Artemis Strategic Bond Fund update

Source for all information: Artemis as at 31 December 2024, unless otherwise stated.

Performance

The fund fell by 1.0% over the quarter, slightly more than the average decline of 0.6% in its IA peer group. Over the year as a whole, however, it returned 5.2% ahead of an average return of 4.4% from its peers. 

Overview - A challenging quarter for bond markets 

Bond markets sold off aggressively in the final quarter of 2024, despite the fact that central banks continued to lower policy rates. Having kicked off its rate-cutting cycle in September with a jumbo 50-basis-point cut, the US Federal Reserve proceeded to deliver another two 25-basis-point cuts over the quarter. The Bank of England, meanwhile, lowered policy rates by 25 basis points and the European Central Bank took rates 50 basis points lower. Despite these cuts, government bond yields moved sharply higher as markets recalibrated their expectations for rates and inflation in 2025 and beyond.

The bulk of the fund’s underperformance came in October, which brought a violent re-pricing across government bond markets. Rising yields made it a challenging month for the fund’s relative returns given our long-duration stance that point.

The initial trigger for the rise in yields was a US payrolls report released as October began. It showed that job creation had unexpectedly accelerated in September. There were also significant upwards revisions to earlier estimates of the number of jobs the US economy created over the summer. Those downbeat estimates had played a key role in encouraging the Fed to cut rates aggressively in September. Rather than weakening, the US jobs market suddenly appeared to be in rude health.

That economic growth continued to beat expectations and polling data pointing to a victory for President Trump increased the upward pressure on yields. The first Trump administration was characterized by policies that are likely to fuel inflation: tariffs, trade wars and unfunded tax cuts. Understandably, the combination of inflation worries, higher funding requirements and increasing bond supplies did not sit well with the bond market.

Bonds were on the back foot again in December, with the US Treasury market leading the sell-off going into the year end. Although the Fed cut rates again, the hawkish tone of the communications accompanying the cut left investors questioning whether this rate-cutting cycle might be over. Powell acknowledge that the decision to cut was “a close call” and that rates were “significantly closer to neutral”. He was also clear that the Fed would need to see signs of deterioration in the economic data before cutting again. The ‘dot plot’, which shows the path members of the Fed’s rate-setting committee expect interest rates to follow, also came as a hawkish surprise. It suggested that there could be as few as two rate cuts in 2025.

As yields on government bonds moved higher, credit spreads tightened as investors were drawn in by the attractive all-in yields. The combination of strong demand and dwindling supply created a powerful technical set up for credit markets heading into the end of the year. The real estate sector and subordinated financials performing particularly well. In this environment the fund benefitted from its exposure to the likes of Blackstone Property and CPI Property Group, as well as its subordinated bank holdings such as NatWest.

The clear highlight of the fourth quarter on the credit side was our holding in Annington, which owns housing units offered to married members of the UK armed forces. The Ministry of Defence bought those houses back for £6 billion. Annington announced it would use the sale proceeds to start buying back its bonds at generous levels.

Activity

Government bonds (16% of the fund)

At the start of the quarter, the fund’s duration was six years. As yields moved higher in the early part of October, we added duration, buying 10-year Canadian futures. Our expectation was that the Bank of Canada would ease monetary stance because the country is at a different stage of the business cycle to the US. This took the fund’s duration up to 6.3 years.

The trigger for us to push the fund’s duration significantly lower were the surprises contained in the UK Budget. Counter to our expectations, Chancellor Reeves delivered significant fiscal easing through additional unfunded spending commitments that will, in turn, see a significant increase in gilt issuance. This was new information for us so, along with the growing threat of a similarly expansionary fiscal policy in the US under President Trump, we reduced duration back to 5.5 years towards the end of October.

For the remainder of the quarter, we kept the fund’s duration closer to ‘neutral’ while trading tactically in response to extreme moves higher and lower in yields. So, when yields rose following the US election, we added duration, buying New Zealand real yields and US real yields which had risen substantially. The threat of tariffs in US and rate cuts in New Zealand increased our conviction in both assets. President Trump’s victory deepened our conviction that there is greater value in US real yields versus European real yields, so we added a new position in 10-year real US yields versus Europe.

We increased duration from less than 6 years at the start of December to 6.5 years mid-month. This tracked the move higher in yields, which peaked on 19 December. This benefitted the fund as the last week of 2024 saw bond yields moving lower again. We then reduced duration again going into the year end as yields fell.

In addition to managing the fund’s duration, we sought to generate returns through implementing tactical cross-market trades. In November, for example, we made money by being short in Japan vs. New Zealand and short in France vs. Canada.

With yields on government bonds having moved higher across the board, valuations are compelling. Equally, there is a clear threat that yields will move higher again for as long as governments remained committed to fiscal easing. We have added steepening risk to the portfolio and believe 2025 will see yield curves steepening globally.

By the end of the quarter, the key positions in our government bond portfolio were:

• Long at the short end of the yield curve in the UK and the US (two-to-five-year rates)
• Long in US inflation
• Short in long-dated bonds in both US and the Eurozone (30-year rates)

Investment-grade (50% of the fund)

We remain positive on credit spreads given the resilience of consumers and corporates (particularly when compared to the tricky positions many sovereign borrowers find themselves in). This fundamental strength is complemented by a supportive technical setup: higher all-in yields are pulling more demand into credit markets.

