12th January 2016
Economists at Royal Bank of Scotland have reportedly warned clients to prepare for a “cataclysmic year” and urged investors to sell.
In a research note published by The Guardian, the team at RBS warn that stocks could fall by up to 20% and oil could slump to $16 a barrel.
The note says: “Sell everything except high quality bonds. This is about return of capital, not return on capital. In a crowded hall, exit doors are small.”
David Smith, fund manager at Hargreaves Lansdown considers what investors should make of the comments…
Government bonds hold little value, unless you believe the sky is about to fall in and we’re heading into a global deflationary spiral, in which case perhaps you should be pleased to get almost nothing in return for lending to governments.
Sterling investment grade corporate bonds offer acceptable but unexciting returns with yields of roughly 3.8% and little capital growth. There are a lot of corporate bonds in issue – most companies have refinanced at relatively low rates – and liquidity has reduced so there is the potential for a crunch if RBS and others succeed in frightening the horses. The default outlook is not particularly scary but there is a ‘mark-to-market’ risk.
Overall, we’re relatively unexcited about the prospects for bond funds from here and so we are defensively positioned within our fixed income portfolios. We maintain a preference for ‘strategic’ funds where managers have more flexibility on how they handle future bond market conditions.
Bond markets – a spectre of risk
Almost seven years have passed since the Bank of England slashed the UK’s base rate to 0.5%. For much of the period since many commentators have called the imminent start of a ‘bear market’ in corporate bonds, yet their prices sit pretty much exactly where they were at the end of 2007.
Bonds issued by the British government (‘gilts’) with 10 years until maturity have a yield of about 1.8%. Given the government aims to devalue the pound in your pocket by 2% per year (via its inflation target), this feels like an offer to lose money over the long term. It can only really sound attractive to people who are afraid of something far worse happening to their capital.
Meanwhile, bonds issued in sterling by quality ‘investment grade’ companies offer yields closer to 3.8%. This is pretty much 2% more than 10-year gilts, and in a world of low inflation, low interest rates and moderate economic growth this looks to be an acceptable if unexciting yield. More enticing yields can be found in areas such as high yield bonds and emerging market debt, but these generally carry extra risks.
The main concerns for corporate bond investors are inflation, interest rates, ‘default’ and their ability to trade when they wish to, the liquidity risk. In the UK at present there is little fear of inflation, with the government’s preferred measure (the Consumer Prices Index, or CPI) marginally negative and few commentators ready to predict notably higher levels anytime soon.
The UK economy, and to a large extent the global economy, remains in recuperation mode following the global financial crisis. Consequently, there is little concern about interest rates rises in the near future either. The market currently suggests there is little more than a 30% chance of any interest rate rise at all in the UK next year (beware, ‘the market’ can be horribly complacent sometimes). Even when interest rates in the UK do start rising, it is likely to be a slow rise rather than any sharp movement upwards.
Company managements have also been given plenty of opportunity to refinance their businesses at relatively low interest rates for many years out into the future. This means the likelihood of these companies failing to pay the interest due on their bonds on time or to repay investors when the bond matures (the risk of default) can also be deemed lower than in the past.
Corporate bond investors, generally, are therefore relatively sanguine about inflation, interest rates and default risks. However, this does not mean risk has vanished.
One area of concern in the corporate bond market is ‘liquidity’, which reflects how easily investors can buy or sell bonds at close to the official quoted price. Companies often have a large number of different bonds trading at any one time. This means trading volumes can be low, which means less liquidity. As demand for income has increased, and private investor demand for corporate bond funds in particular, the ability to trade these corporate bonds has reduced. This is at least partly a result of regulatory changes introduced since the global financial crisis, which reduces the willingness of investment banks to buy corporate bonds should private investors wish to sell. In extreme circumstances, where many investors are selling, it could therefore be difficult for investors to find a buyer resulting in the bid/offer spreads on bonds widening significantly.
Arguably, the higher than usual differential between the yield on corporate bonds and the yield on government bonds (the ‘credit spread’) reflects this concern. That is, investors are paid extra to take this risk. However if liquidity really dries up, and investors can only sell with a high cost, they may quickly conclude the extra yield was not sufficient compensation.
On balance, we view sterling investment grade corporate bond yields as acceptable, but it is increasingly important to have an experienced hand on the tiller. We maintain a preference for ‘strategic’ funds where managers have more flexibility on how they handle future bond market conditions, such as the Jupiter Strategic Bond fund.