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An interest rate rise will be good for my bond fund, says Arnaud

20 August 2015

Canada Life Investments’ David Arnaud tells FE Trustnet why he believes the latest inflation results are good news and why he’s looking forward to rate hikes being implemented by the Bank of England and the Federal Reserve.

By Lauren Mason,

Reporter, FE Trustnet

The latest boost in core inflation is good news as it signifies a strengthening economy and a step closer to hiking interest rates, according to Canada Life Investments’ David Arnaud (pictured).

The manager of the CF Canlife Global Bond fund believes that keeping interest rates stuck at 0.5 per cent for too long creates various economic headwinds, including encouraging consumers and businesses to borrow money they cannot afford to pay back easily.

“One of the risks we have is that the Bank of England is still at 0.5 per cent on their main [interest] rate and it’s a very accommodative policy. The trouble they have is, if they keep their rates too low for too long, they’re creating bubbles,” he explained.

“By keeping rates so low for such a long period of time, you’re telling everyone to borrow money, to go and buy a flat for instance which, after a while, creates bubbles and those bubbles need to deflate.”

“This is the risk of remaining accommodating for too long, so I think with inflation now peaking up the Bank of England has a dual mandate – they want to keep unemployment as low as possible and keep price stability as well, but price stability doesn’t mean zero per cent inflation, it means they’re targeting 2 per cent inflation.”

Price stability is defined by the UK government’s inflation target of 2 per cent and Arnaud says that inching closer to the target is good news as it will enable the Bank of England to raise rates.

“This current rate environment that was set up by the Fed and by the Bank of England was set up in 2008, when we had one of the sharpest financial crises to deal with to-date,” he pointed out.

“Banks were on the verge of going bust, [the Bank of England] needed to stimulate the economy, they needed to stimulate borrowing and they needed to support the banks, so they gave them favourable lending conditions.”

“Is it still the case today? No. Banks have returned to profit, you see that. Lloyds got bailed out, RBS, all the banks that were bailed out have come a long way.”

While Arnaud eagerly awaits a rate hike, many investors are concerned about the impact it will have on their portfolios.

Many investors have reduced their exposure to low-yielding bonds to seek income from dividend-paying ‘bond proxy-style’ blue-chips. However, a number of financial professionals have warned against being lured by the attractive yields that these mega-caps have to offer.

Performance of indices in 2015

 

Source: FE Analytics


 David Coombs, who runs a number of Rathbone funds including Rathbone Strategic Growth Portfolio, believes that signs of a yield trade sell-off have become more apparent in recent months.

Speaking to FE Trustnet in July, he said: “Bond proxy-type stocks have started to become a bit more volatile – we’re starting to question at last whether these valuations are a bit stretched.”

“Also, you’re seeing higher volatility in bond markets and it just feels that the end is in sight in terms of the never-ending rise in these sorts of stocks and asset classes.”

Arnaud also believes that equity valuations are now seeming stretched and argues that many investors are fleeing bonds due to rate rise fears without considering the headwinds that are facing the alternative investment options.

“What should people be buying, exactly? Equities, always the safe, easiest place to buy, are trading at historically very high levels – they are very expensive. The current levels the FTSE is reaching are not obvious entry points,” he argued.

Performance of indices in 2015

 

Source: FE Analytics

“If you buy emerging markets, there’s a lot of tension there. Mostly because the Fed is going to increase US rates, the US dollar is going to go up and most emerging markets have huge levels of debt that are denominated in US dollars.”

“Commodities are dangerous as well. Oil prices are extremely low, we’ve just had the Chinese announcement, the oil sector has been going from bad news to more bad news over the past six months so I would be very, very cautious on commodities at the moment.”

While Arnaud admits that bond yields are extremely low, he says that an obvious reason to buy into bonds is to receive regular payments, which is something that other asset classes don’t offer.

“No matter what yields are doing, you still get your coupon which you don’t get as an equity holder. Let’s not forget that income stream – I think people are too worried about capital depreciation within the fixed income world,” he said.

Currently, Arnaud’s CF Canlife Global Bond fund has between a 5 and 10 per cent weighting in hybrid bonds, which combine both debt and equity characteristics. There’s a further 5 to 10 per cent weighting in contingent convertibles, or ‘CoCos’, which are similar to traditional convertible bonds but have a higher strike price that the company’s stock price must meet before converting.

The manager says that these holdings play an important part in providing investors with the highest yield possible, adding that some positions in the portfolio have coupons in excess of 7 per cent. 


 Arnaud has also increased his exposure to short-dated bonds as a means of weathering interest rate hikes.

“We need inflation, and this fund needs inflation as well because it’s positioned on the short side. This fund is prepared for an increase in rate. [Yesterday’s] data favours an increase in rates so [yesterday’s inflation] data is actually very good news for this fund.”

While CF Canlife Global Bond has underperformed its peer average in the IA Global Bond sector over Arnaud’s three-year tenure by 9.99 percentage points, its performance has improved over the last year, having returned just 20 basis points less than its peer group composite.

Performance of fund vs sector over 1yr

 

Source: FE Analytics

The fund has a clean ongoing charges figure of 0.83 per cent and yields 3.07 per cent.

 

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.