High prices and low yields across government and corporate debt markets have caused a real issue for cautious investors, with the majority of market commentators stating that yields can only rise from their current levels. Brain (pictured), who manages the Newton Global Dynamic Bond fund, agrees that yields will inevitably go up from here and as a result says bond investors cannot expect the high returns that they have seen in the past.
However, he does not buy into the doomsday scenario many experts are forecasting.
"We are in a rising yield environment," Brain explained.
"We aren’t in a rising interest rate environment yet, but while interest rates won’t change for a while, I do expect yields to back up. In this sort of situation, bond managers have to tell their investors that returns will be less than expected."
Quantitative easing has been one of the principal drivers of falling yields in recent years, which has led a number of experts to raise concerns that a bubble is developing in the asset class. If such a bubble were to burst, the effect on bonds – which have historically been regarded as a relatively safe area of investment – could be catastrophic.
However, Brain says that there is still demand for fixed income and that the bond bubble argument is therefore flawed.
"I think the demand for fixed income is pretty understandable and there is a good rationale behind it," he said. "You aren’t getting anything from cash so there is still money coming out of money market funds into bonds."
"However, in terms of a bubble, I think this is where we have to be careful."
"The idea of a bubble is that it can deflate very quickly, however if you were to buy bonds now you won’t lose everything. It’s not like if you buy equities or commodities, as you will still see a source of income."
"Over the longer term, pension funds still need fixed income so they aren’t going to step away from the asset class. On top of that, I don’t expect interest rates to go up any time soon, because the authorities know it is still a fragile recovery," he added.
Brain also says that central banks such as the Fed will not hesitate to step in with more stimulus measures to prevent out-of-control bond yields, because rates on US Treasuries are directly linked to mortgage rates.
Brain has managed the £903m Newton Global Dynamic Bond fund – which sits in the IMA Targeted Absolute Return sector – since its launch in April 2006.
The fund, which aims to beat the LIBOR GBP 1m index plus 2 per cent, has made a positive return in every calendar year since its inception, except for 2011, where the Newton portfolio lost 0.13 per cent.
According to FE Analytics, this has resulted in cumulative returns of 53.35 per cent since the fund’s launch in April 2006.
Performance of fund since April 2006
Source: FE Analytics
To deliver an absolute return strategy, Brain says he focuses purely on fixed interest instruments.
"The way we continue to manage the fund is by investing across the major fixed income asset classes, be it traditional global government bonds, emerging market sovereigns, corporate high yield or investment grade," he said.
"We have a broad universe to pick and choose from and so we don’t have to follow an index. By mixing these asset classes together, we can effectively create an absolute return strategy," he added.
Brain maintains a low-duration portfolio to protect his investors from rising bond yields. The fund’s largest weighting is in AAA credit, making up 27.5 per cent. It also has a meaningful position in high yield.
Although he does take short positions in the fund to reduce overall volatility, Brain says that he cannot over-use them because the cost has a real impact on an investor’s returns.
"We do use other trading techniques. These are very simple, such as selling bond futures or using put options or negative duration. We currently have a 15 per cent short on US Treasuries and we also uses floating rate notes and credit default swaps to keep the portfolio protected," he added.
"You can take more short positions, but the cost of shorting can really eat into returns. For instance, if nothing happens to bond yields or they go down further from here, then we would lose 3 per cent."
"There is the ability to make money from the short side, but otherwise we have a number of positions in high yield because they still give you a good level of income," he added.
One of his short positions is on German Bund yields. He expects them to rise as he thinks European economic data will surprise on the upside.
Newton Global Dynamic Bond has an ongoing charges figure (OCF) of 0.99 per cent and requires a minimum investment of £1,000.
