Artemis Strategic Bond Fund update

Source for all information: Artemis as at 31 December 2023, unless otherwise stated.

• A pivot by the US central bank triggered a powerful rally across bond markets.
• With a return of 7.9% over the quarter, the fund fully participated in the rally.
• We retain our bias towards high-quality corporate and government bonds.

A change in tone by the US Federal Reserve triggered a powerful rally in bond markets

Government bonds started the quarter in volatile but range-bound fashion, as they had been since the summer. From November, however, prices moved strongly higher, pushing yields down. On the credit side it was a tale of two halves: a weak start to the quarter was soon forgotten as spreads tightened into the year end.

The main reason for the change was a shift in tone – and in guidance – from the US Federal Reserve. The Fed’s rate-setting committee made significant changes to its ‘dot plot’ forecast, which indicates its best guess as to the future path of the federal funds rate. It removed the final hike from its 2023 guidance and indicated there would be three rate cuts in 2024. This was a far more accommodative stance than the market consensus had been expecting.

Even as bond markets rallied investors expected some form of ‘push back’ from Jerome Powell. But none came. His press conference lacked any hawkish messaging to counteract the extraordinary rally unfolding in US Treasury market. And while Mr Powell tried to provide a more nuanced outlook by suggesting that the Fed could still hike if it needed to, his comments seemed to provide confirmation that the hiking cycle was almost over and that the next move in the policy rate would be lower.

In the UK, meanwhile, the Bank of England did attempt to temper market expectations of near-term rate cuts – but the market paid little heed and gilt yields pushed lower. For its part, the ECB tried to push back against expectations of easing in the near term but that messaging was undercut by a more supportive announcement on quantitative tightening, which

will be less aggressive than consensus had expected. European semi-core and peripheral bond markets reacted strongly, with the spread between Italian and German yields tightening aggressively on the news.

Weaker economic data supported the bond rally

While economic data releases played a secondary role to central-bank announcements and press conferences, they largely pointed in the same dovish direction: the general trend was for weaker economic activity across the UK and EU, although US remains impressively resilient.

The standout release was in the UK, where inflation data catalysed the surge lower in gilt yields. Headline inflation fell to 3.9% in November versus expectations of 4.3%. Core inflation also surprised significantly to the downside, coming in at 5.1% versus expectations of 5.6%. While these figures were above the Bank of England’s target, the significant undershoot relative to expectations and the widening gap versus its forecasts provided further support to the rally. With the narrative that inflation would prove to be ‘sticky’ increasingly being called into question and with economic activity slowing, the MPC began look at risk of being wrongfooted. The market’s interpretation, which we tend to share, is that it might be forced to stage a sharp retreat from its ‘higher for longer’ rhetoric.

The rally was universal, swift and significant – and our fund participated fully…

Moves across fixed-income markets during Q4 were swift and significant. The yield on 10-year UK gilts fell by 79 basis points over the quarter, with US Treasuries and German Bunds also registering impressive rallies. Gains were led by longer-maturity bonds as investors re-assessed where interest rates might settle now that we’ve moved from a tightening regime to one of monetary easing. And while shorter-dated bonds also rallied aggressively, they underperformed longer-maturity instruments.

With a return of 7.9%, the fund fully participated in the rally, thereby building on its strong performance record relative to its peers since the new management team was appointed in September 2021.

Fund performance relative to major peers

Performance since September 2021

In part, the outperformance it generated over the quarter was a reward for our decision to increase the fund’s duration through the later summer and into the autumn. From being net short at the start of 2022, the fund’s government bond allocation was contributing two-and-a-half to three years in terms of duration by time the powerful rally took hold in early November. In October, for example, we took advantage of a volatile market backdrop to add duration, increasing the fund’s exposure to long-dated gilts after a meaningful sell-off had propelled yields to historically elevated levels. As a result, our allocation to government bonds rose and the fund enjoyed strong returns from its holdings in UK, US and New Zealand government bonds.

A new addition to the team

This quarter saw Liam O’Donnell joining Artemis from Abrdn to take the lead on the government bond and macro components of Artemis’ fixed-income strategies.

Liam managed government bond strategies at SLI/Aberdeen and was also a co-manager of their strategic bond fund for over five years. So he has experience of co-managing a strategic bond fund in collaboration with credit specialists. He also has direct experience of working alongside two of our team; David Ennett and Jack Holmes both worked with Liam at SLI for a number of years. Following Liam’s appointment, management of the Artemis Strategic Bond Fund is now divided between three fixed-income specialists:

Liam brings his expertise in managing sovereign debt.
Grace Le brings a wealth of experience in investment-grade credit.
David Ennett is responsible for the fund’s high-yield allocation.

