Central bankers across the developed world have kept interest rates at extremely low levels to help reflate their economies in the aftermath of the global financial crash and to try to avoid the risk of a crippling deflationary spiral.While a number of industry experts believe that interest rates will have to stay lower for longer to support the economic recovery, Hodges – manager of the £1.9bn L&G Dynamic Bond fund – says that investors need to move earlier to make sure their capital is protected by funds that are going short duration and using interest rate swaps.
“Five years will feel like a long time for some investors and in many ways it is. UK interest rates have never stayed so low for so long. But five years is not forever. There was a before and there will be an after,” Hodges said.
“I don’t expect UK interest rates to rise in 2014, since relatively low wages are reducing upward pressure on rates. The tactical opportunity for bond buyers is now, however.”
There are many experts that take a different view to Hodges.
The majority of them point to the fact that because inflation is still muted (just 2 per cent here in the UK) and is expected to remain so for some time to come, there will be no need for the authorities to hike interest rates because otherwise it would just kill off the recovery.
Performance of index over 1yr
Source: FE Analytics
For example, Fidelity’s Trevor Greetham recently told FE Trustnet that the developed markets are going through a disinflationary recovery as there is still a huge amount of spare capacity in the economy.
As a result, he estimates that the global economy can grow by 3 per cent before inflation is triggered.
Hodges agrees that the chance of an interest rate hike over the next 12 months is very unlikely, however he warns investors not to leave it too late to protect themselves as it will be very difficult to time the market.
“It’s cheaper to buy an umbrella when the sun is shining and it is more effective to buy protection against rising rates now than when they actually start to move and volatility picks up,” Hodges explained.
His thoughts are echoed by Investec’s Alastair Mundy, who told FE Trustnet last year that central banks such as the Fed are playing a dangerous game by telling the market it can control the outcome of such low interest rates and quantitative easing.
“In a desperate desire to avoid deflation, central banks may well inject so much into the system that avoiding longer term inflation will be very hard. My worry is that central banks will discover fine-tuning their policies more difficult than they believe,” Mundy said.
JOHCM’s Christopher Lees also warned investors last year that they cannot just rely on the forward guidance of central bankers.
"I do think 2014 will be categorised by vicious volatility," he added.
"What I would say to anyone who doesn’t agree is, remember 1994 when Alan Greenspan unexpectedly hiked interest rates, which led to a bond massacre? We think that is what will happen in 2014," Lees said.
"The US is slowly, slowly recovering, and we think it is coming."
In order to protect his investors from the threat of a possible rate hike, Hodges is keeping duration extremely short and is also building in defence via interest rate swaps.
“There are a host of instruments available to manage the short- and long term risks inherent to bond investing,” he said.
“It’s too simple just to talk about buying short-duration instruments. For example, I have been very active in the interest rate market so far this year compared with 2013. Last year I kept the duration of the fund relatively low to minimise interest rate volatility, but now it’s been brought close to zero in part by using interest rate swaps.”
“I currently have around 30 per cent of the fund invested in shorter-dated assets, which should mature over the next three years, by which time we expect to be able to reinvest at higher rates, and in the meantime these assets earn the fund an attractive yield.”
Hodges launched the L&G Dynamic Bond fund in April 2007.
According to FE Analytics, it is the second best-performing portfolio in the IMA Sterling Strategic Bond sector over that time, with returns of 76.46 per cent.
The only portfolio to beat it has been FE Alpha Manager Richard Woolnough’s highly popular M&G Optimal Income fund.
Performance of fund vs sector since Apr 2007
Source: FE Analytics
L&G Dynamic Bond has also beaten the sector over one and five year periods, although it has underperformed over three years. This is primarily due to the fund’s losses of 3.38 per cent in 2011.
The fund is made up of 255 holdings. It has a high headline yield of 5 per cent, which is supported by the fact that Hodges has more than half of his portfolio in high yield corporate bonds, which also helps keep his duration low.
The manager also has 30 per cent exposure to investment grade credit (both financial and non-financial) and a further 10 per cent in government bonds – however he is running a number of short positions in the sovereign debt market.
L&G Dynamic Bond has an ongoing charges figure (OCF) of 1.43 per cent and requires a minimum investment of £500.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.
