The impact of the of the European Central Bank’s corporate bond buying programme could have severe ramifications for the global fixed income market, according to Miton’s David Jane, who warns that such extraordinary monetary policies only delay the need for a painful restructuring of the financial system. 
Much of the financial news over recent weeks and months has centred on the UK’s referendum on its future relationship with the EU, which is understandable given the uncertainty in markets the upcoming vote has created.
However, over recent weeks the European Central Bank (ECB) has extended its quantitative easing programme (QE) to the corporate debt market in order to generate economic growth and stoke inflation levels – a task it has so far largely failed to achieve via ‘traditional’ QE measures.
This comes at a time when developed government bond yields have plummeted to record low levels thanks to increased nervousness surrounding macroeconomic headwinds such as a potential Brexit, with the likes of 10 year UK gilts now just yielding 1.13 per cent.
Ten-year UK gilt yields over 10yrs
Source: FE Analytics
Jane, who is head of multi asset at Miton, thinks such extraordinary policies show how broken much of the fixed income market now is. He warns that, by taking such actions, central banks are only gearing markets for a greater and inevitable fall later down the line.
“We suggested many years ago that QE should be seen as emergency medicine to be used sparingly when times were difficult and then quickly exited,” Jane (pictured) said.
“If used for an extended period it can become addictive and difficult to reverse, leading to the requirement for ever more innovative policy. At some point, the pain of restructuring the broken financial institutions and companies must be taken, as was done early in the US, or economic growth stagnates and more and more medicine is required, with ever less effect.”
Bond funds, in general, have had a good start to 2016 – carrying on a bull-run that has lasted nearly three decades.
According to FE data, for example, five of the top 10 performing Investment Association peer groups so far this year entirely focus on fixed income. The IA UK Gilts and IA Sterling Corporate Bond sectors have returned 9.58 per cent and 5.32 per cent respectively, compared to a 3.28 per cent loss from the FTSE All Share.
Performance of sectors versus index in 2016
Source: FE Analytics
The reason for this trend is a general sense of nervousness among investors as risks such as the EU referendum and the US presidential election at a time when economic growth remains weak have led them to want the relative ‘safety’ fixed income can offer.
However, by becoming a constant buyer in the European corporate bond market, Jane says the ECB has put the financial system in a very worrying position.
“[The ECB’s actions] encourage yield seeking investors to buy the bonds of riskier companies where yields at least remain positive or much longer dated bonds, again where yields are higher. Once more, rather than encouraging investment in the economy, the policy encourages risk taking in the financial system,” he said.
He says that, over the longer term, there appears to be two potentially concerning consequences of this corporate bond buying policy.
“Firstly, what happens when a company that has the central bank as a significant creditor gets into financial difficulty?”
“The central bank has a clear conflict of interest between its role as a creditor and its role in the economy. This is potentially a world where unviable businesses will continue with government support with all the negative consequences for economic growth and allocation of capital that this implies.”
“Secondly, we cannot see how the central bank can extract itself from this policy without a significant and negative impact on the markets. The mere suspension of the bond buying programme implies a tightening of policy as, when bonds mature, the cashflows go to the central bank rather than the institutions which traditionally hold the bonds.”
“So these institutions do not have the cashflow to buy the new bonds which are issued to fund the maturity.”
Nevertheless, UK investors have been piling into bond funds.
According to data from the Investment Association, fixed income funds saw net inflows of £679m during the month of April, which compared a net retail outflow of £635m from equity funds over the same period.
Net retail fund sales in April 2016
Source: FE Analytics
Many have questioned why investors have taken such actions, especially given that many were bearish on bonds heading into the year and yields have only fallen over recent months.
Of course, some would argue that though the ECB’s actions could have harmful effects on the European fixed income market, investors aren’t making a mistake buying sterling corporate and government debt.
Indeed, with the potential volatility a Leave vote could create next week, there is the argument that buying sterling bonds now is a good strategy as equities would likely bear the brunt of sudden ‘risk-off’ phenomenon.
However, Jane warns that thanks to the globalised nature of current financial markets, ECB’s unorthodox policy does have an impact on non-European debt.
“We like all the assets we hold to have a reasonable expectation of a positive long term return,” Jane said.
“At present the pool of available investments which offer attractive returns is becoming ever smaller as a consequence of European and Japanese central banks activity and its knock-on effects into other markets. Thankfully, we are not benchmark constrained, and so we do not have to fish from a pool where such a large proportion of government and good quality corporate bonds now have negative yields.”
David Jane took over the Miton multi-asset fund range from Martin Gray in June 2014, having previously held the position of head of equities at M&G and after launching his own boutique.
Performance of fund versus sector under Jane
Source: FE Analytics
He has comfortably outperformed his peer group composite over the longer term and his CF Miton Cautious Multi Asset fund has been a top quartile performer in the IA Mixed Investment 20%-60% Shares sector since he has been at the helm.
Currently, Jane holds 42.4 per cent in bonds in that £316m fund, 49.3 per cent in equities and the remainder is split between property, commodities and cash. It has an ongoing charges figure of 0.82 per cent.