The fund’s current positioning: focusing on high quality credit and government bonds

Activity and positioning 

We took a tactical decision to reduce the fund’s duration as 2023 drew to a close

Given the size of the moves seen in December, it seemed prudent to reduce the fund’s duration into the end of the year. So, in final week of 2023, we reduced the fund’s duration by 0.4 years, selling a mixture of 10-year futures in the UK and France. We also sold some long-dated gilts.

We are conscious that an increase in bond supplies could be a headwind in the first quarter of 2024. Europe tends to frontload issuance towards the start of the calendar year. The UK will also need to tap the Gilt market to meet its funding needs in the early part of the year. At the same time, there must be a risk that the Bank of Japan does something to unsettle markets. Japanese investors have hitherto been strong buyers of EU fixed income assets so any change by the BoJ that makes owning domestic assets more attractive could put European bond markets under pressure. So setting the portfolio up in anticipation of increased supply and potential for hawkish noises from the Fed (or other central banks) made sense.

In investment-grade markets, we remained active in relative value trades throughout the quarter

The fund remains positioned with a relatively defensive blend of fixed-income assets. We still like credit risk although we are currently positioning it towards the higher quality end of the ratings spectrum, where spread compensation and all-in yields remain attractive.

In investment-grade credit markets, the fund took advantage of steeper credit curves in October to rotate from shorter- to longer-dated bonds, where the yield and spread pick-up was attractive in names such as Deutsche Bank and Blackstone Property. (We subsequently reversed the relative value trade in Deutsche after it worked in our favour, moving from the 2030 bond back into its 2024 bond).

Following the strong rally in government bond markets, we rotated the fund’s legacy Legal & General bonds into a more on-the-run bond. Following the rally, their cash price had approached the regulatory par call which gave them little upside.

We also switched from a euro-denominated Ford bond to a sterling-denominated issue, following outperformance by the former. (It’s worth noting that Ford was upgraded to investment-grade during the quarter.)

We were also busy with capital-structure switches. For example, we moved from a subordinated Barclays bond into a new senior bond, which we believed had been priced attractively in the primary market. The result was to de-risk the fund in exchange for a very modest sacrifice in yield.

We added a number of names to the portfolio’s high-yield allocation

Our allocation to high-yield is currently modest by historic standards but we think the short-dated, higher-quality end of the high-yield credit market is extremely compelling from a risk/reward point of view. Our holdings in high yield are overwhelmingly BB-rated credits along with some B-rated debt.

These included high-yield holdings in Allwyn, the operator of several national lottery systems in the US and Europe (including the UK following its recent purchase of Camelot). We like the high margins and low levels of cyclicality of lottery operators, as opposed to casino or other forms of gaming. Allwyn’s BB-minus rated 2029 bonds yield a 7.27% once hedged to sterling which we believe is highly attractive given the stability of the business.

Elsewhere, we took small positions in:

UK homebuilder Miller Homes;
Battery maker Energizer; and
Global beverage can maker Ardagh Metal Packaging.

Our theme has been to add exposure to attractively priced high-yield bonds where we can see sound earnings profiles with limited and/or manageable cyclicality in earnings.

On the sales side, we sold our position in UK North Sea energy producer Ithaca Energy. This was after a strong period of outperformance which left the balance between risk and reward less compelling. We are mindful of mounting regulatory uncertainty around North Sea operators. We reduced our holding in Israeli energy producer Energian and exited our exposure to information storage provider Iron Mountain.

Outlook - The Fed’s pivot may have structurally shifted demand for bonds

It is hard to overstate the significance of the Fed’s fourth-quarter pivot. The dramatic shift in the dot plot for 2024 - and the lack of any real pushback against the market’s dovish interpretation of that shift -represented a seismic change for fixed income as an asset class. The fourth-quarter pivot may well provoke a longer-term shift in investor sentiment that will continue to support the asset class in 2024 and beyond.

The threat of continued tightening meant sentiment towards the bond market has been poor for two years. The Fed’s pivot not only strengthens the case for owning US fixed income, but it should encourage a return to fixed income more generally, as other central banks play catch-up with the Fed.

Clearly, valuations are less attractive after the powerful rally. And we do not have any particular conviction that the Fed will deliver more rate cuts than are currently being priced in for 2024. But focussing on one-year outlook can result in investors missing the wood for the trees. During the last rate-hiking cycle, the Fed’s policy rate peaked at 2.5%. That feels like a reasonable near-term target. Even looking out to Dec 2025, policy rates are priced to be at 3.15%. If that proves accurate, there’s still a lot more room to rally, and remember that’s under a ‘soft landing’ scenario which is far from guaranteed.