You can’t have missed the final curtain calls for corporate and government bonds in recent months. Overpriced, overbought, and soon to fall victim to deliberately-induced rises in interest rates and consumer prices as the spectre of deflation stalks the Western world. Who’d be a bond buyer now?
Well, quite a few of our expert panel would, it seems. Never the sort to follow the herd blindly, they have some interesting thoughts to offer on how we should differentiate between different offerings.
Many thanks to our panel:
- Chris Hiorns, Fund Manager at Ecclesiastical Investment Management
- Alan Wilde, Head of Fixed Income (Global) and Ece Ugurtas, Head of Fixed Income (Specialist) at Barings
- Tom Elliott, International Investment Strategistat deVere Group
- Dawn Kendall, Senior Bond Strategist, Investec Wealth & Investment
- Adrian Hull, fixed income product specialist at Kames Capital
- Michael Stanes, Investment Director at Heartwood Investment Management
1) Hesitant equity markets have seen yields on major government benchmark bonds generally tightening during the last 18 months. But the last month has seen erratic behaviour from both gilts and treasuries. Is this due to political instability, or to insecurity in equity markets, or to some more fundamental reason?
Chris Hiorns, Ecclesiastical Investment Management
There are various reasons for the fall in government bond yields over the past couple of months.; Geopolitical instability (particularly Ukraine), slowdown in growth expectations, particularly in Europe, and inflation figures consistently coming in below expectations. UK growth remains fairly robust, and the Bank of England continues to signal that investors should expect a rate rise in the near future. To the extent that the fall in the gilt yields has been driven by investor ‘risk aversion’ and a flight to quality, one would normally expect to see gilt yields move up as geopolitical events such as Ukraine subside.
But the UK does not exist in a vacuum, and we are likely to import deflation from the Eurozone. Both growth and inflation in the Eurozone are coming below expectations, and pressure for the ECB to engage in meaningful QE is intense. In this environment ten year bond yields have fallen to record lows of only 90bps. This means that whilst UK gilt yields may have fallen sharply over the last couple of months the spread between gilt and bunds is now wider than it has been in more than a decade.
Dawn Kendall, Investec Wealth & Investment
There have been a number of reasons for the heightened volatility in the bond markets since July. Peripheral Europe was impacted by the issues of governance at Espirito Santo in Portugal, but essentially this is a local affair. Phones 4 U bond holders were confronted with the grim truth regarding leveraged debt positions created to pay down Private Equity investors. We now face the end of QE in the US. And finally, the departure of Bill Gross from the world’s largest bond manager, PIMCO.
Alan Wilde, Barings
Bond yields rose sharply following the “taper tantrum” in May 2013 but have remained relatively stable for the last 12 months. German bunds have recently touched their low yields again below 1%. While peripheral European bond spreads (to bunds) are tighter than before the financial crisis.
Risk assets have also performed well – equities; EM Debt and High Yield credit. Indeed, until recently, measures of volatility have been at record lows – suggesting markets have become if anything, a little complacent.
Michael Stanes, Heartwood Investment Management
Greater confidence in the US economic recovery has shifted the market’s perceptions of Federal Reserve interest rates. US growth rebounded in the second quarter with signs that the recovery is broadening. Tapering of quantitative easing likely to end in October and the next stage of the Fed tightening cycle is likely to be the implementation of the first rate hike. Central banks will adjust policy very slowly, but the risks are increasing that the Fed moves before the Bank of England.
Tom Elliott, deVere Group
A combination of the end of QE, weak global growth data of late, stretched valuation in some IT stocks (eg the Rocket IPO), and now fears that redemptions out of PIMCO’s Total Return Fund could lead to forced selling in some illiquid FI markets, are all reasons for market nervousness.
Adrian Hull, Kames Capital
Without wishing to sound anodyne, it is partly all of the above. Certainly, there was relief in £ markets that the Scottish referendum was emphatically a “no” – but there continues to be global uncertainty. The Middle East and Ukraine worry investors but more immediately lower commodity prices are pushing for a stronger $ and inflation and wage growth remains muted in the US – and the UK. And it seems that the US is more “taper” comfortable than it was in 2013 and the fact that 5y yields are unchanged in the US year to date bears this out .
2) High yield and emerging market paper have held up noticeably well in the last year, as investors have sought refuge from poor cash rates on their savings. Can the trend hold if interest rates should rise, as they almost certainly will?
Ece Ugurtas, Head of Fixed Income (Specialist) at Barings
Within global high yield, the combination of sound fundamentals, manageable leverage and upcoming maturity profiles, an attractive risk premium over US Treasuries especially following the recent market weakness, as well as low default rates should all provide a degree of cushioning as unconventional monetary policy is withdrawn.
