Concerns surrounding the fixed income market have intensified recently. After a prolonged rally in the asset class, yields on sovereign and corporate debt are now sitting at extremely low levels.
With the Fed discussing tapering of its asset-purchasing programme – plus the implications that interest rates can only increase from their ultra-low levels – a number of experts have warned that it is only a matter of time before there is a mass sell-off in bonds.
Data from FE Analytics shows that both the government and corporate bond markets witnessed a sell-off on the back of Ben Bernanke’s comments about the tapering of QE, which has been interpreted as a sign of things to come.
Performance of indices year to date
Source: FE Analytics
Although Wilson, manager of the five crown-rated Newton Managed Income fund, understands why investors are becoming jittery over the future of the bond market, he says the belief that prices can only go one way is wrong.
"I agree with the bond bubble scenario, to an extent," he said.
"We could get a bit of inflation in the short-term, but our view is that we are going to stay in an environment of low growth and low inflation for a while yet. We saw it at the start of the year, there were expectations of inflation, but six weeks later there were worries about deflation."
"Sentiment just keeps shifting."
"Nevertheless, I do sympathise with those who are concerned about a potential bond bubble. Fears such as 'who is going to be the next chairman of the Fed' and 'what impact will rising bond yields have on mortgage rates?' are both valid."
"However, if a bubble were to burst, then bonds probably wouldn’t be the worry – where you wouldn’t want to be is in equities," he added.
Wilson points out that institutional investors such as pension funds have to maintain a certain degree of fixed income exposure for liability reasons. He says that if yields were to rise dramatically, pension funds could well enter the market to capture higher rates of fixed income.
However, the impact of institutional capital is not the only thing that could curtail a bursting bubble: Wilson says that central banks – which own the majority of government bonds – will also have a huge part to play.
"This really is a fear thing," he explained.
"The markets are quite jittery and are always worried about something. I have found that during my career, for every 20 events investors worry about, only one really ever matters. That is because people tend to listen to noise without standing back and looking at the situation."
"If bond yields were to rise to 3 per cent, for instance, that would impact mortgage rates and would impact cheap finance for property and construction."
"It would also impact government finances. They are issuing 10-year gilts at around 2 per cent now, but if they had to issue new gilts at 3 per cent, then that is a 50 per cent increase in government funding costs."
"Conversely, economic stability is quite fragile so if we saw some negative data, the central banks will be very quick to step in with some more quantitative easing," he added.
Wilson also says that because of their stimulus packages, central banks like the Fed already own the majority of the Treasury market. As they have no real need to sell these assets, the impact of a sell-off in the market could be less significant than first thought.
"There isn’t much need for them to sell off their government bonds," he said.
"They are actually sitting on quite a nice profit and I think it is a very valid point that they have no requirement for them to push those securities back into the market. That would mean the proportion of the tradable market would be quite small," he added.
Wilson has managed the £152.8m Newton Managed Income fettered fund of funds since its launch in March 2008.
According to FE Analytics, the fund has been the fifth-best performing portfolio in the IMA Mixed Investment 20%-60% Shares sector over that time, with returns of 50.86 per cent, and has beaten the average fund in the sector by 27.4 percentage points.
Performance of fund vs sector since Mar 2008
Source: FE Analytics
The fund has to maintain a high degree of fixed income exposure due to sector constraints. Our data shows that Wilson holds 40 per cent of the fund’s assets in bonds. However, Newton Managed Income still yields 4.7 per cent.
It has an ongoing charges figure (OCF) of 1.4 per cent and requires a minimum investment of £1,000.
Ben Willis, who is head of research at Whitechurch, admits the outlook for the asset class is not great but says that Wilson’s views on the bond market are justified and that sceptical investors need to put things into perspective.
"There is this argument and it does have a degree of volatility," he said.
"From an investment perspective, gilts do have systemic risk and the risks do only seem to be on the downside and for that reason don’t look attractive. When you think yields used to be 4.5 to 5 per cent and are now 2 to 2.5 per cent, you can see they are overpriced."
"However, pension funds and institutional investors have to hold them for liability-matching reasons. On top of that, the Bank of England doesn’t have to sell them. Clearly yields are under pressure at their current levels, but there isn’t the catalyst for a massive shift to happen," he added.
He says that although his firm is underweight gilts, he has not seen pension funds reduce their exposure to government bonds. He also agrees with Wilson by saying that equities could well be even worse off if the bond market were to correct.
"You’ve seen recently that when volatility picks up, correlation also picks up," Willis said.
He says that pension funds would up their exposure to fixed income if yields were to rise and that could well be at the expense of their equity exposure.
"These pension funds are not looking for sexy high-growth assets. Because of liability matching, they are not looking for anything too risky. If we see yields rising, then pension funds would have to buy them," he added.
