As the low interest rate environment recedes, Cherry Reynard asks bond fund managers how they are positioning for the new world.
For an area that is supposed to be the stable asset, ballast for a portfolio, fixed income has looked pretty rocky in 2018. Ten-year gilt yields have been as low as 1.15% and as high as 1.7%. The corporate bond market has bounced around with increasing unpredictability. If investors needed reminding that this is a new environment for bonds after a lengthy bull run, the past 12 months have provided ample proof.
Every bond sector is down since the start of the year. Hardest hit were emerging markets bonds, as might be expected given the volatility in Argentina and Turkey, but the sterling corporate bond and strategic bond sectors were almost as weak. Bonds have failed to provide protection from falling stock markets, which should be a concern for investors who look to them to provide stability.
It is clear that this is a different climate – one that is not usually favourable to fixed income. Interest rates are rising – three times in the US and twice in the UK over 2018. The quantitative easing (QE) programmes that have kept government bond yields low, and therefore prices high, are drawing to a close. The US and UK central banks have already stopped theirs, while the European Central Bank will stop at the end of 2018. Only Japan’s programme trudges on, but that is now the exception rather than the rule.
Ariel Bezalel, manager of the Jupiter Strategic Bond fund, says: “The major central banks are taking away the punchbowl. At the beginning of 2018, everyone was talking about global synchronised growth. It was rubbish! The punchbowl of quantitative easing was pushing up asset prices, but the structural problems that were there in 2007/08 remain. Today, world debt sits at three times global GDP.” In fixed income markets, this means more work for less return.
That is the big picture for the bond market. However, as John Husselbee, head of multi-asset at Liontrust, observes, “we are believers in diversification. Holding no exposure to an individual asset would undermine the concept of diversification, so we continue to hold bonds selectively.”
That means selectivity both on the managers used and on the type of fixed income. Kelly Prior, investment manager at BMO Global Asset Management, says: “Many fund managers who have launched in the past decade have only managed portfolios in an era of low interest rates. We therefore favour investment managers who may have a more seasoned CV and the flexibility to deliver investment returns in sideways or falling markets. To this end, we like the highly experienced duo David Roberts and Phil Milburn in the driving seat of the Liontrust Strategic Bond fund.
“We have also had a preference to invest away from conventional corporate bond managers in recent years, and into more specialist areas of the market where we believe the risk/reward balance is better. Vehicles such as the TwentyFour Income fund have provided us with diversified income through owning asset-backed securities, an area unloved by mainstream investors since the financial crisis.”
The type of fixed income exposure preferred will very much depend on an investor’s view of the outlook for the global economy. If it is positive, then an allocation to higher-risk corporate bonds would be more appropriate; if it is negative, then an investor might look for an allocation to high-quality corporate bonds or those issued by developed market governments. However, deciding which view to take isn’t easy: opinions on the outlook for the global economy are wildly diverse.
Bezalel, for example, is gloomy, even for a bond manager: “We are as bearish as we have been in the last decade. That means a higher weighting in government bonds. The average credit rating on our corporate bonds has moved up from BB on average to A today.” He also points out that there are still ageing populations in most major economies, which will act as a brake on economic growth.
Corporate debt also troubles him. He says: “Corporates are reacting to financial engineering, issuing huge amounts of debt and using them to buy back shares. That has huge ramifications for productivity. It has been poor for some time and this makes it worse.” He paints a difficult scenario while liquidity is taken out of the system, volatility increases, exchange traded funds linked to volatility start to destabilise the system, and problems in emerging markets start to mount. At the same time, the US Federal Reserve continues to raise rates, which puts more pressure on emerging markets and further destabilises the system.
So far so gloomy; but Husselbee is more positive. “Interest rates are rising, thanks to improving economic growth. Inflation is increasing even if it is still fairly moderate. There are still places to go in fixed income. We favour higher-yielding corporate bonds. In an environment where the economy is improving, that means fewer companies defaulting on their bonds.”
He says that investors are receiving a higher income for investing in this type of bond, which gives them some protection against any fall in price. He is looking at shorter-duration high yield bonds to reduce his interest rate exposure. BNY Mellon and Kames have funds specialising in this type of bond.
Juliet Schooling Latter of Chelsea Financial Services suggests using AXA Sterling Credit Short Duration or Royal London Global Short Duration High Yield for the same reason: “If conditions deteriorate, these bonds are maturing fast enough that the moment can then be redeployed into higher-yielding opportunities.” Husselbee is also holding some global government bonds, just in case.
Prior sits somewhere in the middle, a reluctant holder of certain parts of the market: “Our outlook for fixed income investments is sanguine in the medium term, but with current high equity market valuations, we are not ready to give up on fixed income at present. However, we recognise most markets are expensive and, where possible, prefer alternative areas to deliver income and diversification in our portfolios.”
These are confusing times. On the one hand the fixed income market still has some important supports. Inflation is a major enemy of bonds because it makes the fixed income they generate progressively less attractive and prompts central banks to raise rates. While there is plenty of concern that Donald Trump’s tax-cut bonanza in the US will give rise to inflation, along with higher oil prices, there has been relatively little evidence of it to date. In most developed markets, inflation is hovering around central bank targets, with little upward pressure. There are still major deflationary elements at work in the global economy, with ageing populations, weak productivity and high debt.
On the other, fixed income markets still look expensive. Inflation or not, interest rates are rising. Quantitative easing, which has provided a ‘dumb’ buyer for certain parts of the bond market, is being withdrawn. It is difficult to see fixed income thriving in this type of environment. Additionally, it may not provide the protection investors seek from falling stock markets.
There are no perfect assets in today’s environment. Nevertheless, stronger fixed income fund managers have managed to protect investors’ capital and it would be a brave investor who abandoned fixed income altogether.
Should you buy the asset?
Most multi-asset managers agree this is not a time to take passive exposure in fixed income. As Kelly Prior says: “More than at any time in the past 10 years, the ‘beta’ of the market looks relatively expensive and clients should be demanding ‘alpha’ from their fund managers.” Beta is the market return, which is what investors receive from a passive fund, while alpha is the return active managers can add over and above that.
That said, John Husselbee holds the Vanguard Global Bond index fund: “We take exposure to global government bonds through this Vanguard fund. In government bonds, the dispersion between returns isn’t high and we need to keep a keen eye on costs. Within government bonds, there is less room to play the opportunity, but elsewhere investors are likely to be better off with active management.”
Emerging market debt
Emerging market debt has been a notable weak spot among bond markets this year. Emerging markets in general have been under pressure from a rising dollar and higher US rates. This has seen the average fund weaken by 3.8% since the start of 2018. The future for emerging market debt funds will depend on whether there is contagion across emerging markets from Argentina and Turkey, and whether the US dollar and interest rates continue to rise. However, valuations are considerably cheaper than they were 12 months ago.
Kelly Prior of BMO says: “On a fundamental basis, we continue to own emerging market debt across our strategies. Economic growth potential is far superior to that of the developed market, and most economies had their own currency crisis as recently as 2014. After the bruising returns of 2018, investors are compensated with a healthy income and potentially attractive entry point.” The team likes specialist groups such as Ashmore. Liontrust’s John Husselbee is also holding emerging market debt in his portfolios for the higher income available.
Meanwhile, Juliet Schooling Latter from Chelsea Financial Services likes Jupiter Strategic Bond fund, which is taking advantage of short duration opportunities in emerging market bonds, investing in bonds maturing as early as January or summer 2019 that have yields of around 8%. “Although risks in emerging markets are high, the manager thinks that the risks are lower given the very short timescales involved,” she explains.