Spreadbury: Corporates over gilts is a no-brainer
The FE Alpha Manager says yields on UK Government debt could go even lower, but the downside risk is too great to justify holding anything but short-duration bonds at the moment.
With the eurozone debt crisis back in focus, there has been a resurgence in demand for fixed income products. The latest IMA statistics show investors have been flocking to corporate bonds, which have been the best sellers for four out of the last five months.
In this Q&A, Ian Spreadbury (pictured)
, manager of the Fidelity MoneyBuilder Income
and Fidelity Strategic Bond
funds, gives his views on fixed income investing and highlights how high quality bonds are still providing a safe haven for investors.
How low can gilt yields go?
The predominant economic trend of slow growth and falling inflation warrants a very low gilt yield, but at current levels I’m concerned the risks look asymmetric.
In the near-term the problems in the eurozone could well cause gilt yields to grind lower, but at these levels I see limited price upside over a longer time frame.
It is possible yields could go below 1 per cent on 10-year gilts, but I think they are unlikely to stay there for a meaningful period of time.
Within my funds, I have decided to mitigate the potential for losses from an eventual rise in gilt yields by running duration significantly below benchmark.
Bond investors are faced with an ever shrinking pool of AAA-rated assets and the UK has already been put on review for downgrade by Moody’s and Fitch. Could UK gilts lose some of their appeal? What about German Bunds?
My base case is that the UK and Germany both remain safe havens. However, there is a small probability that both gilts and German Bunds face the tail risk of actually losing this status.
In the UK, the level of gross debt across the Government, financial and household sectors remains the problem.
In Germany, the contingent liability linked to the support mechanisms for bailed-out nations could eventually lead investors to demand a credit risk premium for holding Bunds, thereby pushing up yields. This risk will increase if the German government agrees to some form of further burden-sharing to stem the contagion caused by the situation in Greece.
The mitigating factor with these scenarios is the potential for more monetary support from the central banks. The Bank of England would likely expand its asset purchase scheme to counter the deflationary impact of higher gilt yields.
Bund investors would likely benefit indirectly from any further ECB support, whether that be via buying peripheral sovereign bonds or another long-term refinancing operation for the financial sector.
Where are the best opportunities for fixed income investors currently?
The most solid companies could provide an alternative to gilts and Bunds in a world with a shortage of safe assets. Along with falling core government bond yields, this has supported corporate bond returns during the worst periods of market stress.
I am overweight investment grade credit in my funds. I am focused on those companies with business models less sensitive to the economic cycle and that should be able to survive a tough environment. This strategy has resulted in a preference for consumer staples, transport, telcos, utilities and high quality asset-backed securities at the sector level.
In line with this cautious approach to bond selection, I am avoiding over-concentration in financial bonds. Arguably there is value in the sector but, because of the elevated level of macro risk, financials are trading like high yield bonds; they are very volatile, highly correlated to equity markets and there are risks around the security of their income.
Is there still value to be found in corporate bond markets?
Against history, absolute yields of around 4 per cent on non-financial corporate bonds may not look particularly appealing, but in the context of a low rate world also witness to deteriorating sovereign creditworthiness, high quality corporate bonds look like a relatively safe place for investors’ cash. Currently, investment grade corporate bonds yield more than double an average gilt and this attractive additional yield is supported by reasonably strong credit fundamentals.
With a reasonable technical backdrop there is scope for some degree of capital return, but investors should expect coupon income to contribute most. I’d expect this to translate in to mid single-digit total returns over the next 12 months.