Having reached very expensive levels, prices of 10-year government bonds fell dramatically in May last year as Fed chairman Ben Bernanke warned the market that he was considering tapering quantitative easing in the US.
Performance of indices in 2013
Source: FE Analytics
Bond-holders were hit by capital losses and many have been moving into either bond-proxy style assets or just increasing their equity exposure.
However, Pattullo and Barnard, managers of the £1bn Henderson Strategic Bond fund, say that investors are mistaken if they think government bonds and investment grade credit have lost their ability to hedge risk.
“This year has been a classic year when equities have fallen and bonds have rallied hugely,” Bernard said. “I’m amazed at how short people’s memories are and that based on last years’ experience they are forgetting the value of bonds as a diversifier.”
FE Analytics data shows that traditional fixed income assets, such as 10-year gilts, have performed very well so far this year, while, due to concerns surrounding emerging markets and investors wishing to take profits, equities have largely underperformed.
Performance of indices in 2014
Source: FE Analytics
Pattullo and Barnard say this highlights the naivety of many investors’ portfolio positioning.
“Last year gilts were awful, they were down 5 per cent. However, last year was the year to be bearish on bonds, not this year. In January, everyone hated bonds and loved equities. As a result, positioning was extreme,” Pattullo said.
Bernard adds it is no real surprise that a lot of investors have lost money so far in 2014 because the market had become too negative and complacent on fixed income.
“Some of the bearishness on bonds got a bit hysterical last year,” Barnard (pictured) said.
“Some of the headlines were suggesting that bonds would drop 50 per cent, but in a world of no inflation, how are you going to get that?”
The managers think that, like fellow FE Alpha Manager Iain Stewart, fixed income can once again act as a hedge.
They say that last year was a real anomaly because not only were yields extraordinarily low at below 2 per cent, but the catalyst for the sell-off in the asset class was due to the reduction of stimulus.
Pattullo and Barnard admit that gilts were more attractive at the start of the year when they were yielding 3 per cent.
However, 10-year gilts currently yield 2.75 per cent and the managers say that at that price – with interest rates set to remain lower for longer and with inflation subdued – they can still act as a hedge for investors.
“From these yield levels, yes, they are a hedge. They weren’t last year because they were too expensive,” Pattullo said.
Barnard added: “If you are talking about things like geo-political risk, that’s an absolutely classic example of when government bonds are going to provide you with a hedge.”
“Last year it was about Fed tapering, so it was a bond issue whereas most of the time you get risk-off whether it’s peripheral Europe or emerging markets.”
“It’s just last year was quite an unusual year.”
The managers also point out that the likelihood of QE tapering – which started at the very end of last year – causing another dramatic spike in yields is very low as the government bond market has already priced in a further reduction of stimulus.
Pattullo and Barnard have managed the Henderson Strategic Bond fund together since January 2006.
The fund has been a top-quartile performer in the IMA Sterling Strategic Bond sector over that time with returns of 53.68 per cent.
Performance of fund vs sector since Jan 2006
Source: FE Analytics
It has also beaten the sector over seven and five years, although it has underperformed over three years due to its bottom-quartile losses in 2011.
It has, however, since bounced back and outperformed in 2013 when yields spiked. It has also beaten the sector so far in 2014.
The managers say the positioning of their fund has changed recently as they are finding better opportunities in longer duration debt and better quality credit.
“I’d say we were more long duration over short duration, but it is more balanced now after the recent run,” Barnard said.
“Investment grade, instead of high yield, is much more interesting than it was last year.”
“I would say that our high yield exposure has probably peaked and I would expect our holding to come down over the next 12 months or so. We are aware that the majority of the rally is behind us and we are looking for opportunities in investment grade due to where government bonds are.”
A number of managers, such as Hermes’ Fraser Lundie, have warned that there is valuation risk in the high yield market.
Lundie warns investors that the market has never been more consensual as everyone is buying up lowly rated credit for excess carry and short duration bonds to protect against interest rate movements.
Pattullo also says that investors could even be rewarded if they are willing to buy into longer rated, often better quality, bonds.
“The yield curve is very, very steep,” he said. “You can still lend long and make money from it, so to speak. If rates were to come up, the front end of the curve could also come up, which would mean you are losing money in short bonds. Long bonds may, or may not, be a relative safe haven in that scenario.”
He added: “That’s what we have been thinking about recently as there isn’t much growth or inflation.”
The Henderson Strategic Bond fund requires a minimum investment of £1,000 and its clean share class has an ongoing charges figure of 0.72 per cent.
It is yielding 5.8 per cent.
