It has been a poor and sometimes frightening year for investors in bond funds as some of the ‘safest’ fixed income securities have delivered uncharacteristically high drawdowns so far in 2015.
Concerns over the potential first rate hike in the US, improving economic data, a kick back against negative real rates and a lack of underlying liquidity drove yields on major government bond indices’ higher earlier in the year, which caused hefty capital losses across global fixed income markets.
Performance of indices in 2015
Source: FE Analytics
While developed market sovereign debt bounced back somewhat as investors turned increasingly risk-off in the face of the Greek debt crisis and large falls in China’s equity markets, yields have once again spiked as a deal has been struck between Athens and its creditors.
There are major concerns over the future of bond funds, even within some of the most popular fixed income teams such as at Invesco Perpetual.
The team, which is headed up by the highly rated Paul Causer and Paul Read, runs some of the best-performing and largest fixed income portfolios available to UK investors – such as the £5.4bn Invesco Perpetual Corporate Bond fund.
With fears over bonds so widespread, in this article various members of the trusted desk highlight their major concerns over the future of bond funds and how they are trying to protect investors against them.
Rising interest rates
Concerns over the future of US monetary policy has been a headwind for bondholders for a number of years now, but the consensual view (although many would disagree) is that the US Federal Reserve will start to raise interest before 2016 – possibly as soon as September.
Certain experts, such as JPM’s Bill Eigen, have warned a hike will lead to “devastation” in fixed income as markets aren’t priced correctly. They say the sell-off could be even worse than 1994, when a Fed hike caused prices to fall dramatically, as yields are far lower than they have been before.
Performance of index in 1994
Source: FE Analytics
Stuart Edwards, manager of the Invesco Perpetual Global Bond fund, isn’t as bearish but warns that yields are likely to gradually rise over the coming years.
“In so far as it has been reasonably well-telegraphed by central banks in the US and UK – and as we have been told that when rates start to rise they will only be gradual – I think the impact should be fairly limited,” Edwards said.
However, he says investors have to keep a close eye on wage growth and unemployment levels, as central bankers may need to raise rates more quickly than expected to calm their respective economies.
He added: “Our view is that rates will go up and that means yields are going to go up – and those headwinds are likely to stay with us for some time.”
Liquidity is poor and is getting worse
Liquidity has been a major talking point within the industry over recent years and FE Alpha Manager Michael Matthews, co-manager of the Invesco Perpetual Corporate Bond fund, agrees it is a headwind.
Flows into corporate bond funds have been substantial since the period after the financial crisis while, due to increasing regulatory pressures, investment banks can no longer act as the market makers they once were.
The concerns are that if liquidity was to dry-up during a period of rising yields, investors could be hit by hefty capital losses or even worse be locked in their funds as market participants all rush for the exit at the same time.
Of course, those are the worst case scenarios and Matthews says it is very difficult to call how diminishing levels of liquidity will affect markets.
“I think it is very topical at the moment and a lot has been written about liquidity in bond markets, but I would say it is a question which is easier to ask than answer.”
“It is our big known unknown, as everyone has seen the chart which shows the size of the corporate bond market doubling since the financial crisis while dealer inventory has halved. It’s an interesting one because, except during recent weeks with Greece, the primary market has been very liquid.”
“In the secondary market, though, it has been much tougher. It’s not just esoteric areas of high yield, it is right across the market. My view is that illiquidity is here to stay, but this could give us opportunities if the market prices drop to meet demand.”
In order to combat this theme, Matthews is running a very short duration portfolio so that he has the liquidity and firepower to pick up bonds at higher yields.
High yield is now expensive and covenant quality is deteriorating
High yield bonds have been some of the major beneficiaries of the current cycle as low interest rates have not only substantially lowered the chances of default (as companies have been able to refinance their debt at a very cheaply) but the lack of interest on offer elsewhere have forced investors to take more risk.
According to FE Analytics, the average fund in the IA Sterling High Yield sector has returned more than 100 per cent since the market bottomed in March 2009 after the global financial crisis with a maximum drawdown of just 13 per cent.
Performance of sectors since March 2009
Source: FE Analytics
Though default rates are expected to stay low, deputy fund manager and senior credit analyst Rhys Davies says that the bull-run in high yield led to high valuations.
“Opportunities in high yield are now very to find as yields have been pushed down. In many cases we feel the yields on offer not appropriate for the level of risk we would be taking. While we are still able to find enough opportunities to keep us busy, they are very much on a credit by credit basis,” Davies said.
He also warns that covenant quality is deteriorating. Though Davies says it isn’t as bad as the period up to the global financial crisis, it is getting worse as the trend is that covenants are far more stacked in favour of the issuer rather than the bondholder – such as shorter call dates and legitimising their ability to raise further debt in the future.
He therefore says investors are no longer as protected as they were in the past, increasing the chances of capital losses.
The knock-on impact of China’s slowdown
The economic slowdown in China, its move from an investment led-economy to a consumer-driven one, its murky shadow banking sector and over-heating property market have been cited as major global economic headwinds for a number of years now.
However, these concerns have come even more to fore following the dramatic falls in the Chinese equity market over the past month.
“[China] is definitely a big concern for global growth,” Asad Bhatti, senior credit analyst at Invesco Perpetual, said.
“If economic growth continues to slow, it will have large knock-on effects on emerging economies such as Brazil and Russia. They are big producers of commodities and China consumes 50 per cent of the world’s iron ore and copper.”
“That’s why the market has been so focused on the recent sell-off in the Chinese stock market and it has hit sentiment across the world.”
Performance of indices in 2015
Source: FE Analytics
According to FE Analytics, the Chinese equity market fell more than 30 per cent in June/early July following its strong gains earlier in the year thanks easing from the Chinese central bank and the recent ‘Stock Connect’ programme.
In this instance, Bhatti Says recent sell-off was nothing more than the unwinding of a bubble in the A shares market, but if economic conditions in China were to worsen then it would be a big concern for the global economy and risk assets such as corporate bonds.
Most are too young to remember a bear market in bonds
The final and possibly most unnerving concern, according to Stuart Edwards, is the fact that most people working in fixed income now have never seen a bear market in bonds and therefore few will know how to position themselves if yields continually rise.
Certainly, the likes of UK gilt and sterling corporate bond funds have delivered returns of more than 300 per cent over the past 25 years with very low drawdowns.
Performance of sectors over 25yrs
Source: FE Analytics
With many risks coming to the fore, Edwards says he and his team will have to keep their wits about them.
“Interest rates haven’t risen for nearly 10 years. We talk to people working at banks and various economists and the point is a lot of them are quite young so they haven’t seen an interest rate rise during their careers – which means complacency could slip in.”
He added: “There will be a lot of noise and what we need to do is dig deep into the macroeconomic picture.”
