Following a very poor 2013 due to the expectation of tighter monetary policy and improving economic conditions, bonds were the surprise asset class of last year as equity market volatility, falling inflation projections and macroeconomic headwinds caused bond yields to fall.
According to FE Analytics, the average fund in the IA UK Gilts sector returned more than 14 per cent last year and the average IA Sterling Corporate Bond fund gained close to 10 per cent but UK equities only broke even.
Performance of sectors and index in 2014
Source: FE Analytics
It’s fair to say that bonds have been deemed by large swathes of the industry as overvalued for a number of years now but with 10-year gilts yielding 1.5 per cent and many other developed market sovereign bond yields in negative territory, a high proportion of experts have warned that fixed income is now dangerously expensive.
However Spreadbury, who heads up the £3.4bn Fidelity Moneybuilder Income and £1.6bn Fidelity Strategic Bond funds, is expecting returns in 2015 to be similar to 2014’s gains.
“My base case for 2015, for slow growth and low inflation, remains. Interest rates rises are a possibility but are unlikely to derail bond markets so net-net I’m still expecting decent returns from bonds again in 2015,” Spreadbury (pictured) said.
“Maybe not quite as high as they were in 2014, but we should still get decent returns.”
Many market commentators have questioned why investors should buy bonds at their current yields, especially those with a five or 10-year time horizon, as they say the likelihood is fixed income assets won’t be able to generate a positive real return over the longer term.
While much more bullish on the asset class, Spreadbury admits that the current environment is unprecedented.
“The reality is things are very far from normal,” Spreadbury said.
“Yields are not just low, in parts of Europe they are negative. In a recent paper, Andy Haldane at the Bank of England showed interest rates going back to 3,000 BC and it’s interesting that neither long nor short rates have ever been lower than they are now. This is not a normal environment.”
However, the FE Alpha Manager says the good news for bond investors is that nominal growth rates have been coming down over the past six months and that, along with many other headwinds which are preventing a real global economic recovery, is due to the sheer level of debt in the system which has continually grown over the past 30 years.
“It is incredibly disappointing that the high level of debt hasn’t come down in the last few years when interest rates have been so low and it is imparting a high level of systemic risk to the global economy,” he said.
“In my opinion, it’s this debt that is causing the global excess of saving that continues to drive yields down. I think it has also led to a high level of global spare capacity which has been putting downward pressure on inflation.”
“On account of this, I am still very much in the slow growth, low inflation camp. Slower growth should be good for bonds.”
The manager also notes that, while 10-year gilt and US treasury yields have fallen by close to 30 basis points over the past month, there are forces at work which will continue to push them lower; namely the ECB’s full-blown quantitative easing programme.
“In the short run, you do have to say that [QE in the eurozone] is an incredibly powerful technical and what it is doing is highlighting the value in gilts and US treasury bonds.”
“Unless either growth or inflation start rising more than expected, I do think the US and UK treasury market will benefit as European investors switch out and look for higher yields elsewhere.”
The argument that gilts and treasuries look good value because yields in Japan and Europe are much lower has been slammed by certain experts – such as Bill Eigen, manager of the £4.7bn JPM Income Opportunity fund.
Eigen says this relative value trade is a sign that the bond market is now “broken” after years of central bank intervention, as valuations no longer reflect economic realities.
“The scary thing when you look at that is: where is all the money in fixed income going right now? It’s going into traditional fixed income funds that are making that bet all the time that the rate is going to go even lower [and] closer to zero,” Eigen said.
“I don’t know why people are praying that globally rates go to zero because once they go to zero do you know what the opportunity set in traditional fixed income is? Zero. You’re guaranteed to lose money.”
Eigen also predicted that there would be “devastation” in the bond market in 2015 when the US Federal Reserve starts to raise interest rates as the market simply isn’t priced correctly. He says the outcome will be much worse than the situation in 1994 when the Fed raised rates as there is no yield support whatsoever this time around.
Performance indices of in 1994
Source: FE Analytics
Spreadbury disagrees, however. He says that while a rate hike could come in earlier if inflation or growth comes through stronger than expected, the market is correctly pricing in a rise for October this year.
“I don’t think it will hurt bond returns,” he said.
“The market is saying [the first hike] will happen in October, so that’s already in the market. I don’t think that would derail the market. Clearly, the Fed is uncomfortable about these very, very low rates and the knock-on impacts elsewhere and they want to normalise policy as quickly as possible.”
“But, I think it’s unlikely we will see substantial hikes and again, coming back to what I said about the debt level, I don’t think the economy can support higher yields and the Fed understands that as well.”
Spreadbury, along with M&G’s Richard Woolnough who recently won the inaugural FE Alpha Manager of the Year award, is one of two bond FE Alpha Manager ‘hall of famers’ as he has held the rating in every year since they were introduced in 2009.
He has managed his £3.4bn Fidelity Moneybuilder Income fund since its launch in 1995 and our data shows it has been a top quartile performer in the IA Sterling Corporate Bond sector over that time with returns of 233.80 per cent.
Performance of fund versus sector since Sept 1995
Source: FE Analytics
Spreadbury takes a relatively defensive approach to the sterling bond market and this approach has worked well for his investors, as his Moneybuilder Income fund has beaten its average peer in eight out of the last 10 calendar years.
He launched his more flexible £1.6bn Fidelity Strategic Bond fund in April 2005 and it too has been a top quartile performer in its sector since inception.
Both funds have also been top performers in terms of their annualised volatility and risk-adjusted returns, as measured by their Sharpe ratios, over the longer term thanks to Spreadbury’s focus on capital preservation.
His Moneybuilder Income fund has a yield of 3.56 per cent and an ongoing charges figure (OCF) of 0.57 per cent, while his Strategic Bond fund’s yield and OCF are 3.27 per cent and 0.68 per cent respectively.