‘Coupon clipping’ from bonds for income is a thing of the past and fixed income investors now have to rely on managers manufacturing pay-outs, according to a number of investment experts.
Not only this, they warn that the current fixed income landscape is here to stay and the asset class now offers little protection against anything but very low inflation.
Following the continuation of ultra-loose monetary policy since the financial crisis, many investors have piled into bonds over the years in a bid to find steady income.
This has caused yields across the asset class to drop, with 10-year gilt yields currently down 67.15 per cent since the start of 2009.
Given high political uncertainty and the number of macroeconomic headwinds on the horizon, bonds have seen high inflows so far this year as investors have sought safety, causing 10-year gilt yields to fall 44.35 per cent in 2016 alone.
Performance of indices in 2016
Source: FE Analytics
But this has come with heightened levels of volatility across the asset class and the performance of equities and bonds has become increasingly correlated.
If bonds are offering investors low yields and volatile, equity-like returns, does this mean they should still be held to generate income?
Iain Stealey, co-manager of the JPM Global Bond Opportunities fund, says the function of bonds – i.e. to generate regular income over a period of time – hasn’t changed, yet the yields they’re providing have drastically altered.
Annual return components of Bloomberg Barclays Global Aggregate index since 2000
Source: Barclays live, as of 30 September 2016
“Rewind to the mid-2000s and you can see that the Global Aggregate index provided a nice, consistent coupon return with the capital return only marginally adding or subtracting from the overall performance. Compare that to the last few years, during which income return has come down while the capital loss or gain has increased, and has become a larger component of the overall return,” he said.
“Unfortunately for investors, it appears this trend is here to stay as secular stagnation has taken hold.”
The manager warns high levels of global debt will weigh on both inflation and global growth and, as such, central banks are likely to keep interest rates low and find alternative ways to boost growth.
While Stealey believes bonds are fundamental for portfolio diversification purposes, he says investors looking for any meaningful income will have to look elsewhere as “clipping the coupon” is no longer sufficient.
“Investors have to look beyond core fixed income and focus on opportunities across all fixed income asset classes and across all countries,” he continued.
“Although core yields remain low, credit spreads both in investment grade and high yield look to be fair value and can tighten from here, while the recent improvement in emerging market fundamentals – growth and earnings – are creating opportunities in this space for the first time in a number of years.
Performance of sectors over 5yrs
Source: FE Analytics
“Investors should also look for the ability to dial up and down the duration risk of their portfolio. We do believe that yields are likely to remain low for the foreseeable future but that doesn’t mean they will not move.
“With central banks dominating the markets, any surprises and/or disappointments could well cause heightened volatility and investors no longer have the coupon cushion to withstand this.”
David Katimbo-Mugwanya, fixed interest fund manager at EdenTree, says his team has reduced duration risk across portfolios and agrees investors have to look beyond core holdings in the asset class to generate decent income.
“Yield is harder to reach for these days. You have a few people – us included – reaching into the alternative asset space compared to the traditional fixed income investment instruments, which are bonds,” he said.
“You have instruments such as preference shares, you have more alternative assets in real estate which also provide yield, you have people going into infrastructure as well. Not that we do, but they’re assets that also provide fixed income-like returns and a stable yield.
“In terms of the investment universe, when you’re getting crowded out by central banks and general investors.”
The manager says investors must remain flexible and, when looking for opportunities in the fixed income space, consider overseas exposure and diversifying their currency weightings.
He would also advise against holding any long-dated debt - particularly government bonds - but says corporates still offer some spread over benchmark gilts, albeit at historic lows.
“I wouldn’t chase yields aggressively in this environment, either,” Katimbo-Mugwanya said.
“There’s more pain to come when yields rise. A function of yields falling is duration goes up and, when duration goes up, it means you’re gaining a rising yield but you’re going to suffer much more capital loss.
“In fact, the reverse is almost true these days - that investors have been investing in bonds for capital gains as opposed to income and equities for income rather than capital gains because the dividend yields are not much better.”
While yields are indeed at historical lows, they have seen a slight rebound over the last week as investors have started to sell out of their fixed income holdings.
Laith Khalaf, senior investor at Hargreaves Lansdown, says it is natural to see some rebound from an extremely thin yield, given that bonds now offer such little protection against anything but very low inflation for a considerable period of time.
He also says potential rate hikes in the US raise the stakes for bond markets and could be another reason why the gilt market has been spooked.
“Of course bond yields are still exceptionally low, but anyone holding government bonds has seen their capital value fall since the market peaked in August, and by quite some margin for longer dated bonds,” he pointed out.