Holding longer duration bonds provides a lower correlation to equities than short duration holdings, meaning it is one of the only remaining ways to gain genuine asset class diversification, according to Ian Spreadbury (pictured). 
The FE Alpha Manager ‘hall of famer’, who runs a number of portfolios for Fidelity including the £3.3bn MoneyBuilder Income fund, has kept the duration of this investment vehicle in line with history.
This is in contrast to many bond fund managers who have decreased their duration exposure as a result of an impending interest rate hike from the Federal Reserve, which is likely to have an adverse effect on the asset class’s value.
This year has been a torrid time for fixed income investors in general as a result of high prices, low yields and a similar behavioural pattern to equities, meaning the asset class has lost its ‘safe haven’ label.
This came to a head in August when both asset classes correlated as a result of the China slowdown and the subsequent market sell-off.
Performance of index and sector in 2015
Source: FE Analytics
As such, many investors have turned to riskier fixed income assets such as high yield or ‘junk’ bonds to achieve higher yields and to soften the blow of a rate rise, but Spreadbury says that asset diversification is far more important in the current climate.
“Duration has been pretty neutral in the fund relative to the benchmark year-to-date. We’re currently running our duration slightly under benchmark but not much, and I’m reasonably happy with that,” he said.
“I think duration does a couple of things for you. It gives you yield and it gives you low correlation with equities. If you take duration down then inevitably the balance of risk in the fund leans more towards credit risk which is more correlated to equities.”
The manager says that he is fairly happy with valuations of high-quality bonds while yields are at their current levels, despite the fact he deems gilt valuations to be slightly stretched, but he warns that they’re not likely to become cheaper any time soon.
“I do feel that there’s a shortage globally of safe haven assets like gilts, treasuries and European government bonds, so I think that premium could continue,” he added.
However, he says that corporate bonds have repriced slightly this year, which has opened up some opportunities that are at reasonable valuations.
The concern that he has regarding corporates though is that global growth has continued to deteriorate and, if this continues, it could be detrimental to the credit sector as a whole. Nevertheless, the corporates the manager holds in Fidelity MoneyBuilder Income are high-conviction plays that he expects to perform solidly during down-cycles.
“I do feel that we are very much in a low inflation, slow-growth environment. We’ve got this structural debt issue that is still very much with us and I think it is dictating slow growth. I think it’s highly unlikely that inflation will pick up in this environment,” Spreadbury continued.
“Clearly commodities are still heading down and I’m not really sure when that’s going to finish. If anything the Chinese currency is falling and they’re going to export more deflation - I think there’s more spare capacity in the world than economists expected.”
“So I don’t expect inflation to pick up. To be perfectly honest, if the bond markets got any sniff of inflation, I think they would send yields up which would immediately impact growth and put further pressure on inflation.”
The manager says that this low nominal economic growth directly impacts bond yields, and this is why Fidelity MoneyBuilder Income currently yields around 3.7 per cent, which he admits is historically low but offers decent value in real terms.
He adds that despite these low yields there is much more of a case for investing in high-quality bonds rather than buying into riskier fixed income assets.
“High yield historically has a correlation of about 0.6 [to equities]. If you are chasing yield by going into those asset classes, and that’s subordinated financials and subordinated high-yield bonds etcetera, then that’s fine but I think you should expect a high correlation with equities,” he explained.
For some investors though, a yield of below four from fixed income assets may be seen as disappointing, given that the FTSE 100 index is currently yielding an average of 3.9 per cent.
Spreadbury – who has comfortably outperformed his peers since the turn of the century – says that this is unavoidable given that global debt is close to three times GDP and that this is causing the slow growth.
Performance of Spreadbury versus peer group composite since Jan 2000
Source: FE Analytics
As such, investors should be turning to bonds as a diversifier, and the most effective way to do this is to hold longer duration assets.
Despite this, he also manages the Fidelity MoneyBuilder Income Reduced Duration fund, which was launched in 2013 as a means of reducing interest rate risk, which in turn reduces the absolute risk of the fund.
“In absolute terms the volatility of this fund should be lower. However, you are giving up some yield and the correlation of the reduced duration fund, which runs to a duration of about two years, is going to be a little bit higher compared with equities,” The manager said.
“If you think about a bond fund, the two key sources of risk are interest rate risk and credit risk. If you take out the interest rate risk, the balance is more towards credit risk. So when we looked at the correlation of that fund with equities since we launched, it was about 0.3 on average whereas the full MoneyBuilder fund’s correlation was at zero.”
“It’s really about what you want. The difference in income, volatility and correlation with equities just gives you a slightly different mix of those flavours.”
Since its launch, Fidelity MoneyBuilder Income Reduced Duration has returned 4.6 per cent, which is less than half of the average return of its peers in the IA Sterling Corporate Bond sector.
Performance of fund vs sector since launch
Source: FE Analytics
However, it is in the top decile for its annualised volatility and its maximum drawdown, which measures the most money an investor would have lost if they’d bought and sold at the worst possible times, over the same time period.
Fidelity MoneyBuilder Income was launched by Spreadbury more than 20 years ago, and it is in the second quartile for its total return over three and 10 years and in the third quartile for its returns over one and five years.
Fidelity MoneyBuilder Income Reduced Duration has a clean ongoing charges figure (OCF) of 0.61 per cent and yields 2.89 per cent, while Fidelity MoneyBuilder Income has an OCF of 0.56 per cent and yields 3.73 per cent.
