Read (pictured) and co-manager Paul Causer have benefited from their high level of exposure to financials in recent years, especially in Europe. They believe this area still has some decent valuation opportunities, but are very cautious in their general outlook.
“I’m not enthusiastic about the prospects for attractive returns in many areas of the bond market and I think income is going to be crucial from here,” Read said.
“I don’t see much value in investment grade, outside some areas of financials. High yield doesn’t seem like it can offer much capital appreciation from here. We’re not holding much of it, excluding financials.”
“I still don’t see significant near-term interest rate rises in the major developed economies. However, that doesn’t mean government bond yields have to stay low.”
“We saw a significant sell-off in these yields in 2013. We could see more of that. And higher core yields will obviously affect the wider market.”
FE data shows that a number of funds in the IMA Strategic Bond, Corporate Bond and UK Gilt sectors suffered significant losses during the “taper tantrum” in May and June of last year. The average Strategic and Corporate Bond funds managed to regain their losses following on from the correction, but UK government bond managers finished the year down more than 5 per cent.
Performance of sectors in 2013
Source: FE Analytics
In spite of the sell-off in gilts, Read remains wary of them in his portfolios and believes further losses could be on the horizon. He says some pockets of value are available in longer-dated securities, though.
“I don’t think the market is cheap,” he said. “It’s reasonable to expect that the medium-term direction for interest rates is still up, and we saw during 2013 the impact rising yields can have.”
“Without much of an income cushion, investors can face negative total returns.”
“But looking across the yield curve, it’s possible we could see opportunities. With credit spreads very tight, the yields on longer-dated core government bonds could look relatively attractive.”
“Peripheral eurozone sovereigns have been a good investment for us in recent months, but the opportunity has reduced there now, I think,” he added.
Read and Causer’s Invesco Perpetual Corporate Bond and Tactical Bond funds have been top quartile performers in their respective IMA sectors since the beginning of 2012. Much of the outperformance has been down to their overweight in financials – they were something of trend setters in this area.
Performance of funds and sectors over 3yrs
Source: FE Analytics
Read says there is less value in financials than there was, but still highlights it as his preferred bond sector.
“We still like some financials, especially legacy subordinated bank debt. Yields have come down a long way in this area – and we’ve benefited greatly from that – but we see this as reasonable, as the risk of these assets has got a lot lower too,” he explained.
“We’re being very choosy on new bank capital instruments. The risks are often very different from legacy bank capital.”
“We’re also holding positions in hybrid securities across financials and non-financials. What we like here is the opportunity to be paid a higher yield in return for subordination risk on balance sheets we think are strong.”
“In the funds where we have the option, we have relatively high exposure to equities and we also hold some convertible bonds in our bond portfolios,” he added.
Causer and Read aren’t the only ones to use equities within their strategic bond portfolios; FE data shows that the likes of Artemis High Income and AXA Framlington Managed Income have in excess of 10 per cent in equities. Invesco Tactical Bond has just over 6 per cent in equities.
Richard Woolnough, who runs the £20bn M&G Optimal Income fund, has recently been selling down his equity position. It has fallen from 11 per cent in 2012 to 5 per cent at the time of writing.
Given Read’s cautious stance, it is hardly surprising that his funds have become more defensive of late, using high levels of cash and quality investment grade bonds to offset riskier areas in financials – especially those exposed to peripheral Europe. Portugal is currently the biggest regional weighting in the Tactical Bond fund, at almost 12 per cent.
As well as helping the fund to protect against the downside and improve liquidity, Read says his high cash weighting – which is currently at 8 per cent in Tactical Bond and 5 per cent in Corporate Bond – will allow him to snap up opportunities when they arise.
“We’re holding significant liquidity across all of our strategies,” he explained. “This lowers our credit and duration risk but it also gives us assets that can be liquidated very easily. So if value opportunities arise, we can move quickly.”
“Being able to supply liquidity to a stressed market means you can potentially drive very hard bargains.”
“Right now, we don’t see a lot of big opportunities and we’ve been trying to manage expectations for the potential for return in this environment. But I’m sure that opportunities will arise and I want to be in a position to take them.”
Stuart Edwards, who runs the Invesco Perpetual Global Bond portfolio, also points to the dollar as a good long-term opportunity. In the short-term, however, he thinks there are risks.
“If I were to point to one opportunity, it could be the dollar, although I think the timeframe is potentially quite long,” he said.
“The cyclical recovery we’re seeing in the US is dollar supportive, potentially sucking in investment from overseas and raising the prospect of US Federal Reserve tightening.”
“But there are also reasons to believe that we could see a secular revaluation of the dollar. Cheaper energy costs are already reducing costs for US industry and could give it a long-term competitive advantage.”
“This, along with greater domestic oil and gas production, would boost the dollar through an improved trade balance.”
Performance of fund and sector over 10yrs
Source: FE Analytics
As well as outperforming since the beginning of 2012 and over a three-year period, Invesco Perpetual Corporate Bond has a strong medium- to long-term track record, beating its IMA Corporate Bond sector average over five and 10 years.
Tactical Bond was only launched in 2010.
Read is by no means the only person cautious on the outlook for bonds at the moment. FE Alpha Manager Marcus Brookes is outright avoiding fixed interest in favour of cash and a higher weighting to equities, while Henderson’s Bill McQuaker sees absolute return and property as attractive alternatives to the asset class.
