To continue using this website, please tell us a
little about yourself:

This site uses cookies. Some of the cookies are essential for parts of the site to operate and have already been set. You may delete and block all cookies from this site, but if you do, parts of the site may not work. To find out more about cookies on the website and how to delete cookies, see our Privacy and Cookie Policy.

I accept the FE Trustnet cookie policy

For more information Click here

Login

Register

It's look like you're leaving us

What would you like us to do with the funds you've selected

Show me all my options Forget them Save them
Customise this table

Bond investing shouldn’t be about duration alone

Heartwood Investment Management’s Matthew Toms explains how the firm is attempting to strike the right balance in its fixed income exposure.

Matthew Toms

By Matthew Toms , Heartwood Investment M...
Tuesday July 26, 2016

Logic dictates that borrowers should pay lenders and not the other way round. However, the world of negative interest rates is defying that logic and investors are increasingly challenged to find value across global fixed income markets when yields are so low.

Going forward, the risk is that investors are likely to capture more of the downside in market sell-offs than upside in market rallies, and therefore we anticipate higher levels of bond market volatility.

Managing fixed income in the current environment is more challenging and demands investors stay focused on preserving capital as well as seeking return. Over the last few years, investors could make attractive returns from investing in longer-duration assets as yield curves flattened.

However, we believe there is less value to be found by simply taking duration exposure alone, as well as more downside risk.

Of course, it would be impossible to determine with any certainty the point at which interest rates will start to rise; for now we remain under the scenario of ‘lower for longer’. However, there are rational reasons to believe that yields at current levels are unsustainable:

1. While headline inflation will stay low, deflation threats in developed economies have diminished. The rise in oil prices will feed through into headline inflation in coming months.

2. Labour markets are reaching full employment, particularly in the US, and this should put modest upward pressure on wages.

3. From a UK perspective, sterling’s devaluation will ultimately be inflationary, though somewhat offset by lower growth. Further out, a weak currency, large current account deficit, wider fiscal deficit and credit ratings downgrades will be less supportive to UK gilts.

Performance of sterling vs dollar over 1yr

 

Source: FE Analytics

4. We have been saying for some time that central banks cannot be solely responsible for stimulating growth and reflating economies. Governments will at some point have to share the load. A large fiscal stimulus package in the form of significantly higher infrastructure spending could spook bond markets and lead to even higher debt levels in developed economies.

5. The US treasury market tends to exert a gravitational pull towards other developed sovereign bond markets. When the Fed restarts its tightening programme, currently priced for early 2018, this is likely to push yields higher globally.


It is therefore important that investors are be able to strike the right balance between participating when bond prices are rising and avoiding getting caught out should yields move meaningfully higher, such as during the taper-tantrum episode in mid-2013.

It is a difficult conundrum, but we believe the optimal risk/return approach is twofold.

First, we believe it is important to stay fully invested in government bonds on a market weight basis, but in short-duration assets that we would be happy to hold to maturity should interest rates rise. While this position will not always fully participate if bond markets rally, it should help to preserve capital if yields rise sharply.

Second, we are holding a bias towards some higher yielding areas of the credit market. We believe that the current environment is ripe for active investors who are able to cast their net wider and search out value in more esoteric areas of an $87trn global fixed income universe.

In the post-financial crisis years, banks have retrenched from lending, fuelling growth in public debt markets - euro high yield, emerging corporate debt, as well as specialist areas, including infrastructure and peer-to-peer lending.

These sectors are less duration sensitive and offer investors a higher yield premium for the credit risk taken (i.e. risk of default).

Within our own portfolios, we have been increasing exposure to emerging market sovereign debt and US high yield energy bonds, where valuations look more attractive relative to sovereign bond yields. In addition, we are continuing to seek out yield opportunities in property and infrastructure.

 

Matthew Toms is an investment analyst at Heartwood Investment Management. The views expressed above are his own and should not be taken as investment advice.

FE Trustnet Registration

This article is for professional investors only. You will be redirected to the News & Research homepage in seconds. If you are having problems getting to the page, please click here

Videos

Data provided by FE. Care has been taken to ensure that the information is correct, but FE neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

You are currently using an old browser which will not be supported by Trustnet after 31/07/2016. To ensure you benefit from all features on the site, please update your browser.   Close