Artemis Strategic Bond Fund update

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

The Artemis Strategic Bond Fund’s objective is to provide a combination of income and capital growth over a five-year period. In doing so, it provides investors with exposure to a blend of different types of bonds. The managers dynamically manage this blend, shifting between different areas of the bond market in response to changes in the economy and financial markets. It invests in three broad types of bond:

• Government bonds – These are widely viewed as being among the safest type of bond. The interest rate, or ‘yield’, available here is usually quite low but it has risen significantly over the past two years as investors began to anticipate that interest rates would need to move higher. This pushed their prices lower (bond prices fall when yields rise and vice versa).
• Investment-grade corporate bonds – These are issued by companies with higher credit ratings. These are businesses that independent agencies (such as S&P and Moody’s) consider to be at relatively low risk of defaulting on their debts. They tend to offer a higher yield (rate of interest) than government bonds and changes in this additional yield (the ‘spread’) reflect investors’ changing views on the economy.
• High-yield bonds – These are issued by companies that ratings agencies regard as being at greater risk of defaulting on their debts and which therefor offer a higher yield to compensate for the higher level of risk. Their returns are influenced by investors’ appetite for risk and their views on the economy.  

Performance

For full five-year discrete performance, please see the table below. Please remember that past performance is not a guide to the future.

The exuberance that gripped bond markets in the final weeks of 2023 faded a little in the first quarter of 2024. Towards the end of last year, investors rushed to embrace the idea that the US central bank, the Federal Reserve, was poised to begin cutting interest rates – and that it could make as many as six rate cuts in 2024.

The new year, however, brought a steady succession of strong economic data from the US and more evidence that inflation remained ‘sticky’. The combined effect was to fuel worries that interest rates might need to stay higher for longer than markets had hoped.

So, while conditions were choppy, the overall trend was for yields on government bonds to move higher, pushing their prices lower (when bond prices fall, their yields rise – and vice versa).

While the quarter brought challenging conditions for bond markets, the fund managed to generate a positive return. Helped by strong performance from its holdings in investment-grade and high-yield corporate bonds, the fund returned 1.3% on the quarter, ahead of the 0.9% average return from its peer group, the Investment Association’s Sterling Strategic Bond sector, which acts as a ‘comparator benchmark’ against which the fund’s performance can be compared.   

Changes in the fund

Government bonds (17% of the fund)

After generating strong returns in the fourth quarter of 2023, the fund’s holdings in government bonds showed a modestly negative return in the first quarter of 2024 as markets became less confident that central banks were on the brink of cutting interest rates.

In line with our view that rates had stopped rising and would begin to fall in 2024, we had increased the fund’s duration – its sensitivity to changes in interest rates – as 2023 progressed. That decision was validated in December, when the US central bank signalled that it anticipated cutting rates several times in 2024, provoking a sharp rally in government bond markets. Given the size of the gains we felt it prudent to lock in profits and to reduce the fund’s sensitivity to interest rates as 2023 drew to a close.

That decision to reduce the fund’s duration was rewarded through January and February as government bond prices moved lower. As their prices (and yields) became progressively more attractive, we began to increase the fund’s duration once again. That change of positioning was rewarded in March, when a number of the world’s central banks reaffirmed their intention to cut interest rates, sending government bond prices higher as the end of the quarter approached.

Investment-grade bonds (57% of the fund)

In contrast to the weakness seen in government bond markets, investment-grade corporate bonds proved resilient and the fund enjoyed positive returns here.

In terms of activity, the new issue market began to warm up towards the end of the quarter. We participated in a range of deals, including those from: Virgin Money; Southern Water; Coventry Building Society; Telereal; Anheuser-Busch; Land Securities; KBC; Nestle; Northumbrian Water and Paradigm Housing Association.

Within financials, meanwhile, we added exposure to UBS, Citigroup, and French banking cooperative group, BCFM. We sold positions in Swedbank, Morgan Stanley, and UK specialist lender, Close Brothers, where we had increasing concerns around regulatory scrutiny of its auto-finance activities.

Elsewhere, we reduced the fund’s exposure to bonds from Vodafone and Bayer and sold its holding in US media giant Warner.

In January, we sold some of our holdings in euro-denominated investment-grade bonds and reinvested the proceeds in the sterling-denominated corporate bond market, where we judged valuations to be more attractive.

High yield (27% of the fund)

Our allocation to high-yield bonds is currently low by the historic standards of this fund. We do, however, believe that some parts of the high-yield credit market are extremely compelling. Our holdings here are overwhelmingly BB-rated bonds along with some B-rated bonds (these are bonds that ratings agencies such as S&P and Fitch believe to be at less risk of default than lower-quality CCC-rated bonds).

Within our high-yield allocation, we added to some of our highest-conviction positions:

• Copeland, which derives a predictable income stream from replacing the compressors used in refrigeration and HVAC (heating, ventilation, and air conditioning) applications.
• Albertsons, a US supermarket chain.
• Avis-Budget, the car hire firm.
• Miller Homes, a UK homebuilder.

On the new issue front, we participated in new deals from:

• Sally Holdings, a global distributor of beauty products.
• Kier Group, the UK public sector building contractor.

Outlook

Despite recent signs that inflationary pressures, particularly in the US, might not be fading as quickly as once hoped, our central view remains that interest rates worldwide will begin to move lower in 2024.

If and when they do, then bonds have the potential to deliver handsome capital gains.

But, if we are wrong and central banks don’t start cutting rates, then bondholders can continue to harvest yields from both investment-grade corporate bonds and high-yield bonds that are significantly higher than inflation. We regard this as a ‘win-win’ situation for our fund.