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By Emma Wall| 2-15-2017 9:00 AM

What Does Rising Inflation Mean for Bond Investors?

Bronze Rated M&G bond fund manager Richard Woolnough explains how macro factors such as rising inflation influence his investment process

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Emma Wall: Hello, and welcome to the Morningstar Series 'Why Should You Invest With You?' I am Emma Wall and I am Joined today by Richard Woolnough, Manager of the M&G Optimal Income Fund.

Hi, Richard.

Richard Woolnough: Hi, Emma.

Wall: So, we have today the January inflation figures in the U.K., 1.8%, a little lower than we were expecting, but still an increase on the previous month. Now you unlike some of the fund managers are really impacted, and indeed, guided by the macro economic factors when it comes to investment decisions. So for you, how important is this latest inflation figure?.

Woolnough: I call trends. You are trying to see what's happening next and where markets are going, and it just a signpost. It's a signpost that we're at full employment, it's a signpost that the economy is strong and will probably remain strong, all the way through to still two years before we – Brexit presumably formerly happens. In those two years, we have the benefits of very loose monetary policy set by the Bank of England six months ago.

We have, an exchange rate, that's very, very low that encourages growth and important, inflation, and we have full employment and strong credit growth there, because sales all the general housing market. So it's a signpost that inflation is coming back. The question for me as a fund manager is what's priced into the market and bond yields are still very low in the U.K. and therefore for me, it's a signpost that inflation is picking up and you need to be defensive in terms of taking interest rate views.

Wall: This is not just a U.K. solely phenomenon, is it? We have seen inflation figures in Germany and across the EU and indeed in the U.S. start to pick up. You said it does impact then your asset selection. Does it force you to have to think beyond the sort of obvious picks in this kind of market cycle.

Woolnough: As always, you are always thinking about that where inflation, where growth, where interest rates are going to be. In terms of expanding it out, is trying to work out whether index-linked securities are good value versus government bonds. So back post when the events of the same folded around Brexit. We changed our duration of that portfolio, we had a biased tools, buying index-linked securities because we thought the inflation would pick up and the market hadn't priced that in for some reason, but those markets are now back to fair value.

I think the main thing is just a thinking about where the world economies are going, are they healthy and strong or we're on the precipice of the next recession. I think they are healthy and strong. We're not on the precipice of the next recession and therefore we generally like to take credit risk, because we think recession is unlikely. But we don't want to take lost duration risk because we think that the economy is not as fragile as maybe the market so the central banks think.

Wall: 7.7% return last year for investors, pretty good looking considering how low yields are across the developed world. Outlook for the next 12 months can we expect more of the same or is it a little bit more challenged though?

Woolnough: It's always every year, the good starting point is where the asset class sits and where it yields and in order to add value, to do things of the portfolio, you need horrible thing to hear, you need sort of strange things to happen. If the world was calm and stable, then you can't provide that excessive returns. If the market panics and gets too excited then what we can do is value managers as we can add value by not being there when the markets too excited and getting involved when the markets scared and panicking. So, it depends how the market unfolds, if there are events over the year which calls market to be mispriced then we can add more volume and returns to the portfolio if the market is calm and benign then that is lot harder to add value to the fund.

Wall: And finally, will this higher inflation mean the rate rise in the U.K.?

Woolnough: I'm perpetually surprised about where rates are. I think the Bank of England has got various measures it needs to do first, they have currently been buying back corporate bonds that program is way ahead of schedule and I think that might come to a close soon as the signal maybe we're going to put rates up. So, I think it will be a while before we do that, but they said, what they are going to do because they say what price is going to happen.

So it's very, very hard for them to reverse it. But the data if we just sit here and look to the data, the Bank of England wouldn't be talking what – how are they talking, but when you look forward and they still remain very concerned about the events in two years' time that limits their ability and their approach to put rates up. I personally would, but they've got a more forward thinking job maybe then I have in terms of seeing what happens with Brexit.

Wall: Richard thank you very much.

Woolnough: Thanks very much.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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