The US monetary outlook will continue to affect emerging market bonds and currencies, and we cannot rule out further weakness in the short term. We are selective in our exposure to emerging markets, preferring countries with strong fundamentals such as Mexico, where we also have supportive structural reform. Valuations within emerging market debt remain attractive compared to developed bond markets and there are some interesting opportunities for currency appreciation. We believe that any weakness caused by the uncertainty in the US monetary outlook is likely to be short lived.
Adrian Hull, Kames Capital
It is not that rates can go up but the speed with which they increase that is likely to undermine confidence– and market expectations are still that rates will remain at historically lower levels for a while to come yet. There has been some nervousness in HY in September but the back up in yields has cheapened US HY bonds by more than 100bps since June – so we still think that the carry dynamic will remain strong.
Chris Hiorns, Ecclesiastical Investment Management
In terms of corporate bonds, whilst there seems little scope for further tightening in credit spreads which are already at their lowest level since the credit crisis, but with most corporate balance sheets relatively strong, issuance levels relatively low and demand strong, I can’t see that spreads will widen much in the short term.
The UK corporate bond market is seen as ‘cheap’ relative to Europe, which is why more and more issuance is going on in Euros and dollars rather than sterling. So that is going to drive downward pressure on spreads as well.
Dawn Kendall, Senior Bond Strategist, Investec Wealth & Investment
High Yield was looking very fully valued at the beginning of the summer, but with yields now at 6.20% that is ample compensation for the amount of risk we are taking on sub 2% default rates.
Michael Stanes, Heartwood Investment Management
Both asset classes might be vulnerable to investor outflows. That said, relative to other fixed income sectors, high yield bonds tend to perform better in a stronger economy. Companies have also refinanced debt, which is maintaining a low default rate. Emerging market debt (US dollar-denominated) is underpinned by a larger institutional-investor base where flows are likely to be more stable. Fundamentally, many countries have reduced their external debt burdens and are better protected in a rising US treasury environment.
Tom Elliott, deVere Group
Unlikely, given the widespread fear of lack of liquidity in the credit marketplace.
3) There are still many investors who need the security of fixed interest but who worry about the capital implications of rising yields. How can an advisor best resolve these conflicting factors?
Chris Hiorns, Ecclesiastical Investment Management
If you are nervous of rising yields, naturally you want to shorten the duration of your fixed interest portfolio – and, with gilt yields this low and corporate credit spreads this tight, that makes some sense. But you will lose a lot in yield if you shorten the duration too much – and whilst I am slightly shortening the duration of my fixed interest portfolios and increasing liquidity, I am still maintaining exposure across the curve- especially when I feel I can get a reasonably large pick up in yield from what I consider to be a good credit.
And I would not just want to rely on fixed interest investments for security. You can buy a basket of high quality ‘blue chip’ equities offering more attractive yields than the bond market. So I would want some exposure there as well.
Alan Wilde, Barings
Well, the most obvious form of protection from higher yields would be to hedge the interest rate risk and just run with credit risk (of the underlying borrower). But in a low yield environment that is not going to generate very high returns and may still result in capital erosion. The wider the Fixed Income universe, the more likely that a resourceful manager can find combinations of bonds across credit quality, region and currency that enhance returns.
A Strategic Bond Fund for example, can derive alpha from asset allocation decisions. Now that major central banks are running desynchronised monetary policy, there will be great opportunities for this type of product to add value.
Tom Elliott, deVere Group
There is always a role for fixed interest in a balanced portfolio, to help manage volatility. Short duration USD-denominated funds are probably the answer during the upward swing of the US rate cycle.
Adrian Hull, Kames Capital
It may be that a peer rather than a benchmark mandate is better suited and funds that are proactive in asset allocation work better – strategic bonds funds may make more sense where you can proactively manage risk.
For those that are really concerned about higher rates, absolute return products work well.
Dawn Kendall, Investec Wealth & Investment
The answer is to focus on floating rate investments that give the best of both worlds. Higher up the capital structure in terms of protection from bankruptcy over equities but also variable rate of interest to protect against rising yields. These invests come with caveats, caps and floors may temper the direct relationship between rates and yield somewhat, but they do allow the client to flex the income higher as rates rise.
Michael Stanes, Heartwood Investment Management
Fixed income investors tend to maintain a short duration profile in a rising yield environment. However, selectively, investors might take advantage of steep yield curve opportunities in markets where rates are rising. That means overweighting intermediate- or longer-dated maturities relative to the front end of the curve. Potentially, investors would be appropriately positioned to benefit from shorter rates moving higher relative to longer-dated maturities. Outside of the government sector, higher quality investment-grade corporate bonds might also provide stable yield opportunities.
