Despite cutting back on long duration bonds in favour of better yields, investors should not ditch the strategy altogether, according to Fidelity International’s Charles McKenzie.
McKenzie, Fidelity’s chief investment officer of fixed income, said investors have reduced the duration of their fixed interest exposure in recent years as inflation continues to rise and interest rates and yields remain at historic lows.
Earlier today, data from the Office for National Statistics highlighted the issue as UK CPI inflation reached 2.9 per cent in May, up from 2.7 per cent in April meaning the real returns offered by gilts, which have a yield of less than 1 per cent, remains negative.
The chart below shows how expensive bond valuations have become with the Bloomberg Barclays Global Aggregate index up by 28.79 per cent over the past five years despite the low yields on offer.
Performance of index over 5yrs
Source: FE Analytics
Indeed, investors have upped credit risk to capture higher yields while shortening duration for safety.
However, McKenzie said investors should not abandon long-duration bonds completely and instead consider adding global exposure, inflation-linked bonds or a shift away from government bonds as ways of managing duration within a balanced portfolio.
He said: “With interest rates set to stay low, the right balance between yield and safety is difficult. But don’t give up on duration; it still has a very important part to play in a balanced portfolio.”
“A lot of investors, when looking at fixed income want an optimal combination of yield and safety,” he explained.
“Often, they believe the best position to take is overweight credit risk, that generates a good level of income, while shortening duration to reduce the sensitivity to changes in government bond yields.”
He noted, however, that this may not always necessarily be the right thing to do.
“Shortening duration in clients’ and investors’ portfolios has two very important consequences,” the chief investment officer said.
“First of all, if duration is significantly shortened – i.e. by either hedging or favouring more short-dated bonds – you are giving up a lot of income as longer dated bonds usually have a higher yield than short-dated alternatives.
“The second important point to make is that shorter-duration leads to increasingly higher, more positive correlation between the fixed income and equities components of an investor’s portfolio.
“As bonds are typically held to act as a good diversifier from the equity markets, you can therefore miss out on the diversification benefit if you reduce duration by too much."
Indeed, as the below shows, bonds and equities acted very differently during the financial crisis, though many admit that they have become more correlated in recent years, potentially due to this shift to shorter durations.
Performance of indices over 10yrs
Source: FE Analytics
McKenzie said there are three ways an investor can still gain exposure to long duration bonds despite the interest rate environment likely to be benign for some time.
The first is that investors should look to take on inflation linked bonds as a hedge to the rising CPI figures outlined earlier.
“Inflation-linked bonds are not often talked about, but being involved in real assets and inflation linked markets can also be a good diversifier for investors in fixed income,” he said.
“While inflation still looks very well controlled, and we expect that to continue for some time, inflation-linked bonds offer some protection if inflation does indeed surprise to the upside.”
Inflation-linked bonds rocketed last year as it appeared inflation was creeping back into markets particularly the UK which has seen the highest inflation figures following the fall in sterling last year.
Performance of index vs CPI over 5yrs
Source: FE Analytics
Speaking at the end of last year, Ben Conway, who co-manages the top-performing MI Hawksmoor Vanbrugh and MI Hawksmoor Distribution funds with Richard Scott and Daniel Lockyer, said: “They are assets that are expensive and will get more so; we don’t want to play that game.”
The second approach McKenzie should take for long-duration assets is to look at geographies outside of the UK, as people can have a home-bias when it comes to investing.
“It is important to think globally. There are different cycles around the world and investors should take advantage of being invested in different regional markets rather than just their home market,” he said.
“At the moment, for example, we find good investment opportunities in the US and Australian interest rate markets, where global as well as idiosyncratic factors favour a long duration exposure.”
The third option is to look beyond government bonds, which as mentioned earlier are yielding very little in many developed countries including the UK and Europe.
Opportunities outside government bonds exist, he said, but careful selection is key.
“Our research suggests that currently investors get adequately compensated in terms of extra spread for the credit and default risk they are taking on by investing in corporate bonds. In particular investment grade bonds represent the sweet spot at the moment.”
“The picture is more mixed for high yield bonds, rated from BB down to CCC. After last year’s excellent performance, valuations for the asset class are arguably less attractive than they were 12 months ago.
“Nevertheless, we still find value in BB-rated bonds, where we believe there is still appropriate compensation for the additional credit risk that investors have to face.”