Market negativity towards bonds has moved too far too quickly, according to Canaccord Genuity Wealth Management’s Paul Philip, who says a buying opportunity may have opened up for income investors in certain parts of fixed interest.
Many market participants have predicted a bear market in bonds over recent years thanks to high valuations, low yields and an improving economic backdrop. However, most of the time these outlooks have turned out to be wrong as although yields have spiked at times, they have usually fallen immediately afterwards due to macroeconomic woes or equity market volatility.
However, now the US Federal Reserve has raised interest rates and is planning four more hikes over the cause of the year, sentiment towards bonds suggests the much prophesied bear market in fixed income is now under way.
Performance of indices over 1yr
Source: FE Analytics
While the FOMC’s decision did indeed cause yields on government bonds to spike, Philip – senior investment manager at the group – says there are a number of reasons why this isn’t the start of a more bearish trend.
“Fundamentally, there are various elements that make this a positive environment for bond strategies, although naturally investors are cautious of the potential headwinds for bond markets when a rate-hiking cycle is likely to begin,” Philip said.
First and foremost, the manager points out that while the growth backdrop for G7 nations is generally positive and likely to remain that way, it is by no means strong enough to justify huge rises in interest rates.
On top of that, Philip says there are still significant deflationary forces around the world which should keep a lid on bond yields – such as the recent falls in commodity prices and slowing growth in China.
“This is a disinflationary backdrop that looks to be embedded for the foreseeable future. This is limiting any sell-off in developed market government bonds that offer liquidity and a real return, given low domestic inflation levels,” he said.
There are of course many professional investors who disagree with this view, though.
Seneca’s Peter Elston, for example, told FE Trustnet last year that while yields may fall temporarily over the short term, investors are guaranteed to lose money in bonds on a longer timeframe.
He says that most investors believe bonds will continue to act has they have done over the past 25 to 30 years (gradual returns with very low drawdowns) but the last few decades, thanks to a credit boom and various central bank policies, are unlikely to be repeated.
Performance of sectors since 1990
Source: FE Analytics
“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 mind set 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.”
However, it is worth noting that thanks to the significant China-led sell-off in global equity markets yesterday, yields on 10-year US and UK government bonds fell significantly once again.
Philip says that investors can afford to hold sovereign debt for protection but that the major area of interest is within the corporate credit space.
Spreads within corporate bonds have been widening for a number of months now as concerns about a global industrial slowdown and a diminishing appetite for risk among investors has hurt the asset class.
On top of that, there have been increased concerns towards high yield bonds thanks to falling commodity prices, decreased liquidity, the closure of certain funds and an expected pick up in defaults.
Performance of index over 1yr
Source: FE Analytics
However, with yields now far more attractive, Philip says buying opportunity may have opened up for income investors.
“We are not overly concerned that we will see a broad increase in default rates, but liquidity fears – and the risk that investors follow the herd to the exit – will likely continue to constrain demand. The recent increase in corporate bond spreads has appeal for investors seeking low risk income, and outside of oil and resources, the high yield market offers opportunities,” he said.
Nevertheless, the manager can certainly understand why investors are wary of bonds.
He says though that following a panicky few months for fixed income investors, the dust will begin settle and opportunities will arise.
“The problem at the moment is less about the valuation point and more about negative sentiment and momentum, which is why, over the last few months, we have been reducing our exposure to specialist funds providing high yield and emerging market exposure,” he said.
“While some of the proceeds have been reinvested, we have been happy to increase our cash position and we are well placed to buy cheaper assets when we feel that sentiment/momentum may be shifting.”
Chris Iggo, chief investment officer of fixed income at AXA IM, strikes a far more pessimistic tone, though.
“Our overall view is bearish on fixed income as the state of the market makes it difficult to take strong top-down views on most parts of the asset class,” Iggo said. “A tactical cautious approach to managing bonds is required at this juncture, with the Fed pushing rates higher and there being some default and liquidity concerns in the markets.”