The threat of rising interest rates has presented a major quandary for the bond market as many experts have warned the asset class will be hard hit when interest rates inevitably rise. Governor of the Bank of England Mark Carney’s recent speech that hinted rates could rise later this year has added further fuel to the debate. However, FE Alpha Manager duo John Pattullo and Jenna Barnard say investors are overly fixated on the threat and point out that the likely scenario is a gradual rise in rates, which will actually benefit sovereign bonds in the UK.
“Rather than a bear market, we continue to see 2014 as a range trade for 10-year UK and US government bonds,” they said.
Interest rates are expected to peak at 2.5 per cent, the duo says. This, coupled with protracted low inflation, should give the Bank the flexibility to raise rates gradually, which Pattullo and Barnard say is already priced into the market.
Barnard says it matters less that interest rates go up – they inevitably will at some point. Instead the important factor is how they go up relative to expectation.
“If rates peak at 5 to 6 per cent, then we’ve got a problem in the bond market,” Barnard added. “If you think they’re going back to those levels, that’s not priced in.”
However, she says such a rise is highly unlikely.
Inflation fell to 1.5 per cent in May – its lowest level in four and a half years. The managers believe that there isn’t a strong likelihood of a spike, which could cause interest rates to go through the roof.
They expect inflation to look through a potential spike in the oil price as a result of the current turmoil in Iraq, but say the rate could tick-up if genuine wage inflation starts to come through.
The managers believe investors have become too bearish on bonds after the US started to close the tap on its massive quantitative easing programme.
They continue to argue that long-dated gilts in particular still give investors diversification and downside protection, even with the threat of rising interest rates on the horizon, and think there is still money to be made in high yield.
That said, they accept there is “secular stagnation” in the market and returns are likely to be lacklustre for some time as a result.
“For credit investing that’s a good thing,” Pattullo said. “We hate volatility.”
He adds that default rates are unusually low, which makes it much more comfortable to invest in the high yield market, even if yields are lower than they’ve been in the past.
“There are extraordinarily low default rates. I’ve been doing this for 18 years, and [now] it’s almost hard to find a company that’s going to default,” he said. “It’s one of the reasons why you can justify high yield spreads being very tight.”
The pair has been running the Strategic Bond portfolio together since Barnard become a named manager in January 2006. Pattullo has been running the fund for nearly 15 years.
It has been a standout performer over the long and short term, delivering top-quartile returns over 10 years as well as over the last 12 months. It has still outperformed its peers in the IMA Sterling Strategic Bond sector over three and five years, but by a narrower margin.
Over the last 12 months, the fund has gained 8.75 per cent while the sector has picked up 6.1 per cent, according to FE Analytics.
Performance of fund vs sector and index over 1yr
Source: FE Analytics
Much of the fund’s outperformance came in the years ahead of the financial crisis, when bonds were nearing the end of their 30 year bull run. Since 2007, the portfolio has performed more in line with its peers and its less bearish stance on sovereign paper caused it to underperform in 2010 and 2011, losing 2.24 per cent over the latter. The sector gained 2.71 per cent that year.
The fund had strong years in both 2009 and 2012, and has got off to a strong start relative to its peers in 2014.
Source: FE Analytics
Pattullo and Barnard (pictured) are also making a play on increased M&A activity, particularly in the mobile and broadband consolidation sector. They expect US companies in particular to begin making plays for smaller UK businesses, which is why they like to buy debt from “jumbo” companies.
One deal they say could possibly be on the books is US mobile phone giant Verizon making a push for UK broadband company Virgin Media. Henderson Strategic Bond has 11 per cent invested in cash, with the vast majority of remaining assets in corporate bonds. High yield corporates have a 50 per cent weighting, with investment grade corporates making up 30 per cent. The rest is in loans, preference shares and asset-backed securities.
Among the fund’s top holdings are bonds in the Daily Mail & General Trust, Lloyds Banking Group and travel and leisure giant Thomas Cook.
It has ongoing charges of 0.72 per cent.