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Investors are right to dump their bond funds, say experts

16 June 2015

The latest FE Trustnet poll showed that investors have turned even more negative on bond funds due to the recent sell-off and industry experts think they are making the right decision.

By Alex Paget,

Senior Reporter, FE Trustnet

More than one-third of FE Trustnet readers are even more bearish on fixed income funds following the recent sell-off in global bond markets, according to our latest poll, and leading industry experts say they are correct to be negative as a period of losses and volatility is on the cards.

The poll, in which 1,523 people voted, showed that 40 per cent said the recent sell-off had made them less likely to up their exposure to bonds while only 10 per cent said the rise in yields has made the asset class more attractive.

Some 50 per cent said they would not change their exposure as a result of the correction but that is likely to include investors who were already underweight the asset class, which has been deemed expensive for a number of years now.

A number of reasons have been given for the recent spike in yields, which has seemingly calmed over recent weeks, ranging from improving economic data in the eurozone, a kick-back against negative rates, concerns about potential interest rates rises in the US and a lack of underlying liquidity.

Either way, cautious investors have been hit with uncharacteristic drawdowns from bond funds so far in 2015.

According to FE Analytics, during the sell-off which lasted between the end of January and early June, the average fund in the IA UK Gilts sector fell 7 per cent and the average fund in the IA Sterling Strategic Bond, Sterling Corporate Bond and Global Bond all lost money as well.

Performance of sectors versus sectors and index between January and June 2015

 

Source: FE Analytics

As well as anecdotal evidence of investors becoming more bearish on bonds, data also suggests investors are starting to dump their fixed income holdings.

For example, FE Alpha Manager Richard Woolnough’s M&G Optimal Income fund saw outflows of £650m during the month of May, according to FE Analytics. This has been one of the best selling funds of recent years.

Investors can often fall foul of selling into a falling market and crystallising losses when a better strategy would have been to buy on weakness and ride the dip. However, leading industry experts think FE Trustnet readers are making the right decision when it comes to bonds in the current environment.

Charles Hepworth, investment director at GAM, has been underweight traditional fixed income for some time now and with the expectation of rising interest rates in the US at some stage this year, he won’t be changing his allocation.

“Looking at gilts from a UK investor standpoint, the yield has been gradually rising higher since the end of January low it achieved this year. Everyone was worried then about eurozone deflation becoming a more permanent feature and the QE by the ECB was just about to start which many investors had clearly front run and helped push down core European debt yields” Hepworth said.

“The sell-offs we have recently experienced isn’t surprising (to us at least) and we have been positioned very negatively in traditional fixed income for a while now.”  

“A number of factors have been put forward in an attempt to explain the rout but the most likely one it seems is that the European deflation expectations were overdone in the first half of the year – and actually there is an inflationary wave (albeit small) coming soon in Europe.”

He added: “The crazy negative yield environment will be viewed by the history books, and quite rightly so, as a deluded aberration in our view.”


 

Therefore, he says investors shouldn’t be using the sell-off as a buying opportunity.

“We would only rationally re-engage with longer duration fixed income once interest rate increase expectations had been fully priced into the bonds and that is still some way off. This perhaps is just the start of the shift but we aren’t there yet,” Hepworth said.

“Where we do have exposure is in more alternative short duration instruments that aren’t positively correlated to a rising rate environment – such as floating rate debt in MBS and junior financial credits.”

He added: “Additionally we are using absolute return products that are using relative value fixed income trades.”

Two of Hepworth’s largest bond holdings in his GAM Star Defensive and GAM Star Cautious funds are Allianz Sterling Total Return and GAM Star Credit Opportunities, which both sit in the highly flexible IA Sterling Strategic Bond sector.

GAM Star Credit Opportunities, which is headed-up by FE Alpha Manager Anthony Smouha and yields 4.43 per cent, has been the best performing portfolio in the sector since its launch in July 2011 thanks to the manager’s focus on high yielding debt issued by investment grade companies.

Performance of fund versus sector since launch

 

Source: FE Analytics

The Allianz fund, which yields 3.3 per cent, invests across investment grade credit, high yield, government bonds, mortgage backed securities and emerging market debt and is outperforming over one, three, five and 10 years.

Whitechurch’s Ben Willis says a focus on strategic bond funds is crucial in the current environment.

“This recent sell-off has been driven by fears of the Fed increasing rates earlier than expected and global inflationary expectations rising,” Willis said.

“However, it has been market speculation rather than actual events that have resulted in such an increase in volatility. The recent moves in yields and prices have highlighted how the illiquidity in bond markets is amplifying market movements.”

“Despite the recent sell-off, the risk/reward metrics in government bonds continues to look unappealing. We will focus on selective pockets of value and utilise strategic bond funds with managers that we rate highly.”

Rob Morgan, pensions and investment analyst at Charles Stanley, is equally bearish on traditional fixed income and that is largely due to the concerns about higher inflation which have been stoked by rising oil prices, improving wage growth and talk of “normalisation” from central bankers. 

“This news and the latest price action are further reminders that bonds, traditionally considered a conservative and less volatile area in the main, carry significant risks at present,” Morgan said.

“In particular, some commentators have cautioned that if interest rates rise, there could be a sudden rush for the exit, exacerbating price moves and perhaps resulting in exceptionally poor market conditions for those who want to sell.”

“Bonds can sometimes be ‘illiquid’, that is to say trading activity is low and it becomes difficult to sell in sufficient quantities to fulfil redemptions, so in extreme circumstances it could mean that as an investor in bonds or bond funds you may not be able to sell your holding when you need to.”


 

He added: “It is therefore a good time to examine exposure to the asset class to gauge how sensitive holdings might be to such events.”

While Morgan says investors should avoid government bonds and investment grade credit, he says one pocket of value could be in high yield – which has been largely unaffected by the recent sell-off given its shorter duration and equity-like characteristics.

The only IA Sterling High Yield fund to feature on the FE Select 100 is Philip Milburn and Claire McGuckin’s £1.6bn Kames High Yield fund.

While the FE Research team say it comes with its own risks, they believe the fund – which is outperforming over one, five and 10 years and yields 3.85 per cent – is a good option for investors.

Performance of fund versus sector over 10yrs

  

Source: FE Analytics

“There are concerns that when interest rates rise there could be a stampede for the exits, pushing down prices. Investors willing to take this risk can currently get a decent level of income from this fund and benefit from the stockpicking skills of the two managers.”

There are very few experts who think that bonds constitute a good investment at the moment.

However, star manager Neil Woodford thinks that money can still be made from fixed income over the short term as he thinks worst of the correction is over for the time being.

“Other influences, however, could be positive for bonds. For example, their safe haven status in an uncertain world is undiminished and could easily come to the fore again in the event of a Greek default, for example,” Woodford said.

He added: “Also, slowing global growth and the continued threat of deflation will continue to lead to demand for German bunds. My view is the recent bond tantrum has probably now played out and that the ‘bond positive’ influences may reassert themselves over the remainder of the year.”

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