Investors should expect a ramp up in volatility in the bond market as the Brexit referendum draws closer over the next four months, according to Eric Holt, manager of the Royal London Sterling Extra Yield Bond fund.
Since the outgoing Mayor of London Boris Johnson waded into the EU referendum debate in support of an exit at the weekend, the market has given strong signs it is not going to shrug off the chance that a Brexit is on the cards.
Sterling has sold off and gold has continued its rally since the start of the week while the Brexit issues areobstructing the recovery in equities too.
Performance of index in 2016
Source: FE Analytics
Holt, who has been manager of the £1bn Royal London Sterling Extra Yield Bond fund since 2003, thinks the coming months could see greater market turmoil due to the current uncertainty over the seemingly split vote.
“We know the market does not like the unknown and so we expect more volatility. In the longer term that could present a buying opportunity but in the shorter term we should expect more volatility and more uncertainty,” he said.
Senior Fund manager at Royal London Rachid Semaoune says systemic risk has been creeping up in 2016 more broadly due to geopolitical tensions and the Syrian migrant crisis, on top of the Brexit referendum.
“It has been one of the worst starts to year on record. Government bonds have seen their yields narrow to their historic lows. However, we think fears of a recession are overblown. We think the world will continue to grow but at a much slower pace.”
However, central banks are likely to introduce more measures to support growth while interest rates are likely to stay lower for longer, he adds, with the UK not likely to see a rate rise until at least 2019.
This environment has been unsupportive to the riskier parts of the fixed income market that Holt and Semaoune tend to look at for the fund’s core holdings.
Performance of indices in 2016
Source: FE Analytics
The fund, which is benchmark agnostic, has a natural bias to value and a sizeable exposure to high yielding financials’ credit.
This has worked well in recent years with the fund ahead of the IA Sterling Strategic Bond sector average in each calendar year since 2008, but it is bottom quartile so far this year.
According to FE Analytics, the fund has made a total return of 44.32 per cent over the past five years, clocking up the second best total return in the sector over this period
Performance of fund, sector and index over 10 yrs
Source: FE Analytics
Chris Iggo, chief investment officer for fixed Income at AXA Investment Managers, says US high yield in particular looks attractively priced due to the recent sell-off.
“The market as a whole is pricing in default rates that are approaching the kind of levels seen in 1997 and 2008.”
“Away from the oil and gas sector the market should be supported by the stability of US domestic demand, better consumer real income and spending, lower unemployment and more supportive bank financing. There is a huge part of the high yield market yielding in the 5-10 per cent range.”
Financials, predominantly European banks, look even more attractive due to the selling, he adds.
“In Europe that sector still delivers a yield that is 2x the market average and tactically there should be scope for some further near-term outperformance as banks continue to take steps to improve their debt profiles”
“In the US, the bank sector yields 3 per cent with a spread of 173bps over US Treasuries and it is generally acknowledged that the US banking system is in better shape than the European one, even if they face common problems in terms of making money from investment banking.”
Russ Koesterich, BlackRock’s global chief investment strategist, says however that investors still face “a bevy” of challenges
“Risks of a recession appear to have moderated, but weakness in corporate earnings has not. Another challenge for investors will be the Federal Reserve's (Fed's) course of action. The Fed is likely to be true to its word and proceed cautiously, but inflation has strengthened, suggesting that the central bank may not be quite as dovish as the market expects.”
“The Fed is unlikely to raise interest rates four times this year, as it suggested last December, but will the central bankers wait out all of 2016? Probably not, yet this is exactly what the futures market is suggesting. “
“For investors, there are several implications. First, the Fed is unlikely to provide the same backstop for asset prices as it has in recent years. Second, in a world in which central bank policy is both less available and less potent, volatility is more likely to remain above its historical average.”