12th July 2013
The great bond bull market appears finally to be at an end. For the many, many investors who have directed money towards fixed interest over the past five years – and have been substantially rewarded for doing so – is it now time for a strategic exit? Is this the start of a long, slow grind lower for bond markets in which investors should aim to play no part asks investment journalist Cherry Reynard.
This is likely to be a vitally important asset allocation decision. Bill McQuaker, head of multi-asset at Henderson Global Investors says making the right call on fixed income could potentially be more important in terms of asset allocation than equity or sector positioning within multi-asset portfolios.
This New York Times article cites Vanguard research that says investors should expect their core bond portfolios to earn no more than 2% a year for the next decade and that the risk of ‘a negative annual bond return over the next several years is elevated.’ The trouble is that if bonds drop significantly, investors will take a long time to make their money back, unlike in equities, when it can be made back sometimes as quickly as it is lost.
McQuaker says: “For some time, we have been assessing the potential vulnerability of our portfolios if the outlook for rates changes dramatically. If the world economy continues to heal – as we think it will – we think that bonds will have less appeal than they have had in the past. If a substantial weight of money begins rapidly to exit the bond markets, liquidity issues could resurface.”
This has been a lurking problem for some bond funds. There are concerns that liquidity in corporate bond markets is drying up, leaving larger funds facing a liquidity crisis if flows start to reverse something we have discussed in detail on Mindful Money.
This paints a bleak picture for bond investors. However, there are those who argue that the outlook for bonds is not quite as bleak as billed and that economic recovery is by no means assured as Chinese growth continues to be revised lower. Equally, it should be said that there are no signs of imminent interest rate rises in developed market economies outside the US and some – Japan, Europe – are still loosening their monetary policy.
However, in terms of risk reward, the upside for bonds looks limited and the downside quite severe, so is there really any reason to hold them? Yes, argues David Coombs, who manages the Rathbone Multi-Asset Portfolios: ““In an environment in which investors can lose money in bond markets, should we be abandoning bonds and switching everything into equities? Absolutely not.”
He believes that there are still opportunities in a rising yield environment: “It’s more about how investors use bonds in their portfolios,” he says. “You might still achieve a positive return, but importantly, bonds remain a crucial tool in managing risk. And amid the recent furore surrounding outflows, it’s important not to forget this.”
He is investing in macro bond funds, which can switch between the three main risks: liquidity risk, credit risk and interest rate risk: “This means they are less directional and have the potential to make money in down markets.” Coombs points to the F&C Macro Global Bond, the Ignis Absolute Return Government Bond Fund, and the JP Morgan Income Opportunity Fund. “All of these funds can short or zero weight these risks in a more efficient manner than a plain vanilla, long-only bond fund.” McQuaker, for his part, is investing in corporate bond funds with short maturities and flexible mandates, and avoiding conventional gilts and US treasuries.
Of course, as markets fall, it creates opportunities. Tentatively a number of managers have been moving back into high yield debt, for example, after the asset class sold off in the first half of the year. Jim Leaviss, head of retail fixed income at M&G, for example, has shifted back into the asset class in his Global Macro Bond fund after valuations became more compelling following the sell-off.
He argues that the biggest risk area is emerging market debt. Emerging market debt has been a significant beneficiary of US quantitative easing. A lot of liquidity created by QE has been directed towards emerging debt markets. Leaviss adds: “There have already been some big sell-offs in these markets as foreign capital has started to come out again.”
While a wholesale move out of bonds seems premature, there are areas about which investors need to be extremely wary. Government debt – both emerging and developed – still looks vulnerable as quantitative easing in the US is pared back. Bond investors may get away with it, and see a smaller, but consistent, return over the next ten years. However, the real question is whether there is better value elsewhere and it is difficult to argue that investors shouldn’t look further afield for better risk-adjusted returns.