Artemis Target Return Bond Fund update

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

Review of the quarter to 30 September 2023

The fund returned 3.9% over the quarter and 8.3% over the year

We believe this fund offers a compelling alternative to short-dated investment-grade corporate bond funds, the current go-to solution for many risk-averse investors.

Our target is to produce a positive return of at least 2.5% above the Bank of England’s base rate, after fees, on an annualised basis (over rolling three-year periods). Over the quarter, hitting that target would have meant generating a return of 1.9%. In the event, the fund actually returned 3.9%, more than double its target.

The fund has returned 13.6% since launch four years ago, outperforming every part of its investable universe

A memorable quarter for the bond market

The bond market enjoyed one of its strongest quarters in over a decade. 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.

Activity on the credit side was modest

As we had been for much of 2023, we were content to sit back and earn the handsome yields on offer in the short-dated credit market. Within that, however, we undertook a number of relative value trades to optimise the balance between risk and reward within the portfolio:

We completed a switch from short-dated hybrids issued by Mobico (formerly National Express) into its longer-dated senior bonds. Both bonds had underperformed with the fall in company’s share price, but Mobico’s longer-dated bond is euro-denominated and had underperformed disproportionately. If the company posts better results going forward (which we believe it will) the upside in both bonds will be similar; if we’re wrong, then the downside in the senior bonds we now own would be substantially lower.

We bought EDF’s hybrid bonds. The problems that weighed on it back in 2022 now appear to have been consigned to the rear-view mirror.

We added some short-dated, higher quality (predominantly BB-rated) positions in the high-yield market that offered attractive yields through to (probable) early calls by their issuers. This is one of the areas in which we see significant value for yield-focused investors today.

In the fund’s rates module, we tactically traded around some of our key positions

We added a short position in Canadian 10-year bonds relative to their US equivalents as Canadian yields squeezed lower, outperforming US rates. We unwound this tactical position following a strong response from US Treasury market to the pivot by the Fed.

We took profits on some (although not all) of our short European and UK inflation positions after a sharp move lower in breakevens.

Heading into the end of the year, we sold duration in UK and Italian 10-year futures as government bond markets continued to rally.

Elsewhere, we bought New Zealand’s inflation-indexed bonds at a real yield of 2.85%, which looks extremely attractive relative to global peers.

Positioning

We expect bonds of every type to perform well in 2024; longer term, the Fed’s pivot will have a lasting influence on bond markets. And the deceleration in UK inflation and wage growth will oblige the Bank of England to reconsider the future path of policy rates.

At the same time, the sharp fall in yields in December was significant. Furthermore, we still expect a glut of supply in the UK and Europe to weigh on markets in early 2024. As a result, we began to reduce the fund’s duration into the end of the year, adding short positions in the last few days in December. Although do not expect yields to return to last year’s highs, the fund’s positioning coming into 2024 was for ‘cheaper and steeper’ (cheaper bonds and steeper yield curves).

We expect yield curves to steepen because bond issuance by sovereigns will, in combination with quantitative tightening, represent a headwind for the longer end of the yield curve at the same time that more dovish policy shift by central banks should support short-dated bonds.

The fund remains overweight US Treasuries versus shorts in European and UK government bonds, where we expect supply to weight more heavily in the early part of the year. We also retain a core short position in 10-year Japanese government bonds.

Outlook

In the current economic environment, short-dated, investment-grade corporate bonds appear to be the natural home for investors seeking a low-beta, cash-plus return. These form the core of the Target Return Bond Fund’s portfolio. But we believe our strategy offers a number of advantages relative to short-dated investment-grade bond funds:

The narrowness of the index means short-dated, investment-grade bond funds tend to be relatively homogeneous and undifferentiated.

Our more flexible approach gives us freedom to invest in other parts of the bond market and has delivered substantially better returns.

Since launching the fund, we have, for example, invested in short-dated US Tips and short-dated index-linked gilts; we also run yield curve steepeners (and flatteners).

Taking advantage of that flexibility has seen our fund delivering substantially better returns than short-dated investment-grade bond funds since its launch four years ago.