A slow interest rate rise from the Federal Reserve could ultimately make investing in bonds more appealing, according to Rathbone’s Bryn Jones (pictured), although he is wary over the outlook for high yield bonds and long duration bonds over the longer term. 
While the majority of investors have indeed been cutting down their weightings in long duration assets over recent months, the fund manager’s decision to cut back his overweight in high yield bonds is likely to divide opinion.
In an article published last week, FE Trustnet found that the higher-risk high yield sector has outperformed all other bond sectors since the start of the year, achieving a positive return as opposed to taking a nosedive following the recent bond sell-off.
Performance of sectors in 2015
Source: FE Analytics
The asset class’ strong returns so far this year are also part of a longer term trend, as the IA Sterling High Yield sector average has returned close to 75 per cent over six years.
Financial experts, including JP Morgan’s Nick Gartside and Schroders’ Gareth Isaac, believe the ‘cushioning’ that high-yield bonds provide from rising rates and good fundamentals means that now is the right time to invest.
“In the high yield debt space, we think European high yield corporates are in good health and show that cash balances for European companies have grown at the fastest rate since 2009 this year, as management teams remain conservative,” Gartside said.
“We are encouraged that European lending conditions are the most positive since 2007, as high yield typically performs well in this environment.”
“There is a risk that volatility in rates markets has a knock-on effect in the real economy but we point out that the spread between government bonds and lending rates in the real economy looks large by historical standards. We remain constructive on European and US high yield.”
But Jones, who manages the Rathbone Strategic Bond fund alongside David Coombs and is sole manager of the Rathbone Ethical Bond fund, believes that this view isn’t taking the longer-term macro picture into account.
“It’s a bit of a short-term-ist view,” he said. “We’re not short-term investors, we like to take the longer term view. You only have to look at the Kames High Yield fund, which has raised 10 per cent liquidity recently. That’s a sign that Philip Milburn is expecting some redemptions or volatility from people taking money out, should there be a squeeze.”
“I understand why people have [increased high-yield exposure] and I’m slightly overweight in my strategic bond fund so I can’t criticise people for doing that. What I’m saying is I’m trying to contextualise – in terms of what people should do with their high yield over the next six to 12 months – it’s worth being wary of those later risks rather than the ‘right now’ risks.”
Jones attributes his current overweight in high-yield bonds to their shorter duration characteristics and their positive correlation to economic recovery as they are a highly-geared asset class. As a result, and as they usually offer a yield buffer, he says that they are renowned for performing well in the early stages of an interest rate rising cycle.
However, he remains apprehensive as to how much high-yield bonds will be able to contribute to the fund’s portfolio in subsequent stages of the cycle.
Performance of indices over 3yrs
Source: FE Analytics
“What you tend to find is that a peak in interest rates is usually when high yield underperforms significantly,” the manager pointed out.
“The reason for this is two-fold. One, companies aren’t earning as much because households’ balance sheets are becoming pressurised as their own interest expense is rising and they’re having to pay out more money to service their own debt, so they end up buying less.”
“For instance, if you’ve got a mortgage and, at the moment, it’s very cheap, so your excess money is more likely to be spent on goods. When rates go up, you can’t afford to buy those things so companies can’t make as much money.”
“Secondly, their own interest expenses are going up. If their margins are being squeezed and they’re highly geared, then that’s when you have problems.”
Another scare for Jones is that nobody knows when the next peak in rates and high-yield underperformance will be, and that this could be sooner than many investors think.
This factor is particularly concerning, according to the manager, given the lack of liquidity in the bond market thanks to the tighter regulations which have been forced upon investment banks.
“If we get to a peak in rates much quicker than expected and people start exiting their high yield, there won’t be enough liquidity to absorb it because the market-makers aren’t there and you might get significantly more downside volatility,” he explained.
Nevertheless, he expects the next peak in rates to be a lot lower than previous cycle due to the exceptionally low interest rate environment.
Not only does this mean that bonds in general may not suffer as badly as people expect, but he argues that if interest rates do rise then investors’ income can be re-invested at higher rates, which will eventually increase their yields.
“We don’t know what’s round the corner, there could be a black swan that rips the heart out of the equity market and if that’s the case then you still need portfolio insurance,” Jones said.
“We’re not advocating that you buy 30-year gilts, [as] we’re in that camp that rates will rise. But having a level of portfolio insurance at the shorter-end can still protect you as long as it’s a stable raising rate environment.”
“A 200 basis-point rate rise is obviously going to impact every bond holder, but we don’t think central banks are going to be forced to do that – we think all rate rises are going to be quite steady. Then if you’re protected by the income of a bond fund, you can still get an annual return. It’s only [a worry] if you get a nasty shock in rate rises.”
Because he believes that interest rate hikes are going to be gradual, Jones say having bond exposure that provides a decent income should be seen as more desirable than it currently is.
“We’ve got bond exposure in our multi-asset portfolios, albeit we’re trying to manage some of the risks with duration and high yield,” he explained.
“I’m overweight [high yield] right now, but we’re looking to move to neutral in the next six months because if we start getting rate rises soon, that will give me an opportunity to start exiting some of the high yield positions and at least get into neutral with a possible view to go underweight further out in the rate rising cycle.”
“It’s more of a strategic view than a ‘right now’ tactical view.”
Jones’ Rathbone Ethical Bond fund has outperformed its peer group composite and its benchmark by 12.52 and 14.94 percentage points respectively over five years, delivering total returns of 45.79 per cent.
Performance of fund vs sector and benchmark over 5yrs
Rathbone Ethical Bond fund has a clean ongoing charges figure (OCF) of 0.69 per cent and yields 4.5 per cent.
