The US Federal Reserve is expected to end its monthly asset purchases, or QE, this , bring to an end what has been seen by most as the major driver of returns from bonds over recent years as yields were driven to such low levels.
Performance of sectors over 5yrs
Source: FE Analytics
However, in the absence of the Fed’s constant buying and the expectation of higher interest rates in the UK and US, Trindade – manager of the AXA Sterling Credit Short Duration Bond fund – says investors should expect capital losses from most parts of the market.
“Basically, we think there will be more volatility in the bond market going into the end of this year as monetary policy begins to normalise,” Trindade (pictured) said.
“The major reason why volatility has been so low is because of the artificial liquidity from central banks, and that is coming to an end this month. Against that backdrop, we expect yields to rise.”In order to prepare his portfolio for that scenario, he has been gradually changing his fund’s holdings.
“We have been increasing our weightings to floating rate notes. They now make up 16.5 per cent of the fund, having been 9 per cent at the start of the year. The second thing we have been doing is increasing the quality of the portfolio, adding A and AA names as we think they will hold up best during times of volatility.”
The manager thinks it is the right decision to end quantitative easing and for central banks to raise interest rates from a “moral hazard” perspective and he expects the first hike in the UK to come early next year and in the summer for the US.
His thoughts are similar to those of Peter Doherty, manager of the Tideway Global Navigator fund, who told FE Trustnet earlier this year that interest rates need to rise to stop appeasing debtors, which he warns will come with consequences if it is to continue.
While Trindade says the rise in rates will be gradual, possibly as low as 0.25 per cent in the first instance, and that they shouldn’t cause a huge sell-off in the market, there are other potential headwinds – namely deteriorating liquidity in the market.
FE Trustnet recently highlighted that RBS’s liquidity monitor shows liquidity – which the bank defines as a combination of market depth, trading volumes and transaction costs – in credit markets has declined around 70 per cent since the crisis and it is still falling.
“Liquidity could be a big issue if we see a lot of outflows from fixed income funds as yields rise,” the manager said.
“It can be very difficult for managers because if yields are rising and everyone is looking to exit, the door becomes very small. That’s one of the reasons why I have 20 per cent of my portfolio maturing each year, as it gives me natural and consistent liquidity.”
His £175m AXA Sterling Credit Short Duration Bond fund sits in the IMA Sterling Corporate Bond sector, but, as its name suggests, it isn’t your typical credit fund.
Trindade aims to protect his investors from rising rates and to not expose them to too much volatility. Given that strategy, it isn’t too surprising to see that it has underperformed against the sector average over recent years.
According to FE Analytics, the fund has returned 10.3 per cent since its launch in November 2010 while the sector has returned 25.38 per cent over that time.
Performance of fund vs sector since Nov 2010
Source: FE Analytics
As the graph shows, however, it has been considerably less volatile over the period. Its maximum drawdown, which measures how much an investor would lose if they bought and sold at the worst possible time, has been just 1.5 per cent since launch, while the sector’s maximum drawdown is 5.57 per cent.
The fund has also underperformed, relative to the sector, so far this year as longer-duration assets have rallied. However, he expects that to change over the coming few months.
“If our view is correct, I think this fund will be first quartile or even decile.”
“The fund is structured protect against the downside and so it is very well positioned to withstand that sort of environment [of rising yields]. The way this fund works means that it is either first or bottom quartile, it is never really in the middle.”
AXA Sterling Credit Short Duration Bond has a yield of 1.5 per cent and has a clean ongoing charges figure (OCF) of 0.45 per cent.
