1st August 2013
It was only a matter of time before the great bond bubble – like any other investment bubble – burst writes investment journalist Tony Levene.
Now it has finally exploded in the retail investor space with the Investment Management Association, the trade body for unit trusts, reporting the largest ever bond fund sales redemptions in in June as holders cashed in £624m worth – with the vast majority switching to equity funds which took in £884m over the month. It is unlikely that July figures, due at the end of August, will look significantly different.
And a major upwards revision on Wednesday of US gross domestic product figures by the US Bureau of Economic Analysis, adding 3.6% to the US economy also suggested the recession was not as deep as imagined. This could fuel equities further, bringing the moment when interest rates start to rise again – bad news for bond holders – somewhat closer.
Private investors are not the only ones to exit. Institutions also hit the sell button. Morningstar European Research analyst Ali Masarwah says: “Bond fund investors grew nervous in June as the U.S. Federal Reserve said it would taper purchases in its quantitative easing programme. 10-year German government bonds went from 1.21% on May 1 to 1.81% on June 24. The exodus from bonds in Europe mirrored the United States in relative terms. Outflows from bond funds in Europe were 1.75% of beginning assets, whereas in the U.S. the figure was 1.88%.”
For many months, those without a direct interest in advocating “fixed income” assets, had warned yields across the bond spectrum from the highest rated sovereign debt to junk, had become unsustainable. Pushed by regulators to upgrade balance sheets, pension funds, banks and insurers chased bond prices up (and yields down) on top quality assets to the level where they were guaranteed losses.
The signs were clear. Figures from FE Trustnet show sterling corporate bonds – the most popular fixed income sector – grew just 1% over the past six months, fell 3.5% over three months and only managed a weak 1.7% recovery over the past month despite June’s equity sell-off. This compares with a five year 37.8% gain. The sterling high yield sector was up 52.8% over five years, the six month figure was just 1.6% while over three months, the bonds showed a 1% loss.
Contrast this with UK equity all companies where one year shows a 27% gain, six months 10%, three months 5.4% and one month 6.2%. And for those much maligned – by bond managers – investors who held the faith with equities over the five years since the economic crisis, the UK mainstream equity index gained 53.3% over the period – in line with sterling high yield and way ahead of the safer sterling corporate bond sector.
Jason Hollands at BestInvest says: “The news from the IMA that fixed income funds saw record redemptions in June does not surprise as we have been warning for some months over the growing risks in fixed income and the absence of fundamental value across much of the market.
“Quantitative Easing” and its huge bond buying programmes by central banks is to blame as this severely distorted prices in large parts of the fixed income market, so many bonds look simply aren’t attractive once inflation is factored in.
“In particular, developed market government bonds, index linked bonds and investment grade corporate bonds look vulnerable as and when the markets finally decide that “QE” will come to an end. Investors are therefore right to wake up to the fact that so-called “low risk” bonds will generate capital losses at some point.”
Aviva Investors head of multi-asset retail funds Peter Fitzgerald says the data makes it clear that the current level of interest rates and bond yields is low on both an absolute and relative basis.
“Moody’s Baa (a mid range rating) corporate bond yields, for example, have declined from over 13% in the mid-1980s to below 5% today. In addition to this, these yields were consistently higher than equity market earnings yields until the last couple of years. If you look at the ratio of bond-to-stock yields, the normal figure since 1985 has been 1.4 times, whereas today it is much lower, at around 0.8 times.”
He warns: “Few investors will disagree that current interest rates and bond yields are low, but there are those who seek to justify current valuations and do so by arguing that the spread over government bonds makes them attractive. I disagree. Government bond markets have been manipulated and rates are artificially low. The problem that should concern every investor is what would happen to their portfolio if bond markets were to sell off or interest rates were to rise.”
But Adrian Lowcock, Senior Investment Manager at Hargreaves Lansdown does not believe the bond story is over. He says: “In June we saw all asset classes fall as investors took fright from Ben Bernanke’s comments the US will begin to taper QE. Bond yields rose as prices fell and for the first time in a long while investors experienced a loss on their fixed income investments. Bond markets recovered quickly having initially overreacted to Bernanke’s comments. One month’s data is not enough to decide whether investors are now in redemption mode from Corporate Bonds or if this was a knee-jerk reaction.
“The rate of QE might slow down in the US but has been expanded significantly in Japan. Monetary policy is likely to remain loose for some time yet and the yields on cash low. This puts a ceiling on how far bond yields can rise.”
He adds: “It has become more difficult to make money in bonds; however investors can still access attractive yields of around 4%-5%. There will be a time to sell out of bonds, but we don’t think this is it yet. Investors looking for fixed income exposure should consider strategic bond managers who are able to invest across the whole of the bond market and make tactical short term investment decisions to profit from periods of volatility.”
And what about buying when everyone else is heading for the exit? Across the Atlantic, star bond fund manager Kathleen Gaffney of the Eaton Vance bond fund believes her ‘greed’ for more from bonds will beat the current market ‘fear’. Although she has not had much luck since launching this fund in January – it’s down around 5% – she is adamant that sticking to her guns will prove right.
Her view is that in the indiscriminate sell off, credit risk — junk bonds — have been hammered as spooked investors have sold. While the US 10 year benchmark Treasury is up nearly one percentage point since early May, junk yields had even bigger price-eroding moves up, forcing yields to rise back to the point where they are once again looking enticing as the gap between Treasuries and junk widens.
Many UK advisers caution against a zero bond weighting in portfolios – if only to diversify. If online self-selecting polls have any credence, just under half of IFAs believe the FTSE100 index will hit 7,000 within six months. But it’s a yes-no question with no way of knowing how many of those who are less optimistic would forecast a fall to 6,000 or below if they could.
Meanwhile for investors wanting exposure to bond funds, here is Bestinvest’s pick of the bunch. These are funds where managers have a high degree of flexibility: Kames Strategic Bond, Legal & General Dynamic Bond, M&G Optimal Income and TwentyFour Dynamic Bond.
It also rates AXA Global High Income as high yield bonds offer more attractive yields which should be less exposed to changes in interest rate expectations but not immune from any future turmoil.