Large swathes of the fixed income market are no longer offer protection against equity risk says Fraser Lundie, co-head of credit at Hermes Investment Management, who warns that excessive low yields mean that most bonds are now positively correlated to risk-assets. 
Lundie, who also runs the Hermes Multi Strategy Credit fund, warns government bonds, which have been used for many years as a safe haven in times of economic uncertainty and as a hedge against the stock market, look particularly unappealing.
Traditionally, there has been a negative correlation between equities and bonds, so when stocks sell off, bond prices have tended to rise. Indeed, FE data shows that over the past 10 years, gilts have had a correlation of just 0.04 to the FTSE All Share.
Relative performance of indices over 10yrs
Source: FE Analytics
However, bonds have rallied for a long time, due to ultra-loose monetary policy from the world’s central banks and more recently hit historically low yields in the wake of the EU referendum result in June.
Lundie says he is concerned about bonds for the next few years, particularly as a hedge against risk, given that this prolonged rally has led to greater correlations between the two asset classes.
“Bonds may not be a good hedge because if you look at that negative correlation, it’s largely driven by inflation expectations and one might argue that we are at or near the bottom of the expectations on a multi-year horizon,” Lundie (pictured) said.
“If that’s the case then who’s to say we’re not going to have several years that look more like the 80’s and 90’s where you had a positive correlation between government bonds and risk assets - and if that is going to happen then it has big implications for the risk/return profile”.
Performance of indices during the ‘taper tantrum’
Source: FE Analytics
An indication of this positive correlation was during the taper tantrum of 2013, when the Federal Reserve first muted the idea of reducing its quantative easing programme, which led to a significant sell-off in the government bond market, as well as a sell-off in the risk asset market.
Since then, though bond yields have, in some cases, fallen into negative territory, with the prices continuing to rise. Lundie warns that a 0 per cent yield is not the floor anymore, given the unorthodox monetary policy approaches being taken by central banks around the world.
“So if you take away the floor then who knows but whether it does or doesn’t the real point for me is remembering why you’re buying them in the first place.”
With yields so low, Lundie says the only reason for holding bonds remains as a hedge, but there are other ways of achieving downside protection.
“We believe that finding such alternative sources of downside protection to long-duration credit is imperative now that the goldilocks conditions of the past – strong long-term bond yields and negative correlations – no longer exist.”
The manager uses the idea of a defensive bucket within his portfolios, incorporating multi-strategy credit and absolute return credit.
“We run essentially bearish credit strategies to replace or take away that dependency on interest rate correlation,” he says.
“At the moment we don’t particularly like the tech sector and within that we think that there is some stretched valuations versus the fundamentals in names like Hewlett Packard,” he said.
He has therefore taken a short position in the technology giant, which he believes is expensive at current valuations.
Another option is to look at the liquidity profile of a company, Lundie says. If a company looks able to cover short-term issues, but has longer-term problems that may not be solved, he will take a long position over one year, with a short position over five years.
This, among other strategies, is what he is using in his Hermes Multi Strategy Credit fund, which has returned 7.7 per cent to investors since its launch in May 2014.
Performance of fund since launch
Source: FE Analytics
James Klempster, manager of the Momentum Factor range of funds, agrees that, while bonds are the ultimate safe haven in periods of market volatility, there is very little value at the moment.
“We have very little exposure to the gilt market – they just look phenomenally unattractive and the chances of us getting a real return out of the asset any time soon is very low indeed,” he said.
He says there’s very little value out there today in government bonds, but, as he has to hold some bonds to satisfy his investment criteria, he has chosen to back high-yield corporate bonds.
“We do need some interest rate sensitivity in the portfolios - what’s known as duration - so we have other fixed income asset classes in there. We use high yield which is lower quality credit based in the US and we tend to hedge that into sterling to take out the currency risk”.
Klempster uses the AXA US Short Duration High Yield Bond fund, which he says is relatively conservative compared to its peers.
It buys lower duration bonds meaning they are less likely to be impacted by interest rate changes, but also that the risk of default is smaller – given their shorter period of time to maturity – and therefore the certainty of achieving returns are higher.
Indeed, a look at the graph shows it has underperformed both equities and government bonds over recent years, but has also exhibited lower volatility and smaller drawdowns.
Performance of fund vs equities and government bonds over 3yrs
Source: FE Analytics
“We think there’s good enough opportunities in high yield that you don’t need to be the high risk player there we would rather be slightly more conservative and rise up the market,” Klempster said.
“We would rather have managers that are more conservative and that buy the stuff that’s better covered. That tends to be the best way to achieve decent long-term returns in high yield.”
