After an extended bull run in fixed income assets such as sovereign debt and corporate credit, bond-holders have had a much more difficult time of it this year, with the major indices delivering negative or flat returns over the past 12 months.
Performance of indices in 2013
Source: FE Analytics
Yields have been steadily rising throughout 2013 as the market's monetary policy has been expected to normalise, and with the news today that the Fed has started to “taper” QE by $10bn a month, experts believe that 2014 will be no different.
With that in mind, the experts give FE Trustnet a round-up of their predictions for the bond market in 2014 and reveal where investors will be able to find opportunities.
Corporate bonds
Enzo Puntillo, who manages the JB Total Return Bond fund, says that although the outlook is poor for corporate credit, bond investors can still make moves to protect their capital from higher yields and therefore falling prices.
Puntillo says that the anticipation of continued tapering will uncover areas of opportunity, one of which will be in convertible bonds.
A convertible is a bond issued by a company, usually a bank, which could be turned into equity at certain points in its existence. Typically, that would be because the price of its shares has fallen beyond a certain level at which the company would need to raise capital.
Old Mutual’s Christine Johnson recently told FE Trustnet that convertible bonds are now much more attractive than they have been in the past, as not only can you receive a coupon of around 7 per cent, but as the regulators are forcing the banks to maintain capital ratios, the chances of the bonds turning into equity are very low.
Alex McKnight, who runs GAM Star Global Convertible Bond, says that while convertibles have had a good run of late due to their popularity, he expects them to continue to outperform their traditional revivals.
“2013 was the first year since the global financial crisis in which convertibles have notably outperformed plain vanilla credit,” McKnight said.
“We also saw a pickup in new bond issuance, driven by strong equity markets and rising yields, making it more attractive for corporates to issue convertibles instead of straight debt.”
“While an obvious contributor to outperformance was strong equity markets, the real differentiating factor was the about-turn in the interest rate environment.”
“This is a change that is set to continue, and with that we expect both continuing growth in issuance and outperformance from the asset class.”
Gilts
Gilts have been very popular with risk-averse investors over the last two decades, however falling prices have meant many have been hit with capital losses over the last year.
However, John McNeil, fixed income manager at Kames Capital, says that concerns about rising yields have gone too far.
He says that as the Bank of England will keep interest rates low to keep the housing market recovery going, yields of gilts will only rise gently over the coming 12 months.
“Short-dated yields are likely to remain at very low levels for the foreseeable future. Two-year yields have been no higher than 0.69 per cent since October 2011,” he said.
“If economic data continues to improve, five-year and 10-year yields will tend to move higher; however, there is a natural limit to how far this move can go if two-year yields don’t move very much.”
“In fact the current gap between two-year gilt yields and five-year gilt yields of 1.2 per cent would be considered wide relative to the history of this spread. The gap between two-year gilt yields and 10-year gilt yields is around 2.4 per cent.”
“Again this is relatively wide relative to its history and the widest this spread has ever been in recent history is around 3 per cent.
The manager says that pension funds have an inherent need for gilts so there will be constant demand for them, which will keep yields range-bound.
“Longer-dated gilt yields will be supported by continued life and pension fund demand, as mature pension schemes seek to better match their assets and liabilities,” McNeil said.
McNeil admits that this year has been a particularly difficult one for gilt-holders, as most have been hit by capital losses for the first time in four years. However, he says that 2014 should be slightly better.
“This is the first negative total return on all-stock gilts since 2009. Since 1986 there have not been two successive years of negative returns for all-stock gilts. This is not a prediction for 2014, merely an observation that a further negative total return year would be historically unusual,” he added.
Emerging market debt
Like other bond sectors, 2013 has been a very difficult year for investors in emerging market debt.
Prices have dropped significantly since tapering was first mentioned back in May, with the majority of emerging market debt funds seeing capital losses and huge amounts of outflows.
Performance of funds over 1yr
Source: FE Analytics
One of the worst-hit portfolios was the Investec Emerging Market Local Currency Debt fund, which stood at £2.3bn in May, but had shrunk to £1.3bn at the last count.
Alessandro Ghidini, manager of the JB Emerging Markets Inflation Linked Bond fund, says that next year will also be volatile, so investors need to be selective.
“Uncertainty surrounding the timing and magnitude of the shift in US monetary policy will keep volatility at high levels in emerging markets in 2014,” Ghidini said.
“This will open interesting opportunities to take strategic exposure to hard emerging market currency bonds, whose fundamentals remain generally very solid, with prices already starting to show material value.”
“In the local currency space, more selectivity will be needed, and countries with a high dependency on foreign capital to finance their current account deficits should be avoided,” he added.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.
