The move by bond funds towards higher yielding areas of the market such as emerging market debt has prompted Brewin Dolphin to back the passive Vanguard Global Bond Index fund, arguing that its exposure to the US is an appealing feature.
Index-tracking funds have become increasingly popular in the UK in recent years and now account for 11.3 per cent of assets in the Investment Association universe. But many investors have avoided taking passive exposure to bonds and prefer to take an active approach.
Reasons for this including difficulties in accurately replicating indices (the Barclays US Aggregate bond index, for example, contains about 9,000 securities), the fact that the most indebted issuers make up a larger share of benchmarks and the challenges in passively matching duration in illiquid markets.
Added to these concerns are the high valuations of bonds across the globe. Years of central bank intervention through ultra-low interest rates and unprecedented quantitative easing programmes have forced yields down to historic lows in many parts of the market.
Performance of indices over 6yrs
Source: FE Analytics
The latest Bank of America Merrill Lynch (BofA ML) Global Fund Manager Survey, which polled 145 fund managers running a combined $392bn between 2 and 9 April 2015, highlighted growing fears of a bubble in bond markets.
A net 84 per cent of fund managers say the asset class is now overvalued, which is the highest reading in the survey’s history. When the panel was polled in March, a balance of 75 per cent believed bonds were too expensive.
Despite these concerns, it is difficult to argue that an investor can build a truly diversified portfolio without bonds. Although fixed income is expensive and some now doubt it can protect against equity falls as it did in the past, it is simply too large an asset class to be ignored.
Brewin Dolphin says a diversified approach is needed for bond exposure and highlights one product from index fund pioneer Vanguard as being an attractive way of achieving this, thanks to its exposure to the perceived safe haven of the US.
Ben Gutteridge, head of fund research at the wealth manager, said: “Our preferred means to achieve a diversified position in the global bond market, yet retaining a significant weighting in US bonds, is via the Vanguard Global Bond Index fund.”
“This is a passive strategy, but is one of only very few options providing the exposure we most specifically require. Most active managers are avoiding US bonds giving the longer term trends in the US economy and what this might mean for treasuries.”
The US is expected to be the first major developed economy to lift interest rates, which currently sit at a historic low of 0.25 per cent. Its economic recovery seems to have slowed over recent months – with growth easing and employment rising at a more relaxed pace – but still looks strong when compared with its peers.
However, the weakness that has emerged means the Federal Reserve will find it difficult to lift rates much higher than their near-zero levels for the immediate future and has left managers seeking yield elsewhere.
“Managers are, instead, finding value in areas such as emerging markets – particularly Mexico,” Gutteridge said.
“There is fundamental value here [Mexico] but such is the nature of the investment that these bonds will suffer selling on days of risk aversion. With emerging market risk still very much on the table as China continues to slow, the Vanguard offering is likely to better shape portfolios.”
Performance of indices over 3yrs
Source: FE Analytics
China’s slowing economic growth has dominated emerging markets over recent years. Along with interest rate rises by the Fed, it is seen as a major headwind for the asset class and has caused investors to shun its stock markets in favour of the developed world.
Earlier this month, official figures showed that Chinese GDP grew by 7 per cent in the opening quarter of 2015. While this might be high in from a developed world standpoint, it was the slowest quarterly growth in six years and was the result of a weak housing market and an industrial slowdown.
While emerging market bonds are looking increasingly interesting to some bond funds, there are fears that hot money will pour out of the asset class if China continues to struggle to rebalance its economy and if the US lifts rates.
Vanguard Global Bond Index has very little exposure to emerging market debt, with the US being its largest weighting at 37.8 per cent of assets. It also has 13.5 per cent in Japan, 6.4 per cent in France, 5.7 per cent in Germany and 5.6 per cent in the UK.
The £2bn fund is benchmarked against the Barclays Global Aggregate Float Adjusted Index Hedged index and offers exposure to a wide range of sectors and bonds. It is designed to give investors core exposure to fixed income markets and holds government, agency, corporate and asset-backed debt in its portfolio.
When it comes to performance, the fund has outpaced its average peer in the IA Global Bonds sector since launch in June 2009 with a 41.57 per cent total return. It has lagged the index, however.
Performance of fund vs sector and index since launch
Source: FE Analytics
The fund is currently second quartile over one, three and five-year periods.
Meanwhile, it outperformed its average peer in four of the last five full calendar years, delivering first-quartile gains in 2014, and over 2015 so far. Its only year of underperformance against its rivals was in 2012, when the fund was in the third quartile.
But despite this strong track record, Brewin Dolphin does not expect the fund to produce stellar returns in the coming years given the bond market environment at the moment.
Gutteridge said: “It is hard to see US bonds being a real money spinner over the medium term but the combination of a more benign Federal Reserve, a shortage of yield in the quality bond space and the dollar exposure, makes such assets well worthy of consideration for inclusion in portfolios.”
Furthermore, he adds that some sources of support can be seen from asset allocation changes being made by fund managers across the globe.
BofA ML’s survey found that the balance of managers overweight Europe has eased from 60 per cent to 45 per cent over the past month and Gutteridge says the money freed up here has been channelled into safe havens such as government bonds.
“Though flow data remains positive, there has been a clear slowdown in the pace of European equity buying of late. Picking up the mantle appears to be US bonds as investors choose to eschew risk for safety,” he added.
“With data continuing to disappoint in the US it seems increasingly likely the Federal Reserve will be hamstrung in their ambitions to lift interest rates (much) off the zero bound. With the dollar having undergone its fastest annual rate of appreciation since the end of Bretton Woods, much of the work the Fed would have hoped to achieve through rate hikes has already been realised, rendering interest rate increases increasingly difficult to justify.”
“There is statistical support for the thesis that first-quarter data is seasonally weak but, for now, investors are using weaker corporate earnings, an absence of inflation and a surprisingly weak payrolls print as a reason to take some risk off the table. What is more, at circa 1.9 per cent, the US 10-year treasury is a global ‘high yielder’ in comparison to other G7 markets.”
Vanguard Global Bond Index has a clean ongoing charges figure of 0.15 per cent.
