Following the Fed’s hint that it would tighten monetary policy next year, many bond managers and commentators were saying it signalled the end of a 30-year bull market in fixed income with losses expected for several years to come.
If you add in that the rate of inflation in the UK slowing, with official CPI figures plummeting to 1.3 per cent in November from 2 per cent at the start of the year, the outperformance of index-linked bond funds is even more bizarre.
Yet, every portfolio in the 18-strong sector will have left investors very happy. In fact, the average return in the IMA UK Index Linked Gilts sector is higher than any other IMA sector at 18.57 per cent over the year to date.
According to FE Analytics, this means it beat the next best sector – IMA North America – by three percentage points and significantly outperformed other areas of the fixed interest market.
Performance of sector in 2014
Source: FE Analytics
The next closest fixed interest sector – the IMA Sterling Corporate Bond peer group – returned less than half of this from the point of view of the average fund in the sector. Also, the worst performing fund in the IMA UK Index Linked Gilts still beat the best performing fund in the IMA Sterling Corporate Bond sector.
The sector’s best performer is the £127m Hermes Active UK Inflation Linked Bond fund managed by Penni Coe since October 2012, since which it has returned 28.45 per cent while the sector average return is 22.98 per cent.
Performance of fund and sector since Oct 2012
Source: FE Analytics
FE Alpha managers Steve Russell and David Ballance, who co-manage the £2.5bn CF Ruffer Absolute Return and £3bn CF Ruffer Total return funds, have benefited from holding linkers this year.
However, Russell and Ballance anticipate further upside as they expect rising rates and stronger growth to make conditions to come alongside a ramping up of inflation.
“Despite a marked absence of inflationary pressures UK index-linked bonds have made handsome gains this year, prompting some observers to wonder whether the time is right to take some profits, especially in the longer-dated issues,” the managers said.
“We are resisting this temptation. Our strong conviction is that should economies to any degree reach ‘escape velocity’ such a development will inevitably be accompanied by a rise in inflation; equally we remain unshaken in our belief that the global monetary authorities will find it impossible to raise interest rates in such a scenario given the extent of outstanding debt.”
Index-linked gilts make up 11.5 per cent of the CF Ruffer Total return and 12.7 per cent of the CF Ruffer Absolute Return.
The two funds have benefited from their relatively high exposure to the asset class, with both seeing a sharp rise in returns in October and November, the strongest period for index-linked gilts over the course of the year.
Performance of funds over 3yrs
Source: FE Analytics
Bond boutique TwentyFour’s Mark Holman notes that index-linked gilts as an asset class was the place to be this year, despite rates markets drifting higher as the Fed carried out its tapering and a low yielding starting point.
“10-year gilts started the year at almost exactly 3 per cent, and as I type they are comfortably below 2 per cent … a return in excess of 10 per cent. Those that had this trade right were the out-and-out winners in 2014,” he said.
“Credit spreads which were expected to tighten in 2014 did exactly that, although the strongest performance by far came in the first half of the year. The second half was far more volatile as markets became concerned about a combination of rising geo-political risk, central banks easing off the liquidity pedal, and a slowdown in China and the eurozone.”
“In a strange way, by the time that rates do rise, we may have more calm in markets as it is the unknown prospect of rising rates that worry investors most, just like the prospect of tapering did 12 months ago.”
However, he says he is not expecting index-linked gilts to continue to see a positive return next year.
“Without the support of a strong conventional market, we see little upside from inflation breakevens, so whilst they may provide a good hedge for certain investors, we see the total return for 2015 as a negative one,” Holman forecasts.
