7th December 2012
The bond market is undoubtedly nearing the end of decade-long bull market, writes Cherry Reynard, but few have been willing to predict its immediate reversal. Might 2013 be the year? Certainly, a number of factors are conspiring to make further gains look unlikely.
The first is its astonishing performance in 2012 – the average fund in the sterling high yield sector has risen 19.1% this year; and even in the steady-as-she-goes sterling corporate bond sector, the average fund is up 14.9%. That is an unusual return profile for the bond markets and history would suggest that the best year may be behind them.
Then there is the gilt problem. Gilt yields are at historically low levels, with many UK government bonds providing a negative real return. The selling point for corporate bonds used to be that spreads over government bonds were wide, but this year has seen that margin of safety eroded. Valuations and yield levels across the bond market now look anything but compelling. Equally, there are growing concerns about liquidity, with net issuance falling.
Anyone with a choice is avoiding fixed interest. Gilts and developed market government bonds are almost entirely friendless with diversification their only real selling point. For example, David Coombs, head of multi-asset investment at Rathbone, says: "Gilts have little intrinsic value these days, but they can offer protection against falling equity markets. Furthermore, low nominal spreads look very vulnerable. We favour exposure to gilts in the long duration space, which tend to have a lower correlation to equities, and thus provide us with a good diversifier."
Johanna Kyrklund, Schroders’ Head of Multi-Asset Investments, agrees: "We would argue that bonds only merit inclusion in portfolios due to their diversifying characteristics and we increased our allocations to equities in 2012."
Mark Burgess, Chief Investment Officer, Threadneedle says: “In fixed income, we continue to question the appeal of so-called safe haven core government bonds such as UK gilts and German bunds. Yields remain at historically low levels (and are particularly unattractive in real terms) and the risk of capital losses down the road is significant. The US Treasury market faces similar concerns, although the continuation of QE by the Fed means that yields are unlikely to balloon in the short term."
The rest of the market – such as investment grade corporate bonds – may find more supporters, but many asset allocators are sceptical that there is any long-term value. Robert Talbut, chief investment officer of RLAM concludes: “Corporate bonds have performed extremely well and while still delivering reasonable returns, cannot repeat recent years’ experience."
So for those who – for reasons of income or stability – have to invest in bonds, is there any part of the bond market that may be strong in 2013? Burgess says: "Higher-yielding areas of fixed income such as emerging market debt and high yield look more appealing, although strong returns over 2012 to date and significant spread tightening mean it is much more difficult to make a strong valuation case for these sectors than it was a year ago."
A recent survey by Fitch ratings showed that 39% of fixed income investors believe developed markets sovereign bonds are the asset class with the worst prospects. In a sign of the extent to which investors are re-embracing risk, investment grade financials and emerging market corporate debt – very much a new asset class – are emerging as favourites. High yield also continues to be favoured, despite its strong run this year.
The last word should perhaps go to one of the best bond fund managers in the country Richard Woolnough of M&G. There have been some worries over liquidity in bond markets and the larger bond houses – of which M&G is undoubtedly one – have been seen as vulnerable. He issued this quasi-defence on his Bond Vigilantes website: "It has been a great few months for corporate bond issuance….This huge flush of new transactions where buyer (investor) meets seller (issuer), shows that the primary market is in a historically healthy state, with buckets of liquidity. However, since the credit crunch there has been a great deal of discussion re the corporate bond market becoming less liquid, as dealers’ ability to bid for bonds has gone down the pan. Which is right?
After some discussion he eventually concludes: "It appears that daily volume of primary markets is at record levels, while secondary market liquidity has not grown in line with the size of the market place, but is not as low as a simple analysis of dealer inventory would imply….The total liquidity of all transactions, both primary and secondary, indicates a growing, interesting market place as banks are being replaced by the corporate bond market as the funding vehicle of choice."
After a strong run, the bond market certainly doesn't offer compelling valuation, but investors can generate a decent yield from some parts of the bond market and, for the time being at least, no significant back-up in yields is predicted. The real question for investors is whether they might find better value elsewhere.
Next week Cherry considers the prospects for equities.