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Andrew: Why I’ve not given up on the world’s most hated asset class

17 July 2015

M&G FE Alpha Manager Steven Andrew tells FE Trustnet why he holds nearly a fifth of his fixed income exposure in ‘non-mainstream’ government bonds, and why he could be adding to his weighting soon.

By Lauren Mason,

Reporter, FE Trustnet

Income investors can still afford to hold a decent proportion of their portfolio in government bonds as certain areas of sovereign debt offer good value, according to M&G’s Steven Andrew (pictured).

The FE Alpha Manager, who has run the M&G Episode Income fund since its launch five years ago, currently has a 43 per cent exposure to fixed income securities in his portfolio.

In an article last month, FE Trustnet explored the belief that multi-asset income funds need to look past traditional fixed income securities such as government bonds and investment-grade bonds in order to provide investors with a decent yield.

Toby Hayes, vice president and portfolio manager at Franklin Templeton, said that seeking decent yield while also maintaining a defensive portfolio is now almost impossible given years of extraordinary central bank intervention.

“In today’s environment, I believe the concept of having a low-risk, high-income portfolio through traditional asset allocation is nonsense. You may achieve a ‘low-risk’ portfolio in the sense that it is designed to be low volatility, but it is likely to consist mainly of government bonds that are currently yielding next to nothing. Therefore, a different approach is required, we believe.”

Following impending interest rate hikes from the Federal Reserve and the Bank of England as well as fears that valuations in the asset class are stretched, bonds have endured drastic sell-offs over recent months with more investors turning to equities for income instead.

Performance of sectors in 2015

 

Source: FE Analytics

Worst still, many expect a start of a structural bear market in the asset class as yields have been forced artificially low as a result of ultra-low interest rates and quantitative easing.

However, while Andrew holds a 47 per cent weighting in equities and says they are a great source of income, he also holds the remaining part of his portfolio in fixed income assets, which many investors may find slightly daunting given the current macroeconomic situation.

“It’s difficult to try and gauge what a categorically cheap and a categorically expensive bond looks like in a world that has transited and continues to transit from one of being high growth and higher inflation to low growth and lower inflation,” he said.

“The distance that you need to travel for the long end of the yield curve, not only with policy rates, but perhaps more pertinently as investors, is that much shorter.”

“As the market has tried to grapple with all of these competing noisy – such as things going on in Greece and Asia – the market is principally trying to grapple with the exit of very low interest rates and trying to tackle with the consequences for markets of the Fed raising rates and, in a more local context, the consequence of the Bank of England raising interest rates.”

“What we’ve seen as a consequence of that has been a sell-off in the long-end and a sell-off in the 10-year end of the curve as well, but when we look at US yields having sold off now from 2.2 [per cent] lows [on 30-year bonds] at the beginning of the year, to yields of 3.1 [per cent], that’s quite a material sell-off.”

However, Andrew adds that this is still a low number historically, as 2013’s ‘taper tantrum’, which was caused by then-Federal Reserve Chairman Ben Bernanke’s announcement that monetary expansion may start to reduce, led to markets selling off by around 25 per cent, raising the average 30-year bond yield from 2.7 per cent to 3.99 per cent.

As a result, Andrew believes that there are yet more sell-offs to happen, and will not “step in” to reposition the bond weighting in his portfolio until yields on 30-year bonds average at around 3.6 per cent (US 30-year treasuries currently yield 3.1 per cent).


 Nevertheless, the manager has distributed his bond allocation carefully in a bid to protect his portfolio from any potential headwinds.

Currently, 8.6 percentage points of M&G Episode Income’s 43 per cent fixed income exposure are in developed market sovereign bonds, with 4.8 per cent of the fund in US 30-year bonds, 1.9 per cent in 30-year Italian bonds and 1.9 per cent in German 30-year bonds.

“I would put a circle around those three and say they’re the mainstream bonds. With Italy as an occasional outlier, you would expect those bonds to behave, depending on the price, as the risk-free asset camp,” he explained.

“In an environment where the market at large is saying, ‘I’m scared of something and something nasty has just surprised me’, they’re the guys that should hold value and should go up in price because the market is saying, ‘I don’t want risk. I want something that’s liquid, that’s globally traded, I know the prices I’m going to get for it, and more importantly I’m going to be able to get my money back if I need it’.”

However, the fund holds 17.6 percentage points of its fixed income allocation in higher-risk government bonds with varying lengths of maturity – currently, 3 per cent of the fund’s portfolio is in Columbian bonds, 2.9 per cent is in Mexican bonds and 2.6 per cent is in South African bonds.

Fixed income allocation of fund in end of June 2015

 

Source: M&G Investments

Andrew says that the fund’s allocation to developed market sovereign bonds is currently the lowest it’s ever been – in the past, the manager has held up to 25 per cent in long-dated developed market government bonds in the portfolio.

“There are a mixture of emerging market bonds in the portfolio at the moment, so you’ve got the likes of South Africa, Chile, Columbia, a little bit of Peru, but also the likes of Mexico, Australia and New Zealand,” he said.

“There is a broad range that allows us to generate a good, sustainable income. Some of the global bond markets and some of the sovereign markets are still exhibiting very nice yields – for example Mexico, and even higher yields from South Africa and Brazil and somewhere in between from the likes of Columbia and Chile.”

Many investors would see the fund’s allocation to emerging market bonds as being risky, especially given their recent poor performance and the substantial headwinds facing the asset class in the form of a stronger dollar and tighter US monetary policy.

Performance of sectors over 3yrs

 

Source: FE Analytics


 However, Andrew points out that too many people confuse volatility with risk, and volatility is nothing more than a daily change in the market’s sentiment.

Risk, on the other hand, he describes as overpaying for an asset and therefore increasing the odds that the money will be irrevocably lost.

“Ultimately, the core of our whole philosophy is to ask, ‘how can we avoid fundamentally overpaying? How do we make sure we’re paying a good price?’ You establish a good valuation framework and then you have the emotional intelligence to stick to it at times when everyone is telling you, ‘don’t you know that’s going to sell off very aggressively?’” the manager explained.

“Well they might be right, they might be wrong, but if you’ve bought it at a good price, even if it does then sell off aggressively, it adds volatility and not risk. As long as you have a constructive portfolio and not all of it is facing in the same direction, you should be heading for value.”

Since the fund’s launch in November 2010, M&G Episode Income has achieved a top-decile return of 41.98 per cent, outperforming its peer average in the IA Mixed Investment 20%-60% Shares sector by 15.24 percentage points.

Performance of fund vs sector since launch

 

Source: FE Analytics

The £343m fund also has a top-decile alpha ratio, a top-decile max drawdown, which measures the most an investor would have lost if they bought and sold at the worst possible times, and a top-decile Sharpe ratio, which measures risk-adjusted performance, over the same time period. 

M&G Episode Income has a clean ongoing charges figure (OCF) of 0.81 per cent and yields 3.57 per cent.

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