Over the quarter, we added to holdings such as TP ICAP, which benefits of volatility government bond markets, and Whitbread, which continues to deliver strong results. We also participated in new issuance from German lender Bayerische Landesbank.

The fund rotated into a number of holdings that had lagged. We sold the likes of ING and Commerzbank and rotated into Zurich. We rotated from Coventry Building Society into Barclays, and from MetLife into New York Life.

We also continued to make a number of relative-value switches within companies’ capital structures. For example, we switched from AA’s 2029 bonds into bonds due to mature in 2028.

High-yield (31% of the fund)

We bought newly issued bonds from Belron, a windscreen-repair business that operates globally and which trades as Autoglass in the UK. The windscreen-repair business, in which Belron is the global leader, exhibits low levels of cyclicality and high margins. Pricing is being supported by the increasingly complex nature of modern windscreens, which incorporate a wide range of technologies including assisted-driving sensors. Belron typifies what we are looking for in a high-yield bond issuer: a resilient business model, high cashflows and structural growth.

We also bought newly issued bonds from German pet care retailer Fressnapf and non-opioid pain medication specialist Gruenenthal. In the case of Fressnapf, the pet care sector displays remarkable resilience. It will use the proceeds of the bond issue to fund its acquisition of Italian pet care chain Arcaplanet. We view this as a value-creating transaction.

We added a position to InPost, the delivery services company whose core offering consists of convenient lockers and deliveries to corner stores. It continues to gain market share. Online retailers appreciate the lower cost of non-doorstep delivery solutions and consumers value the convenience of localised pick-ups and drop-offs.

We added some exposure to the US retail sector, where valuations reflect an excessive degree of pessimism towards US consumers. To this end, we added Crocs and, at the other end of the fashion spectrum, Victoria’s Secret. We added to an existing position in Gap following encouraging results and bought into US grocer Albertsons following the collapse of its proposed merger with Kroger.

We added some exposure to two auto parts companies: Forvia and Schaeffler. There has been concern regarding the outlook for the auto sector, some of it justified. We share some of these concerns and so reduced the fund’s exposure to the autos industry in the summer. We remain highly cautious on the outlook for OEMs (the car manufacturers) as well as for regional and smaller players. In our view, however, bonds issued by strong, well-positioned, highly cash-generative companies were unfairly caught up in the wider sell off. In Forvia and Schaeffler we have global tier 1 suppliers who are not overly exposed to any one market or car maker.

We took advantage of market dislocations in December to switch between different bonds issued by car rental giant Avis. By switching out of its US dollar bond and into a euro-denominated bond we increased our spread from +235bps to +315bps without assuming any more credit risk. Such discrepancies often open up in global high yield; our active approach seeks to exploit them.

Offsetting these additions, we trimmed a few positions where the upside had become limited. These included UK financial advice consolidator True Potential, US medical products maker Medline and French frozen grocery chain Picard.

We exited our position in European lottery operator Allwyn. It is experiencing ongoing issues in its recently acquired UK lottery business, which is misfiring just as regulatory pressures on its cash returns are about to bite. We still admire the bulk of Allwyn’s business and will likely revisit it should a more compelling valuation opportunity arise.

We exited our holdings in European car park operator, Q-Park, US fast food franchise operator, Restaurant Brands International and wheelchair maker Sunrise Medical on valuation grounds. We sold positions in US Reit, Medical Properties Trust, and global auction house, Sotheby’s. We see better risk/reward elsewhere.

Outlook: Our clear preference is to own short-dated bonds and credit

The first quarter of 2025 should see continued heavy supply of government bonds. Unless economic activity deteriorates meaningfully, we expect longer term bond yields to continue to drift higher given record levels of issuance. The greatest risk for fixed income lies in governments’ record funding requirements. Debt-to-GDP ratios have exploded post Covid and, while consumers and corporates appear to be resilient to higher interest rates, governments do not. Rising bond yields at a time when sentiment remains weak raise the danger that this becomes a systemic problem. We are alert to the possibility that government bond markets experience another Truss-like moment at some point in 2025.

While sentiment is poor, valuations have improved significantly. Very little easing in monetary policy is now priced in even though the majority of central banks are indicating their belief that interest rates need to move lower. The US Federal Reserve maintains a view that the long-term ‘neutral’ level for interest rates is around 3% but market pricing currently shows interest rates settling at 100 basis points higher than that. In the UK, Governor Bailey recently suggested that 100 basis points of cuts in 2025 wouldn’t be too much. The market, however, is currently pricing in just 50 basis points of cuts.

The market is currently focusing on what the second Trump administration will mean for US growth and inflation and reading that across to other developed economies. In our view, this is the wrong approach. The market seems to believe that fiscal policy under President Trump will mirror that of 2016-20. President Trump has inherited a completely different economic setup to the one he was presented with in 2016. Then, the US budget deficit was 3% and inflation was less than 2%. Today, however, the US budget deficit is running at 6% and inflation is uncomfortably high (and looks to have been a key voting issue for Republicans).

The balance between risk and reward at the short end of the yield curve looks appealing. With five-year US Treasury yields standing at around 4.4% at a time when policy rates stand at 4.375% and the Fed views the ‘neutral’ rate of interest as 3%, this part of the US yield curve appears appealing. We take a similar view in the UK, where markets are pricing terminal rates of 4%. This leads us to focus on short-maturity instruments, which are far more closely anchored to expectations for monetary policy than longer-dated bonds.