Despite frequent warnings for investors to get out of fixed income, market strategist Anastasia Amoroso says investors need to ask themselves three questions before they sell their corporate bond fund.
The fixed income market is under close scrutiny at the moment, following fears over the impact of an interest rate increase from the Federal Reserve and a recent sell-off that left holders of some ‘safe’ government bonds with losses.
Since the start of the year, bonds have endured a much tougher time than would be expected. Although the average IA Sterling High Yield fund has made a positive return, those in the Sterling Corporate Bond and Global Bond sectors have posted respective losses of 1.05 per cent and 2.56 per cent.
Performance of sectors over 2015
Source: FE Analytics
A number of issues – such as improving economic data, a kickback against negative rates and a lack of underlying liquidity, which saw major government bond indices fall by more than 5 per cent – have been blamed for the correction and some analysts are expecting even worse setbacks over the coming months.
Against this backdrop, there are also mounting fears of how liquid the bond market would be in a sustained period of weakness, especially as the new regulatory environment means investment banks can no longer act as the market makers they once were.
Amoroso, global market strategist at JP Morgan Asset Management, agrees that bond market liquidity is something that needs to be closely watched, as it can ultimately have a huge effect on how the market reacts to adverse events.
“While the supply of dealer bond liquidity and banks’ appetite for corporate bonds have declined, the demand for this liquidity has increased. The share of the corporate bond market controlled today by mutual funds and ETFs has doubled since the financial crisis. These vehicles offer daily or intraday liquidity and are ultimately controlled by retail investors,” she explained.
“That is important because while this category of investors has helped absorb large volumes of new bond issuance, historically retail investors have also been quick to sell. For example, flows into US investment grade and high yield mutual funds have been remarkably strong since 2009, but in the spring and summer of 2013, retail investors rushed to redeem their investment grade bond funds amid the so-called ‘taper tantrum’.”
Amoroso notes that investors who have been buying corporate bonds could quickly start selling them in the event of an interest rate rise by the Federal Reserve, leading to faster discounting of prices and extra volatility in the bond market if there aren’t enough dealers to absorb these sales.
The question of how investors should react to negative events in the bond market is a difficult one, given that there are the above liquidity concerns. The strategist says investors need to understand a number of things about the bond market before they panic.
Firstly, it is not a lack of liquidity that causes episodes of volatility but events; next, volatility tends to recede with time, even in periods of lower liquidity; and finally, there are “long-term pillars of support” in the corporate bond market, namely insurance companies, pension funds and foreign buyers.
On this last point, she said: “Although these investors do not step in overnight to buy bonds (and they can’t alleviate the short-term lack of liquidity), they do step in over time as their investment needs dictate. As rates rise and spreads widen, a large cohort of willing buyers, such as institutional and international investors, could help stabilise the market.”
These facts mean investors can formulate a plan of action on how to react to further upset in the bond market, she added. Amoroso suggests there are three main rules for bond fund investors to consider.
“Do consider carefully what event causes spreads to widen,” she said.
“The onset of volatility may be exacerbated by a lack of liquidity, but is initially triggered by an event. Has the event, whenever it occurs, fundamentally shifted the quality or the default risk of a corporate bond? If the answer is yes, then it may be time to sell. If not, selling might not be the best answer.”
Performance of indices over 10yrs
Source: FE Analytics
Earlier this month, Standard & Poor's warned that global corporate bond defaults are, in 2015 so far, occurring at their fastest pace since 2009, with 50 companies defaulting. This is almost double the rate of defaults during the same period a year ago and compares with 60 corporate defaults across the whole of 2014.
But these defaults will ultimately have had more to do with the fundamentals than a large macro event causing large pullbacks from corporate bonds. It is important for investors to know the difference between the two and how events really affect the investment case for their holdings.
Amoroso continued: “Don’t sit on the sidelines forgoing valuable coupon income and don’t rush out of your corporate bond fund if the fundamentals have not changed. Volatility is like the tidal cycle, it rises and then it recedes.”
Attempting to time the market is one of the worst mistakes an investor can make and experts point out that it is usually time in the market that helps to generate decent long-term returns. Although it can be painful to watch funds go down over the short term, riding this out is something investors will have to put up with if they are in it for the long haul.
However, the key element to the strategists’ rule is ‘if the fundamentals have not changed’. While investors should be wary of selling assets just because of a period of volatility, they should always keep this course of action open if the reasons they found them attractive have been weakened significantly.
The final rule to consider, according to Amoroso, is to diversify fixed income allocations away from single factor interest rate risk.
“Find diversified strategies that give you optionality to benefit from potential dislocations and help diversify your interest rate exposure. Don’t bet on one set of rates and credits, and instead do capitalise on many,” she said.
Over recent weeks, a number of commentators have argued that investors need to hold flexible bond funds to navigate the difficult market conditions thought to lay ahead, with some investors such as Standard Life Investments' Bambos Hambi advocating absolute return bond funds.
Bill Eigen, chief investment officer for absolute return and opportunistic fixed income at JP Morgan Asset Management, told us: “The fixed income landscape is changing and presenting investors with new risks and opportunities. Historically low income is forcing investors to reconsider their objectives, while high correlations across asset classes are creating obstacles around diversification.”
“Coupled with the prospect of higher rates, the need for diversification and steady returns has never been more important. Absolute return fixed income can deliver on this proposition, in today’s market and all markets.”
