Traditional ‘safe haven’ bonds are guaranteed to lose money over the long-term, according to Seneca’s Peter Elston, who warns that both private and professional investors are at risk unless they rethink the way in which they view fixed income in their portfolios.
The traditional asset allocation model for investors approaching retirement to is to ‘de-risk’ their portfolio as they enter their later years by reducing their exposure to risk assets (such as equities) and upping their positions in developed market government bonds.
In truth, this has been a phenomenal strategy for most over the past 30 years as a huge credit boom, falling interest rates and recent monetary policies such as quantitative easing have led to an almost unprecedented rally in fixed income.
FE data shows, for example, that since its inception in December 1989, the IA UK Gilts sector has returned 325 per cent. While the FTSE All Share has returned more than 600 per cent, as the graph below shows, those bond funds have delivered investors an incredibly smooth ride.
Performance of sector versus index since Dec 1989
Source: FE Analytics
According to FE Analytics, the average gilt fund has had a maximum drawdown of just 13.95 per cent over that time. The FTSE All Share, on the other hand, has had a maximum drawdown of close to 50 per cent.
Here is where Elston, chief investment officer at Seneca, is concerned.
He says that most investors still expect a similar outcome from bonds over the next 30 years or so, but with most developed market government bonds now throwing off negative real yields, this simply cannot happen again.
“There is no value in bonds. To make any money out of them you have to expect inflation to fall very sharply from current levels, which is already very low, and you’ve got to expect real interest rates to fall from already very low levels,” Elston (pictured) said.
“It might happen, but it has to have a very low probability when central banks are trying everything to stop that from happening.”
Of course, many have predicted the a bear market in bonds for a number of years now, only for yields to continually fall and hurt many managers’ relative performance.
There are also those who argue that while yields are very unattractive, government bonds can continue to act as a natural hedge against equity market volatility as they have done in the past.
According to FE data, the FTSE All Share posted 15 negative quarters (out of a possible 40) over the 10 years between the start of 2005 and the end of 2014. In 11 of those, the IA UK Gilts sector average delivered a positive return.
Performance of sector versus index between 2005 and 2014
Source: FE Analytics
Elston, however, say investors are very naïve to think that will continue.
“It might continue in the short term but it will end at some point,” he said.
“The mind set at the moment is that bonds are low risk. That’s historically what government bonds are supposed to be. If you buy this 10 year inflation-linked gilt, you are guaranteed to lose 8 per cent of your real capital.”
“If you buy the 30 year and hold it till maturity, you are going to lose 25 per cent of your real capital.”
“There is no arguing with that. Is that low risk? I don’t think so. I would call that high risk because you are making a permanent loss of capital. It is very important to look at it from that point of view, rather than volatility.”
All told, Elston says the industry view on bonds needs to drastically change.
He says that despite the clear lack of value and yield, private investors and pension funds continually buy bonds for safety based upon the outcome of the last 30 years – a period Elston believes to be a freak when taken into a longer term view point.
“I suspect that the mind set is still very much [that they are low risk] rather than the reality that they are high risk. If you look at insurance companies who are, because of regularity capital are being forced to hold bonds, you look at central banks who are big holders of bonds and there is a similar mindset among other pension funds and retail investors that bonds are safe.”
“They [bonds] may continue to do ok for another year or so, but this bond bull market is going to end. From 1940 to 1980 the US long bond index fell -2.7 per cent per annum in real terms. But gradually, so it was low risk, right?”
James Dowey, chief investment officer at Neptune, agrees with Elston and says investors have never had it so easy in bonds over the past 30 years due monetary conditions.
“As we move from 2015 to 2016, we are closing a chapter on the global economy and markets and opening a whole new one.”
“I think we are going to see a rising interest rate and bond yield environment. That isn’t a controversial thing to say but was is controversial is that this secular trend of falling interest rates (both real and nominal) that we have seen 30 years and has dominated the careers of most people in the market, is over.”
“Over the past 30 years or so, it has been a very easy period to look like a real hero in pretty much every asset class, but bonds in particular. In short, I don’t think anyone is capable of responding well if that trend [falling interest rates] is about to end.”
One of the major arguments against a bear market in bonds (apart from the view that there is still too much debt in the system, the population is getting older and the high levels of over-capacity in the economy) is that pension funds are waiting on the side and crying out for higher yields.
Therefore, if yields were to spike for any reason, there would be natural demand for bonds as groups aim to match their liabilities.
Certainly, many believed that 2014 would be the start of the bear market in fixed income as the US Federal Reserve was due to end quantitative easing, global growth seemed to be improving and equities were going gangbusters.
However, as soon as US and UK 10-year government bond yields breached 3 per cent in the January, they went on to deliver double digit gains.
Performance of indices in 2014
Source: FE Analytics
However, Elston says pension funds will not be able to continually support the market over the longer term.
“I see those negative real yields and that, to me, screams no value whatsoever.”
Given Elston’s comments, it is no surprise that the five-crown rated CF Seneca Diversified Income fund holds no G8 government bonds.
Its manager Alan Borrows has, in part, designed the fund to help investors generate enough income through retirement. The group also use a distinctive value approach to multi asset investing, unlike the majority of their peers.
Therefore, the manager derives the large majority of his yield (which is currently 5.13 per cent) from equities and ‘alternatives’, which includes the John Laing Environmental Assets, Ranger Direct Lending and Doric Nimrod Air 2 (an airline leasing investment trust).
Elston says these alternative trusts are crucial for income seeking investors due to their attractive yields and as they offer a different, uncorrelated, dividend stream relative to bonds and equities.
In terms of bonds, Borrows only holds high yield bond funds, short-dated bond funds and emerging market debt funds.
According to FE Analytics, while the fund has only narrowly outperformed the IA Mixed Investment 20%-60% Shares sector over five years from a total return point of view, it has been one of the its top five income payers over that time.
CF Seneca Diversified Income’s dividend history
Source: FE Analytics *figures based on a £10,000 investment made in Jan 2014. The 2015 dividend payment shown above only includes two thirds of the fund's distributions.
Not only has the fund paid out £3,450 on an initial £10,000 made in January 2010, it has a good record of gradually increasing its annual distributions as while it has reduced its pay-out twice over that time, it was only by a miniscule amount. It also looks likely to have increased its dividend again this year.
CF Seneca Diversified Income has an ongoing charges figure (OCF) of 1.35 per cent.