Low interest rates, quantitative easing, changes to the pensions system and an older population all mean bubbles are starting to form across income producing asset classes, according to Rathbones’ David Coombs. 
In order to revive their economies and restore confidence in markets following the global financial crisis, central banks around the world took the decision to slash interest rates to very low levels and pump liquidity into the system via quantitative easing.
Given the majority of that stimulus has been pumped into fixed income, it has caused a domino effect across all asset classes as investors have been forced to take more risk in order to find a reasonable level of yield.
While this has meant investors have seen decent returns from nearly all of the major asset classes since the last crisis, Coombs – head of multi asset at Rathbones – says it has had a very negative knock-on effect.
Performance of indices since the global financial crisis
Source: FE Analytics
“That hunt for yield, coupled with quantitative easing where markets have been flooded by easy money, has had a huge impact on yields in relatively risky asset classes,” Coombs (pictured) said.
“Even in mainstream assets, we are seeing yields on investment grade bonds yielding sub-3 per cent and high yield is sub-5 per cent. Liquidity in both of those asset classes has dropped significantly over the past 10 years and the average ratings have dropped significantly.”
He added: “So the risks are higher but the potential returns are lower.”
FE Trustnet has written on a number of occasions about diminishing levels of liquidity within fixed income markets, with many warning about a crisis in the asset class if yields were to rise sharply and investors try to sell their bonds en masse.
Nevertheless, Coombs notes that there have been a number of worrying developments within the investment world over recent times.
For example, he says 20 years ago he would have never dreamt of buying corporate bonds with credit ratings below AA rating for clients, but now managers are really struggling to build multi-asset income funds without them if they are trying to generate a positive return.
“We need to take a step back and think what that means. Yes, spreads might look interesting but in terms of actual absolute return and risks you are taking for your clients, the returns have never been lower and if you look at the risks in terms of liquidity, the risks have never been higher.”
“We need to be much more thoughtful in the way in which we approach this strategy in the coming months and years.”
Coombs says that this reach for yield has affected all asset classes which is leading markets down a route that will end, eventually, in a crisis.
“What normally happens when you get a lot of factors chasing a narrow range of assets? Well, it’s the ‘B’ word isn’t it. It is something that always strikes fear into any investor,” Coombs said.
“I think we are starting to see, maybe not big fat bubbles like 1999, but small bubbles emerging all across the income producing asset classes whether its high yield, emerging market debt, investment grade bonds or indeed government bonds. I would add commercial property to this as well, where you have even worse liquidity.”
“We need to be very, very careful and focus on quality and a yield that is sustainable to offset this liquidity risk and these bubbles that are forming.”
Commercial property funds (despite many of them locking their investors in during the financial crisis due to a lack of liquidity) have become one of the most popular areas with investors, with Henderson UK Property, M&G Property and L&G UK Property all among the top 20 best-selling funds over the past 12 months.
They have also performed very well over recent years, with commercial property funds considerably outperforming both bonds and equities since the ‘taper tantrum’ of May 2013 when the US Federal Reserve first hinted it would reduce its quantitative easing programme.
Performance of funds versus indices since the taper tantrum
Source: FE Analytics
He says there are a number of other examples of bubble-like tendencies, which he describes as “canary in the coal mine warnings about liquidity risk.”
Firstly, he says the valuations of some of the higher risk areas of income producing assets such as student accommodation, aircraft leasing and caravan parks.
Closed-ended funds likes Empiric Student Property and GCP Student Living are trading on premiums to NAV of close to 10 per cent, despite the fact they have only been launched in the last three years.
Coombs is concerned that many investors who buy these niche areas in search of higher yields (those two trusts yield around 3.5 per cent) have no idea about the risks they are taking and are naïve to think they add a layer of defence within their portfolios.
It’s not just private investors, though, as he warns many fund managers are taking high level of risks without properly informing their unitholders.
“When I hear of mainstream property funds extending their investment powers to take in niche properties like medical centres, garage forecourts or car showrooms, I get very, very nervous.”
“That to me is risk reach and it says to me that the manager is struggling to find quality assets. Let’s remember why we buy commercial property, it’s a premium asset class that should be able to have a sustainable income stream with good quality yields.”
“Are we really buying property funds to generate lots of capital gains? I think that’s where you are creating lots of equity-like risk and you are going to get a different outcome in your portfolio.”
One of the main reasons why Coombs, who has comfortably outperformed his peers with better risk-adjusted returns since he began running funds in the Investment Association universe, is concerned about bubbles is because he is soon to launch his own Rathbone Multi Asset Strategic Income fund.
Performance of manager versus peer group composite
Source: FE Analytics
While he admits there have been a “plethora” of multi asset income fund launches over recent years and also says it can be a worrying development as it has often proven to be a prelude to a period of vast underperformance (such as new tech funds in the late 1990s), he thinks the think hunt for yield will continue for some time to come.
Performance of indices since Oct 1998
Source: FE Analytics
Given his concerns about bubbles though, he is running his portfolio in a very different way from his competitors.
He splits his portfolio into three areas, liquid assets (cash, government bonds, high quality investment grade), equity risk assets (equities, high yield bonds, emerging market debt) and diversifiers (commodities, property, infrastructure, hedge funds).
He currently holds his maximum 85 per cent in equity risk assets (70 per cent of which is equities), 10 per cent in liquid assets and just 5 per cent in alternatives.
“At the moment, quite frankly, equities provide the best value for money,” he said.
“Within Strategic Income, you will see we are taking slightly more risk and it comes back to my point about diversifiers – we disagree with many of our competitors as we think diversifiers in the income world are far more risky so we have less in them and more in equity risk.”
“We are at our riskiest that we can be in that portfolio and I think that says it all in terms of where we think you need to be right now to drive genuine income for a client and to make sure it’s sustainable.”
“That’s not an easy conversation to have with an investor, I agree, but they have to understand that.”
Rathbone Multi Asset Strategic Income is not currently open to investors, but the paper strategy yields 4.1 per cent.