Carmignac P. Flexible Bond: Letter from the Fund Managers

Inflation once again reached record highs around the world, prompting central bankers to further tighten monetary policy by enacting steep rate hikes. In the US in particular, inflation is being driven by enduring factors such as higher rents and wages, at a time when the US job market is running hot. The US Federal Reserve has responded by picking up the pace of its policy tightening with a 75 bp rate hike in June – the biggest such move since 1994. In Europe, however, inflation is mainly the result of soaring energy prices, although it now seems that the price appreciation has spread to all segments of the economy, including wages and services. All of the world’s main central banks – apart from a handful of exceptions, such as Japan – have either started lifting their policy rates or announced they will soon, in order to tighten lending conditions and slow consumer-price growth. This has had a dramatic effect on bond markets: yields and credit spreads have jumped, resulting in losses across all market segments.

We adjusted our asset allocation in Q2 in response to the changing market climate.

• We substantially reduced the portfolio’s modified duration. Rates are moving higher as a result of the monetary policy tightening being carried out in response to inflation. We now have a negative modified duration on core rates, achieved by concentrating our short positions on the short-dated segments of the European and US yield curves and on Japanese yields. In the last two weeks of the quarter, bond markets began pricing in fewer expected rate hikes – for instance 8 hikes by the ECB in 2022 rather than 11. But we believe the revised figures are too low given the persistent nature of today’s inflation. We also have net short positions on Italian, Spanish, and French rates. We increased our exposure to inflation breakeven rates in EUR and USD, following the severe correction on these instruments, as discussed above.

• We increased our credit-market exposure by 10%. With the steep rise in credit spreads, valuations have returned to particularly attractive levels. The market dislocation may be costly but it’s also throwing up opportunities. We reinforced our positions on the strongest convictions in our portfolio, and especially on European financial debt (whose spreads have moved in the opposite direction as those on peripheral debt), on certain high-yield and EM issuers, and on CLOs (which are appealing in terms of both the returns they offer and their hedging role). But given the extremely high volatility and the ongoing uncertainty on both the economic and geopolitical fronts, we decided to keep a substantial level of protection (around 23%, consisting of CDSs) on our exposure to corporate and EM debt.

We believe that inflation will remain strong. It may have peaked in the US (with Europe soon to follow), but inflation readings will likely plateau at elevated levels. That means central banks will have to continue with their policy tightening and thus create a further drag on the economy. We doubt they’ll put an end to the rate hikes anytime soon – and they may even step up the pace in the near term, backed by new instruments designed to contain the rise in the spreads of the most fragile issuers. We’re therefore keeping our modified duration very low and have a bearish outlook on the assets most vulnerable to the withdrawal of monetary stimulus.

Our portfolio remains centred on our three main themes, which offer attractive valuations and solid fundamentals even in this turbulent climate: corporate bonds issued by companies linked to commodities and energy prices; subordinated debt; and EM debt. Around 14% of our portfolio consists of cash and money-market instruments, and we have credit protection (CDSs) in place in order to mitigate the impact of market downturns and enable us to invest in future performance drivers should the market dislocations get worse, creating new opportunities in the process.