The manager of the £18.5bn M&G Optimal Income fund has made steady returns even as government bond yields have risen, but thinks the asset class’ worst days are behind it regardless.
“There’s not a bond manager in the world that likes bonds – the consensus now is very strong, but you need to stand back and question where we are,” said Woolnough (pictured), speaking at the annual M&G conference in Paris. “In my opinion, we are getting nearer and nearer to an attractive time to be buying bonds. We have been buying more and more and more, and are getting back to neutral.”
“If you look at the 30 year US government bond yield, if it gets to 4.25 per cent then it is a buy for us. When it gets to this point, we believe a bear market for bonds has been completely priced in.”
Thirty-year government bond yields are currently a touch below 3.5 per cent.
Woolnough says that the recent rise in government bond yields has made them the cheapest relative to cash for 15 years, pointing out that he is finding it easier to find attractive real yields.
“With inflation at 2 per cent, a real yield of 4 per cent is very attractive – take Verizon, for example,” he said.
Telecoms company Verizon is currently the largest issuer in M&G Optimal Income, with a total weighting of 3.1 per cent in the portfolio.
The manger says he has been increasing his exposure to long-duration bonds, which he thinks were hit too hard following reports of QE tapering last year.
He has also been increasing his credit risk, arguing that the low default rate cross the bond market has given his portfolio a layer of protection.
“Default numbers of B-rated debt is very low,” he said. “[During the financial crisis] the bond market closed, and since then GDP growth has been very poor. During a period like this you would expect bond defaults to be well above the average of 5 per cent, but that hasn’t happened.”
Woolnough adds that the presence of companies like Blackstone that have been bailing out companies at risk of default has contributed to the lower than expected rate.
Sitting in the IMA Sterling Strategic Bond sector, M&G Optimal Income can hold up to 20 per cent in equities. Woolnough brought up the exposure to as high as 12 per cent in 2012, but says he has brought down that exposure recently because of equities’ strong run, and the more attractive real yields in long-duration debt.
FE data shows that M&G Optimal Income currently has just under 9 per cent in equities.
Head of FE Research Rob Gleeson agrees that bonds are becoming more attractive for investors, but thinks the negative sentiment surrounding them in recent years has been over the top anyway.
“I think the bond bubble argument is yesterday’s news,” said Gleeson. “Yields have only risen 2 per cent, but I think that’s been enough to make them much more attractive.”
“Talk of a bubble in bonds was overstated anyway. People seem to look at bonds in a similar way to how they look at equities, but bonds aren’t going to fall 30 or 40 per cent a year like equities.”
“They are traded in much higher volumes, and are therefore less susceptible to steep declines. Even when they were more expensive 18 months or so ago, I still think they had a place in diversified portfolios, and if you look at how they’ve done since then, many have done well.” “People have been pointing to record low gilt yields and saying bonds can only lose money from here, but there is more than one driver of performance,” Gleeson (pictured) added.
“If you have good credit selection like Richard Woolnough, there’s the opportunity to make money by picking companies with risk that he thinks he’s compensated for.”
Source: FE Analytics
FE data shows that M&G Optimal Income has deliver annualised returns of 8.55 per cent over a three year period. News of QE tapering in the US last year was seen by many as an enemy to bonds, and certain areas of the markets – namely long-dated US debt – saw yields rise considerably; however, Woolnough’s fund still managed returns of 7.26 per cent over the 12 month period.
In cumulative terms, M&G Optimal Income has returned 27.9 per cent, marginally outperforming the FTSE All Share with a significantly lower rate of volatility. The average Sterling Strategic Bond fund has made just over 20 per cent over the period.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
Woolnough argues that the bond market is far bigger than when he started his career, which has enabled him and his rivals to deliver steady returns even as government bond yields have risen.
“The bond market is a very diverse asset class. You can be very risky, investing in high yield, or be much more conservative looking at short-dated bonds,” he said.
“In 2006 when we launched the fund, we built a product that would look across the entire asset class. You forget what it was like in 1995, when most of the market was AAA, AA or A-rated bonds and a little bit of BBB. From here, the high yield market will only get bigger.”
He points to a 100-year bond in EDF energy that he’s recently bought into as an indication of the breadth of opportunities available to him.
“There’s an emotional reaction because it’s such a long time until maturity, but this is another opportunity,” he said.
Gleeson agrees that the opportunities available have become more attractive, pointing out that banks’ unwillingness to lend means that small and medium-sized businesses will continue to rely on bonds for financing.
M&G Optimal Income has clean share class ongoing charges of 0.91 per cent. The fund is currently yielding 2.73 per cent and is a top quartile performer in its IMA Sterling Strategic Bond sector over a one and three year period, and second quartile over five.