Investors should not be duped into thinking bonds offer good value given the recent macroeconomic headwinds, according to Miton’s David Jane, who says that as yields are so low they offer very little upside potential and limited negative correlation to equities but a huge amount of downside risk. 
The widely predicted bear market in bonds seemed to have started earlier this year as yields on developed market government bonds spiked considerably due to a variety of reasons such as better than expected growth, a retaliation against negative rates and poor underlying liquidity.
However, those managers who have been positioned for the end of the 25 year-plus bull run in fixed income have seemingly been proved wrong once again, as yields have fallen due to the recent volatility in equity markets.
According to FE Analytics, the Barclays Sterling Gilts index is up 3.43 per cent since mid-July compared to a 3.66 per cent loss from the FTSE All Share.
Performance of index since July 2015
Source: FE Analytics
On top of that, given the uncertainty about economic growth, the US Federal Reserve’s decision to not increase interest rates and the various deflationary forces, predominantly out of China, facing the world, many have been upping their exposure to bonds in expectation of another rally.
However Jane, head of multi-asset at Miton, isn’t convinced at all. He points out that as a 10-year UK gilt yields 1.84 per cent, it is mathematically impossible that bonds rally strongly from here or can continue to offer a decent hedge against equity market volatility like they have done in the past.
Therefore while he agrees with most bond bulls that interest rates are likely to stay “lower for longer”, it doesn’t mean that investors should buy in.
“The challenge you have is you can’t make any money out of them. Even if we are right and the market is overestimating future interest rates and you buy in today, you will get very limited negative correlation with equities,” Jane (pictured) said.
“Although bonds did go up when equity markets went down, they went up so little it didn’t really make that much difference to your portfolio. Unless you ran a portfolio that was 20 per cent equities and 80 per cent ultra-long-dated bonds, you basically lost money. So why would you take that bet?”
“At the same time, if we are wrong and inflation comes back and interest rates do go back to some sort of ‘normal’ level, then you would possibly lose 20 per cent or more. Even with your best case scenario, you aren’t going to make any money and you could potentially lose a lot. With interest rates so fundamentally low, the risk is all to the downside.”
He added: “The whole risk-reward profile of bonds is entirely wrong.”
Bonds have certainly been a good friend to investors over the longer term. Our data on the Barclays Sterling Gilts index dates back to December 1998 and over that time it has outperformed the FTSE All Share by 20 percentage points.
It has also outperformed with a third of the volatility of equities and a maximum drawdown which is more than six times lower than the FTSE All Share.
Performance of indices since Dec 1998
Source: FE Analytics
Given those returns and the lack of yield on offer, many still think the bull market will end soon. One of those is Rathbone’s David Coombs, who told FE Trustnet last year that he was well underweight the asset class.
“At some stage, someone is going to look at this in five years’ time and say, ‘what were we doing?’ The average rating on a bond fund is BBB, you have ridiculously low nominal yields, almost negative real yields and higher duration. What were we thinking? Bubble?” Coombs said.
There are also those who think that rally will continue, though, such as FE Alpha Manager Ariel Bezalel.
“Since the beginning of 2015, some observers have ‘called the top’ of the great bond bull market – the call in my view is somewhat premature. Prevailing economic forces suggest instead that the great bond bull market is far from over, and global central bank policy is likely to remain loose for the foreseeable future,” Bezalel said.
Due to a combination of ‘lower for longer’ rates, falling inflation and a lack of deleveraging, Bezalel has been upping his exposure to sovereign debt within his popular £2.6bn Jupiter Strategic Bond fund.
It isn’t just bond managers who are becoming more bullish on their asset class, though, with the likes of City Financial’s Mark Harris also buying more long-dated bonds for his multi-asset funds over recent weeks.
However, Jane – who has comfortably beaten his peer group composite since he started running funds in the IA universe in July 2002 – says he will not be following them into the asset class.
Performance of manager versus peer group composite
Source: FE Analytics
“Bonds are a market where avoidance of loss looks to be the better option. The risk is all to the downside. Maybe spreads could narrow back to where they were last August and rates could go back to their January lows or maybe lower, but in either case there is not enough money to be made compared to the risk that you might have got it terribly wrong.”
Nevertheless, given the need for income and the fact that corporate bonds (both investment grade and high yield) have been caught out by the recent volatility, some have argued investors can find attractive spreads.
Jane understands that argument, but points out the current volatility in corporate bonds is actually higher than the level of interest available. All told, he says it is an asset class that is best largely left alone.
“Generally, in bonds, we take the view that we are here to not lose money. I’m really not interested in the negative correlation to equities argument because it doesn’t mathematically work very well here,” he said.
“The buying rates argument because there are ‘attractive’ rates of interest available doesn’t really stack up either, because to get a yield of 4 or 5 per cent you’ve really got to buy credits which are scary. Why would you bother?”
As a result, Jane has limited his bond exposure within his Miton Cautious Monthly Income, Cautious Multi Asset, Defensive Multi Asset and Total Return funds to very short duration assets and debt issued by high quality, defensive companies.
