The performance of government bonds since the beginning of last year has surprised the large majority of industry experts, as due to an improving global economy and the prospect of tighter monetary policy in the US, 2014 was expected to be characterised by rising yields.
Performance of sectors versus index since January 2014
Source: FE Analytics
However, as the graph above shows, the complete opposite happened. Growing macroeconomic headwinds such as European deflation, geo-political concerns, a huge fall in the oil price, increased stimulus from various central banks and increased equity market volatility have all contributed to the lower yields on offer.
With 10-year gilts yielding 1.7 per cent, 10-year US treasuries yielding 2 per cent and same-maturity government bonds in Japan and the eurozone yielding less than 0.5 per cent, the large majority of experts say the asset class is hugely overvalued.
However O’Nolan – co-manager of Fidelity Multi Asset range – says the current environment of low, sluggish but potentially accelerating growth along with continued and very strong disinflationary trends should be good for both equities and bonds.
“In the funds that I manage, we’ve been overweight equities for the best part of two years now and we think the underlying growth trend is still positive and, with central banks still easing, this is a good environment for stocks – so we remain positive,” O’Nolan said.
“On bonds, we have moved overweight more recently. The lower inflation is pushing bond yields down and that will help to push bond prices up.”
O’Nolan’s comments are very much at odds with what the large majority of fund managers have been doing in their portfolios.
According to the Bank of America Merrill Lynch Fund Manager Survey, the large majority of experts are hugely bearish on the asset class. It showed that out of 157 managers running a combined $459bn, a net 79 per cent say the market is overvalued. Bonds are also perceived as the asset class most vulnerable to increased volatility this year, according to the survey.
FE Trustnet has also spoken to a number of managers who are avoiding fixed interest in their funds, such as Miton’s David Jane, who said earlier this week that he had taken an axe to his bond exposure over recent weeks.
“Clearly we have entered the territory of the greater fool argument. It seems extremely farfetched to believe that investors would prefer the safety of government bonds when they offer the upside of a loss and the downside of a greater loss. That certainly doesn’t feel safe in our eyes,” Jane (pictured) said.
“We have heard arguments that it’s a positive real return or that yields could fall even lower given falling inflation expectations, but none of these really stack up when considering the potential return is negative to a long-term holder.”
On top of that, Bill Eigen – manager of the JPM Income Opportunity fund – said there would be “devastation” in the bond market this year as sovereign debt is not priced correctly and will plummet in value when the US Federal Reserve inevitably raises interest rates from their ultra-low levels.
However, O’Nolan has a different view.
He says that while there is a chance of higher interest rates at some point over the medium term, there is a much higher likelihood that inflation – which fell to just 0.3 per cent in the UK according to recent data – will stay lower for longer.
One of the major reasons for that is the fall in the oil price – which has recently recovered to $60 a barrel but is still down 37 per cent over one year, according to FE Analytics.
Performance of indices over 1yr
Source: FE Analytics
“Low inflation is good for stocks and bonds. The impact is clearer for bonds, where falling inflation expectations put downward pressure on yields,” he said.
“At the same time, the fall in oil prices combined with central bank easing is positive for equities. So far, most of the fall in bond yields reflects lower inflation expectations and not the fear of a weaker growth. The outlook for bonds will depend on how real growth develops and how the Fed reacts to the disinflationary shock.”
O’Nolan started upping his exposure to bonds within his Fidelity Multi Asset range – which he has run with George Efstathopoulos and Nick Peters since Trevor Greetham left at the start of the year – since January.
However, he says he has trimmed his position in sovereign debt more recently, but has kept a high weighting to corporate bonds.
Stuart Edwards, manager of the £430m Invesco Perpetual Global Bond fund, is more cautious on fixed income as he warns core government bonds are due a correction.
“With the ECB joining the Bank of Japan in embarking on QE, the scope for a significant near-term sell-off in core government bonds is, in my view, limited,” Edwards said.
“That being said, I do not believe in the Japan-type deflationary scenario that core government bond markets seem to be pricing in. Core government bonds are, in my view, due a correction and if the Fed does, as some think, start normalising monetary policy this year we could see bond yields come under pressure.”
Given the uncertain backdrop and the poor level of compensation core government bonds offer, Edwards has been reducing his duration. However, he has been increasing his position to index-linked bonds as the market’s price for inflation – as measured by breakevens – has fallen markedly.
Performance of fund versus sector since March 2013
Source: FE Analytics
Edwards has managed the Invesco Perpetual Global Bond funds since March 2013 and over that time it has lost 1.47 per cent, but has slightly outperformed the IA Global Bonds sector – which is also its benchmark – in the process.
The fund is a concentrated portfolio of just 64 holdings and due to the manager’s outlook, has a relatively low yield of 1.18 per cent. Its ongoing charges figure is 0.67 per cent.