While government bonds have traditionally played an important role within conventional balanced portfolios, investors should recognise the potential risks facing the asset class and ensure they have an active asset allocation approach in place, Columbia Threadneedle’s Toby Nangle argues.
Bonds have gone through a 35-year bull market that has only intensified in recent years as the world’s central banks responded to the global financial crisis by dropping interest rates to record lows and embarking on massive quantitative easing programmes.
FE Analytics shows that UK government bonds (as measured by the FTSE Actuaries UK Conventional Gilts All Stocks index) made a 162.25 per cent total return between the turn of the century and the end of June 2016, outpacing the FTSE All Share’s gain by a significant margin.
Performance of indices since 1 Jan 2000
Source: FE Analytics. Total return in sterling terms between 1 Jan 2000 and 30 Jun 2016. Past performance is not a guide to future performance.
“Bonds have been in a bull market for some time and this has boosted returns for static investors,” Nangle (pictured), who runs the Threadneedle Dynamic Real Return fund, said. “The falling yield environment over the past 30-plus years have boosted bond returns meaningfully.” 
The manager notes that during this time declines in yields have been sharpest at points when stock markets were falling; indeed, bonds have tended to make returns of between 8 and 12 per cent over 12-month periods when equities were down 20 per cent or more.
“Because of the secular decline in UK and government bond yields over the period, the ‘bad times’ for bonds – which were the ‘good times’ for equity markets – have not been associated with large negative returns,” he added. “Instead, they have usually been associated with small positive returns.”
“But given that UK and global government bond yields are now so low, we doubt that they will be able to deliver the sort of ‘insurance’ with which they have been associated for the past 25 years.”
In the three years between its launch and the end of June 2016, Threadneedle Dynamic Real Return made a 15.38 per cent total return. This means it achieved a similar gain to the FTSE All Share but is behind the FTSE Actuaries UK Conventional Gilts All Stocks index by just over nine percentage points.
However, as the chart below shows, the £267.1m fund has achieved this return with less volatility than both indices. Over the past three years, its annualised volatility has been just 4.50 per cent compared with 6.66 per from gilts and 10.09 per cent from stocks.
Risk/returns over 3yrs
Source: FE Analytics. Total return in sterling terms and annualised volatility between 1 Jul 2013 and 30 Jun 2016. Returns net of fees. Past performance is not a guide to future performance.
Nangle said: “The Dynamic Real Return fund’s return has been achieved with less volatility that UK bonds, but how? Has it simply loaded up with long bonds? In fact, it hasn’t.”
“Apart from some short-dated UK government exposure, so near cash-like, the only UK government bond exposure the fund has had is to the War Loan – which was called back in late 2014. Other government bond exposure has been limited to Australian and Mexican government bonds.”
At the end of June, the fund has only 3 per cent of its portfolio in developed market government bonds. Its largest weighting was to investment-grade credit, principally through at 24 per cent allocation to Alasdair Ross’ £525.2m Threadneedle UK Short Dated Corporate Bond fund.
The following chart shows the fund’s historic asset allocation. It shows how the fund – which places the importance of finding the areas of the market with the most opportune risk/reward balance at the heart of its investment process – has used a wide range of assets to achieve equity-like returns with less volatility than government bonds.
Threadneedle Dynamic Real Return asset allocation since inception
Source: Columbia Threadneedle Investments, June 2016
Nangle says the fund is highly unlikely to allocate meaningfully to long-dated government bonds in the future, as their present high valuations mean they could find it increasingly difficult to live up to their ‘safe haven’ reputation should the market be hit by fresh falls.
“With yields where they are, there is a strong argument for not having any significant element of duration[1] in the portfolio, which we have done within the Dynamic Real Return fund – albeit in hindsight a good opportunity given the prospective risk adjusted returns from long duration fixed income assets,” he said.
“So while we believe that global government bond yields have been depressed by aggressive and unorthodox central bank activities, and as such do not offer much upside to investors, we also recognise that the function of government bonds within a 60/40 equity to bond strategy (to reduce volatility and provide some downside protection during equity market falls) is meaningfully challenged and therefore the need for active asset allocation is even more evident.”
Important Information. Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. The mention of any specific shares or bonds should not be taken as a recommendation to deal. The fund characteristics described above are internal guidelines (rather than limits and controls). They do not form part of the fund’s objective and policy and are subject to change without notice in the future. Any opinions expressed by Columbia Threadneedle Investments are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Threadneedle Opportunity Investment Funds ICVC (“TOIF”) is an open-ended investment company structured as an umbrella company, incorporated in England and Wales, authorised and regulated in the UK by the Financial Conduct Authority (FCA) as a Non-UCITS scheme. Subscriptions to a Fund may only be made on the basis of the current Prospectus and the Key Investor Information Document, as well as the latest annual or interim reports and the applicable terms & conditions. Please refer to the ‘Risk Factors’ section of the Prospectus for all risks applicable to investing in any fund and specifically this Fund. The above documents are available in English only and may be obtained free of charge on request from Columbia Threadneedle Investments at PO Box 10033, Chelmsford, Essex CM99 2AL. Threadneedle Investment Services Limited is registered in England and Wales, Registered No. 3701768, Cannon Place, 78 Cannon Street, London, EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.
[1] Duration is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.