A significant rally in yields has left government bonds very overvalued, according to FE Alpha Manager Ian Spreadbury, who has moved to reduce his overall duration in preparation for a correction in the fixed income market. 
Fixed income has been the asset class that has continually deceived investors over recent years.
Many experts have been bearish on bonds as a result of the low yields that followed central bank policies such as ultra-low interest rates and quantitative easing, but prices have once again soared in 2016.
There have been a number of drivers behind this trend, whether that has been due to macroeconomic headwinds in the form of China’s slowing growth, lacklustre global economic growth, fears of a policy mistake by the US Federal Reserve or uncertainty surrounding the imminent EU referendum. Whatever the cause, there has certainly been a flight to safety.
According to FE Analytics, for example, 10-year UK gilt yields reached their lowest ever level earlier this month (1.11 per cent) and are therefore down 31 per cent since the start of the year.
Ten-year UK gilt yields in 2016
Source: FE Analytics
German, US and Japanese government bond yields have also dropped considerably so far this year, with much of the developed sovereign debt market now offering a negative yield.
However, Spreadbury, who runs the £1.6bn Fidelity Strategic Bond fund, thinks this trend has gone too far.
Although he is renowned for his more cautious approach and his belief that much of the bearish commentary surrounding bonds has been way off the mark, the FE Alpha Manager has started to sandbag his portfolios against a correction in the market by reducing his duration – or sensitivity to interest rate movements.
“At the start of last week, we reduced duration across the Fidelity Strategic Bond and Fidelity Flexible Bond funds by two years,” Spreadbury (pictured) said.
“This was in response to the extraordinary rally in government bonds witnessed over the last fortnight. Yields on 10-year German bunds turned negative while yields on US and UK 10-year bonds sank to record lows.”
“These moves have largely been due to a slew of disappointing economic data, starting with May’s US payrolls report and more recently, concerns about the UK EU referendum. Polls have indicated an increasing chance of a Brexit, which is being interpreted as a risk-off event for markets globally.”
Spreadbury certainly hasn’t become a raging bull, however.
He has longed argued that bonds haven’t been in a bubble, adding that yields wouldn’t spike materially given overcapacity in the global economy, high debt levels and an ageing population.
However, the manager prioritises capital protection – Fidelity Strategic Bond has been top quartile for annualised volatility and top decile for maximum drawdown in the IA Sterling Strategic Bond sector over 10 years, as well as posting the best risk-adjusted returns (as measured by its Sharpe ratio) – and therefore he thinks now is the time to shield portfolios against a reversal in the recent trend.
Fund’s annualised volatility, maximum drawdown and Sharpe ratio versus sector
Source: FE Analytics
“Whilst we have benefitted from our relatively long duration position compared with peers over the last 18 months, government bond valuations now look more stretched than before,” he said.
“Government yields are well below expectations for nominal growth and we believe a significant deterioration in inflation and growth, or an expansion of monetary support globally, is needed to justify current valuations.”
“While government bonds have benefited from a shortage of safe havens, which may continue over the short to medium term, we felt it prudent to reduce duration at these levels.”
A number of leading market commentators have argued that bond prices no longer reflect economic reality, especially when many investors are paying to lend to various governments around the world.
However, while Spreadbury has reduced Fidelity Strategic Bond’s duration from 7.03 years to 5.04 years, he doesn’t expect to lower it much further from here as he understands the role his fund plays within an investor’s portfolio.
“With government yields exceptionally low, it may seem tempting to reduce duration further, however the duration component continues to play an important diversifying role for the portfolio. Specifically, duration helps to offset credit risk and reduces the fund’s correlation to equities, thereby improving its diversifying properties when used as part of a balanced portfolio,” Spreadbury said.
Since Spreadbury launched the Fidelity Strategic Bond fund in April 2005, it has been the fourth best performer in the IA Sterling Strategic Bond sector, with gains of 91.53 per cent – putting it some 30 percentage points ahead of the peer group average over that time.
Performance of fund versus sector since launch
Source: FE Analytics
It has beaten the sector in five of the last 10 calendar years, largely as a result of its tendency to lag in rising markets. Nevertheless, FE data also shows it has had the fourth lowest downside capture ratio over 10 years – again reflecting Spreadbury’s ability to protect capital.
He currently holds around a quarter of his portfolio in government bonds, with the rest split between investment grade corporate bonds, high yield and asset-backed securities. The fund yields 2.84 per cent and has an ongoing charges figure of 0.68 per cent.