That fragilities are emerging a year into an aggressive rate-hiking cycle is not surprising. But that they appeared in the banking sector, where fundamentals appeared solid, caught many investors off-guard. 

Our base case remains that the issues faced by a handful of banks over the quarter are not a sign of systemic weakness. We do, however, worry about their potential transmission to the ‘real economy’: the availability of credit will be squeezed (indeed, credit conditions were tightening even before SVB collapsed). More casualties could emerge over time as weaker business models are exposed to a higher interest-rate regime, particularly given our view that central banks will need to keep rates higher for longer to tame inflation.

At a minimum, the banking stress episode that began in mid-March is a reminder that we are moving into a ‘late-cycle’ dynamic. It therefore appears prudent to adopt an increasingly defensive positioning. Accordingly:

• We have gradually transitioned the fund to a lower level of credit risk.  Our largest exposures are currently to investment-grade credit and government bonds (4.5 years of duration contribution combined, split c.50/50). In high-yield credit, our focus is firmly on the high-quality end of the market, particularly on BB-rated issuers (1.0 year of duration contribution). 
• We have nudged the fund’s duration higher. Its headline duration is 5.5 years with our most recent operating range being 5.25-5.75 years.

Chart 1: The fund’s duration has moved higher

Over a volatile quarter, fixed-income markets generated a healthy return

The quarter began on a fairly positive note, with the macroeconomic outlook appearing brighter compared to the gloomy expectations that prevailed towards the end of 2022. Accordingly, credit spreads narrowed through to early March. Yields on developed-market government bonds, meanwhile, initially moved lower only to rise meaningfully again through February into early March as persistent inflationary pressures and firm economic data forced investors to revise up their expectations for ‘terminal’ rates in this cycle. 

However, the banking stresses that emerged in mid-March then triggered a classic ‘risk-off’ reaction: government bonds rallied and credit spreads widened. The net result was that government bond yields ultimately ended the quarter lower. Credit spreads, meanwhile, generally recovered to end the quarter not far from their levels when the year began, helped by the authorities’ swift response to the problems in the financial sector.  In general, fixed-income assets delivered healthy returns for the period despite the elevated volatility. 

Our positions in the government bond allocation provided a useful positive contribution 

Yields on government bonds fell over the period, pushing prices higher. In this environment, our exposures to UK and US government bonds made a useful positive contribution. In our credit allocation, our strongest performers were found among non-financials, for example:

• National Express
• Virgin Media and 
• Warner Bros

all made useful contributions. 

The main detractors were our financial bonds 

The biggest hit came from our holdings in so-called ‘AT1’ (additional tier one) bonds. Also known as contingent convertibles, or ‘Cocos’, bonds like this can be converted into equity or written down entirely if a bank runs into serious trouble or specifically if a bank’s capital ratio slides below a certain level. They emerged following the global financial crisis, born out of regulators’ desire to have a greater quantity and quality of capital held across the banking system.

While our overall exposure to AT1s was modest (c. 3% of the fund in total), our holding in Credit Suisse’s AT1 bonds cost the fund approximately 1.2%. The bonds were written down to zero, smoothing its acquisition by UBS. 

Our view on AT1s is that the facts have changed following the writedowns seen at Credit Suisse. Like us, many investors will be reassessing their holdings and mandates. From this point, the increased risk of writedowns means that a greater risk premium must be attached to AT1s. Overall, we expect the technical backdrop for the AT1 market to remain challenging for some time and so we have been managing down our holdings. They now account for 0% of the fund. 

Activity – Credit

We participated in a number of primary bond issues in the credit market.

These included BB-rated high-yield credits such as Teva (pharmaceuticals) and Adient (auto seats). In the investment-grade space, meanwhile, we subscribed to new issues from BT and BHP. 

We took profits on a few of our investment-grade, non-financial positions. 

Valuations in some quarters had begun to appear a little stretched. So we took profits on GE HealthCare and HCA and trimmed our holdings in Dell and IBM. 

We rotated some of our remaining holdings in bank 'AT1’ bonds into more senior long-dated bonds.  

Examples of purchases included Goldman Sachs and Wells Fargo’s Tier 2 bonds. These had experienced meaningful price falls due to being long-dated exposures. As the sense of panic subsided and bond prices recovered, we managed down our residual holdings of AT1 bonds.

Activity – Government bonds

Holding government bonds is no longer a hazard to your financial health…In fact, we now view them as a compelling diversifier in the context of a broader portfolio.

After their strong relative performance, we rotated our exposure to Australian government bonds into US Treasuries. 

Given the strong performance of our holdings in the UK-inflation linked space (in both short-dated and longer maturities) we took some profits and rotated our holdings. 

We bought bonds towards the front end of the curve in New Zealand which we believed offered relative value. 

Inflation breakevens, in contrast to the situation for much of 2022, are no longer pricing in an excessive inflation premium. This means we can now buy cheap insurance against higher inflation. We therefore initiated positions in longer-dated inflation-linked bonds in Canada and the US. Given the level of real yields available, we now believe these are compelling at current valuations.