The much forecasted bond market collapse is becoming ever more likely, according to Henderson’s Chris Burvill, who says the chances of increased economic activity and higher inflation mean the expensive asset class is as “sinister” as ever.
As a result of the credit boom of the 1980s and very accommodative monetary policy in the period up to the financial crisis, government bond yields have been trending downwards for the past three decades making fixed income arguably the most profitable asset class over recent history.
This rally has been strengthened since the period after the financial crisis though, as unorthodox monetary policies such as ultra-low interest rates and quantitative easing programmes have flooded the market with liquidity and forced prices even higher.
Performance of sectors and indices over 15yrs
Source: FE Analytics
A high number of industry experts have warned that the bond market is overvalued and prone to an extended bear market for several years now, only to see their more contrarily positioned funds underperform as result.
However, due to improving economic data, a kick back against negative interest rates and diminished levels of liquidity, yields on UK, US, Japanese and German government all spiked in tandem this year causing a rout across global fixed income markets.
Performance of indices in 2015
Source: FE Analytics
Though the falls have now seemingly stopped, many warn that the recent sell-off was a just a precursor to an even more “brutal” correction later down the line. One of which is Burvill, who runs the £2.3bn Henderson Cautious Managed fund.
He has long been bearish on bonds, but as he thinks the economy is improving at a much healthier rate than most people believe, he thinks the long-awaited bear market in bonds is now very likely. 
“If we are going to get this improving outlook, some areas have to suffer – and it’s plainly the bond market which is looking a little bit tired and a little bit weary,” Burvill (pictured) said.
“I, like many, have been worried about bonds for a while now and I fully admit that I have been too early but this time around it does feel a lot more sinister for bond markets. As many have argued, they are priced for perfection; i.e. the economic news to worsen.”
“It is difficult to see where the next good news (but bad news for the rest of us) for the bond market is coming from – short of some huge geo-political issue which is difficult for anyone to predict.”
Several leading market commentators have warned about the outlook for fixed income, such as City Financial’s Mark Harris, who warned that bond prices are likely to fall yet again when the US Federal Reserve starts to raise interest rates later this year.
“Is this a correction or a change in trend? That's the big question for everyone,” Harris said.
“We are still working it through but I suspect, at this stage, it is more of a correction than a complete trend change. However, we think it is extremely difficult to make money from bond markets at the moment but it is easy to lose money and lose it very quickly.”
He added: “It is a very challenging environment that will trick a lot of people. If that is a warning shot of what we believe could occur later in the year, it is going to be fairly brutal because liquidity just dried up.”
However, the reason why Burvill is so concerned about bonds is due to his view on inflation, which he thinks will trend upwards from its currently low level.
The likes of the eurozone and UK have dipped into deflation as a result of the substantial fall in the oil price (which now stands at $62 a barrel) but Burvill points out that those falls will be “anniversaried-out” of the CPI figures.
Performance of index since January 2014
Source: FE Analytics
On top of that, as core inflation has been steadily picking up, he expects an inflationary shock to spook the still overvalued bond market.
“It is more sinister this time because those of us who watch the expected inflation outlook have been watching the breakeven rates in both the UK and the US starting to move upwards. Inflation expectations have been falling and falling and falling and took another lurch down last year with the oil price collapse,” the manager said.
“The point is, oil prices have fallen, they aren’t falling at the moment. In these sort of statistics (breakeven rates) and with our type of investors, we are looking ahead and discounting what has happened and try and see what will happen.”
“If oil prices stay where they are, at above the $60 level, that will soon be inflationary rather deflationary. That, and other factors, are starting to come into the minds of those who are on the lookout for future inflation and that plainly won’t be good for the bond market.”
Like many bond bulls though, Burvill says the major caveat to his argument about a bond market collapse is the evidence that central banks have shown they are in no rush to raise interest rates too quickly, which could well keep a lid on yields.
Nevertheless, the manager is by no means positioned for such an outcome in his Henderson Cautious Managed.
The fund, which sits in the IA Mixed Investment 20%-60% sector, is a “plain vanilla” mixed asset fund which invests in direct UK equities and direct bonds – be them sovereign debt, corporate credit or high yield. This approach has worked well for Burvill in the past, as Henderson Cautious Managed has been a top quartile performer over three, five and 10 years.
Performance of fund versus sector over 10yrs
Source: FE Analytics
However, in order to protect his investors against future bond market falls, he has upped his cash weighting to a very high level.
“We have plenty of cash [16 per cent] and we are not being unusual in holding cash but we are aware, as most are, that we are charging management fees and there are plenty of costs for investors.”
“The cash is there to protect us if the bond market does weaken. As I say, we expect it to struggle to produce returns this year and if the bond market does wobble we are pragmatic, we are perfectly capable and willing to shift some of that cash into bonds.”
“Either way, we are able to deploy that cash and we would see an increase in our underlying yield. We are well aware that cash is burning a hole in our pockets but it is there very much for strategic reasons.”
Henderson Cautious Managed yields 2.8 per cent and has a clean ongoing charges figure (OCF) of 0.71 per cent.
