Government bonds were one of the standout asset classes in 2014, having a strong run even though many investors went into the year thinking returns would be much lower than previously seen. The 10-year gilt started 2014 at a yield of close to 3 per cent and fell steadily through the year; they currently yield just 1.37 per cent.
The success of bonds translated across to the funds world as well. FE Analytics shows IA UK Index Linked Gilts was the best performing sector in 2014 with an average return of 18.56 per cent, while IA UK Gilts was in third place and IA Sterling Corporate Bond was in seventh.
Performance of bond sectors over 2014
Source: FE Analytics
All three sectors have also made more than 3.5 per cent over 2015 so far, although they have been beaten by equity funds in the Japanese, emerging markets and European spaces over this very short time frame.
Chris Iggo (pictured), chief investment officer for fixed income at AXA Investment Managers, says the level of yields now in the bond market appear to be “far too pessimistic” about the health of the global economy but does not see a catalyst for change any time soon.
While current bond prices would suggest a very weak economic outlook, Iggo points out that the reality on the ground seems to be far from this. Many economies have improving growth rates, employments rates are rising and the fall in the oil prices will boost consumer spending power.
“I believe that the level of government bonds is not consistent with expected nominal economic growth and that the biggest risk to fixed income markets over time is a change in forward expectations about monetary policy and inflation. Again, that does not look imminent so bond yields are likely to remain low for some time,” he said.
“It also means prospectively low returns from bonds. It’s hard to see value in most parts of the fixed income market as a result of the level of yields and unless one has a very pessimistic view about life.”
Iggo thinks that high-yield bonds have a chance of performing well in this environment, although he concedes that they have a higher correlation with equities.
One reason for his confidence in this area is the quantitative easing programmes of the European Central Bank and the Bank of Japan, which will ultimately encourage investors to take more credit risk.
“My preferred asset allocation would be to take the equity exposure in a balanced portfolio and replace part of that with high yield fixed income and then have the fixed income part in a bar-bell of short duration credit and inflation linked bonds to provide the duration but also the hedge against a rise in inflationary expectations that could be a result of a large European QE programme,” he said.
“Another alternative is to have a very diversified approach to managing bond portfolios, one that does not over emphasise one part of the market too much, that is not governed by market cap weighted benchmarks and one that is flexible in managing the duration and credit risk. We have found that, over time, a diversified fixed income approach produces much better risk adjusted returns.”
He added: “We comfort ourselves in liking US high yield because the yield is attractive and the US economy is strong and the Fed is still some months from raising interest rates. That market is up 3.4 per cent from its low in December and probably has another 2 to 3 per cent upside in the short term as spreads narrow. If you like equities, then like high yield too.”
Performance of indices over 5yrs
Source: FE Analytics
Iain Stealey, portfolio manager on the JPM Global Bond Opportunities fund, agrees that US high yield looks attractive at the moment. He is also sanguine about the impact of falling oil prices on this part of the market, even though it is home at a number of oil & gas companies.
“US high yield continues to look attractive with an average 6.4 per cent yield, particularly relative to negative yields on certain government bonds, but requires a selective approach to navigate the index’s energy exposure. Eighty-five per cent of the market is ex-energy and therefore a net beneficiary of falling oil prices”, he said.
Furthermore, Stealey highlights European high yield even though the yield on offer is not as attractive as its US counterpart. One advantage Europe does have, however, is the launch of the €60bn-a-month bond-buying programme by the ECB in an effort to stimulate the region’s flagging economy.
“European high yield [is] not so ‘high’ at only 4 per cent, but still interesting,” the manager said.
“Corporate borrowers have a supportive central bank, an improving economy, a boost from the weakening currency and falling oil prices, all of which are positive fundamentals. Not a bad trade when the yield on equivalent duration German government bonds, i.e. five years, is in negative territory.”
