The consensual view on bonds is, not only are they unattractive, but a bear market scenario in fixed income is only a matter of time following a multi-decade rally in the asset class.
FE data shows, for example, that gilts have returned 193 per cent over the last two decades, leaving a 10-year government bond yielding just 1.7 per cent today.
Performance of sector and index
Source: FE Analytics
While the graph above shows traditional fixed income portfolios such as gilt funds have delivered a lower return than equities over the last 20 years, the most investors could have possibly lost from the IA UK Gilts sector over this time is just 7 per cent – compared with a hefty 45 per cent from the FTSE All Share.
Of course, there are still those who disagree with that assessment because although yields are near all-time lows, they could stay around these levels, given that inflation is running near zero, growth is by no means widespread, any interest rate hikes are expected to be minimal and well documented, there is still over-capacity in the global economy and debt-levels – which were the cause of the last financial crisis – are still very high. 
On top of that, there are swathes of institutional investor and large pension funds that are crying out for attractive levels of income; so even if yields were to spike in the short term, there is the belief that a wall of professional money could provide a floor for bond prices.
When you take these factors into consideration, it is easy to make a case for bond yields to stay low for the time being. Therefore, traditional bond funds may continue to perform well.
However, most industry experts make the point that investors buying into bonds for the long to medium term now simply cannot expect the asset class to give them the protection that it once did, as they aren’t pricing in the chance of higher inflation or interest rates at some stage over the coming five to 10 years.
Chris Metcalfe (pictured), investment director at iBoss, is a proponent of this view and recently told FE Trustnet that fixed income was in “completely unchartered territory” due to an extended period of ultra-low interest rates and quantitative easing from the world’s central banks.
Therefore, he argues that a crash in bonds is inevitable as central banks start to normalise monetary policy.
That being said, the investment director is fully aware of the need for asset classes that can act as diversifiers away from equity risk and therefore he has turned to managers with a high degree of flexibility within their fixed income funds.
One of his favourites has historically been Stewart Cowley, who had held very bearish positions within his Old Mutual Global Strategic Bond fund.
This positioning, such as his various shorts on bond indices and high weightings to low-duration assets, meant his £500m fund had struggled relative to its peers in the IA Global Bonds sector for a number of years – but Cowley was adamant that his position would start to pay off.
Performance of fund versus index over 3yrs
Source: FE Analytics
“In the words of the great Winston Churchill ‘success is not final, failure is not fatal; it is the courage to continue that counts’,” Cowley said in an FE Trustnet article last month.
“The year has been a frustration with seemingly all government bond markets falling in yield terms, led by the fragile nature of the eurozone economy plus geopolitical events. For a macro-driven fundamental-based fund, this has borne the cost as performance has suffered; however, it makes the story for 2015 even more compelling.”
“We are 12 months on with a US economy gaining continued traction and 12 months closer to an interest rate hike. The investment strategy that has been prevalent in 2014 will come to fruition in 2015.”
There were signs that this turnaround was starting to happen as well, given that his fund is top quartile over three and six months as volatility has hit the gilt market due to increased political uncertainty as a result of the upcoming election.
However, despite the pick-up in performance, last week it was announced that Cowley was to step down from his fund. Metcalfe says it is an odd time for Cowley to leave, given that his positioning would continue to help the fund outperform as the US Federal Reserve is likely to start raising rates this year.
“I don’t want to over-egg the point here, but it reminds me of the end of the tech bubble when managers were losing their jobs for avoiding the sector. Yes, Cowley has underperformed, but there have been clear reasons for it. The timing really isn’t ideal,” Metcalfe says.
Metcalfe says Cowley’s departure is a real blow for investors, including himself, as they are losing one of the major bears in the bond market. He says he and his team will now have to start the process of finding a replacement – a task he acknowledges will be hard given Cowley’s relatively unique exposure.
“From a manager’s point of view, we are really looking for someone like Stewart Cowley,” he said.
“We will be looking for high-conviction managers who don’t follow the crowd because you can’t be high conviction but still follow a benchmark.”
In truth, Metcalfe accepts that it will be difficult to find a like-for-like replacement for Cowley. However, he does use other bond funds within his clients’ portfolios, which he hopes not only provide a dampening effect against equity market volatility, but also against rising yields.
One of these is the five crown-rated Twentyfour Dynamic Bond fund, which has been a top decile performer in the IA Sterling Strategic Bond sector since its launch in April 2010.
Performance of fund versus sector since April 2010
Source: FE Analytics
Metcalfe likes the £735m fund due to its relatively nimble stature and because Twentyfour, as a group, solely focuses on fixed income.
“It is a genuinely strategic fund and we like the fact the team seem to be very aware of the current market, its history and the risks out there,” Metcalfe said.
The fund, which has an attractive yield of 5.5 per cent, invests across global government bond, corporate bond, high yield, insurance, asset backed securities and money markets for opportunities and protection.
Outside of more mainstream strategic bonds, Metcalfe says investors can afford to own more esoteric vehicles – even if they have been through a period of relative underperformance recently.
Two of these are the M&G UK Inflation-Linked Corporate Bond and Insight Inflation Linked Corporate Bond funds, which Metcalfe believes will give investors good protection over the coming years given that all of the world’s central banks are “gunning” for higher levels of inflation.
Another more niche fund that is a good option in the current environment, according to Metcalfe, is M&G Short Dated Corporate Bond – which only invests in securities that have a low sensitivity to interest rates rises.
Performance of fund versus sector over 2yrs
Source: FE Analytics
This means the £400m fund has struggled over recent years as interest rate hike expectations have dissipated, given the lower-than-expected levels of inflation – which in turn has meant longer duration assets have outperformed.
Nevertheless, Metcalfe says it is a sound choice for investors who want to protect their fixed income allocation from a bear market in bonds.
“It is either number one or bottom in the sector, depending on what happens to gilt yields.”
All in all, though, Metcalfe urges investors not to chase returns in the fixed income markets at this point in time, as he believes that while there may still be some short-term gains in that strategy, it will only end in long-term pain.
“In reality, it’s all about downside protection at the moment and we are not chasing returns. We don’t want to hear why an asset class has further upside because, sometimes, you have to just sit on the sidelines.”