FE Trustnet News and Research

FE Trustnet readers plan for a bond bear market – Are they right?
 
Alex Paget
By Alex Paget  18 Apr 2016

Following on from our recent survey, we ask whether or not FE Trustnet readers are correct to be so bearish on fixed income within their portfolios.

Some 70 per cent of FE Trustnet readers are underweight fixed income within their portfolios, according to our latest survey, which also showed that 98.28 per cent of you believe a gruelling bond bear market is possible.

Many industry commentators have been calling the collapse of the bond market for a number of years now with yields being forced down to very low levels by historical standards.

Although volatility has ramped up more recently, those who have been bearish on bonds have tended to be wrongly positioned, however, as yields have continued to fall thanks to a continuation of easy monetary policies from the world’s central banks, falling inflation expectations and general equity market uncertainty.

According to FE Analytics, for example, over the past two years both UK gilts and sterling corporate bonds have more than doubled the returns of the UK equity market with much lower drawdowns and volatility.

Performance of indices over 2yrs

 

Source: FE Analytics

However, with 10-year UK gilts now yielding 1.4 per cent and inflation seemingly ticking up, bearish comments surrounding the future of fixed income have once again emerged.

This is also borne out in our most recent survey, which we produced to gauge investor opinion on bonds prior to our FE Select Fixed Income Event – where M&G’s Jim Leaviss, Newton’s Paul Brain and Aviva’s Chris Higham gave their views on the current market to delegates such as Tim Cockerill at Rowan Dartington Signature, Ben Willis at Whitechurch and AXA Wealth’s Adrian Lowcock.

Our survey showed that 70 per cent of you are underweight bonds in your portfolio while just 24.17 per cent are neutral and only 5.83 per cent were overweight.

 

Source: FE Trustnet

What’s more, FE Trustnet readers seem to set on being underweight bonds for some time to come. According to our survey, 63.56 per cent expect to have the same allocation to bonds in 12 months’ time, 20.34 per cent expect to have even less while only 16.10 per cent think they will be buying more.

This is very much in keeping with what many industry experts have told FE Trustnet recently, with some arguing that investors now need to completely rethink how they build diversified portfolios given the lack of value in bonds.

“It’s an extremely important point,” Peter Elston, chief investment officer at Seneca, told FE Trustnet last week.

“I have said in the past that building a portfolio using a value-orientated approach isn’t necessarily going to lower your short-term volatility, but it will limit your chances of longer term real loss of capital.”

“It’s all about how you define risk. If you think risk is volatility, go and buy a 10-year government bond with a real yield of less than 0 per cent. If you view risk as the permanent loss of capital, don’t touch them with a barge poll.”

There are, of course, various reasons why investors are cautious on bonds but most of them relate to the fact that many still believe this much prophesied bear market in fixed income will happen.


 

In the survey, we found that 98.28 per cent of you believe a gruelling bond bear market is possible while 65.51 per cent think there is at least 50/50 chance of it happening. On top of that, 17.24 per cent of FE Trustnet readers think a bear market in bonds will definitely happen – it’s only a matter of time.

 

Source: FE Trustnet

There are counter arguments to this, though.

Barring a very aggressive period of rate hiking from central banks or runaway inflation, FE head of research Rob Gleeson says that given there is so little yield available in the world, the chances of a bond market crash are low.

“When these assets become stressed they look a hell of a lot more attractive,” Gleeson said.

“While there may not be enough liquidity for corporate bonds at yields today, if those yields were 1 or 2 per cent higher, suddenly you find a load of buyers because there is no yield anywhere.”

“There is a natural floor price to how this will go and if the market gets stressed and corporate bond yields rise, yes you are going to be sitting on losses, but there is a natural floor to it because there is no income anywhere so these bonds start to look very attractive very quickly.”

It’s also worth pointing out that many investors, for whatever reason, still need exposure to fixed income within their portfolios. Again, we could see this in the survey.

In terms of those that hold bond funds, 70.09 per cent use them to maintain a diversified portfolio. Then, 28.21 per cent hold them for income and the remainder use them to protect against stock market falls.

Interestingly, however, FE data shows – due to valuations and distortions created by policymakers – correlations have risen between bonds and equities. Having had a negative correlation over the past 20 years, the correlation between gilts and the FTSE All Share jumped to 0.8 at times last year suggesting bonds don’t necessarily offer diversification many believe they do.

“I have to say I can't get that excited by bonds at the moment, but they do still play an important role in terms of diversification in my view – especially for an income portfolio,” Rob Morgan, pensions and investment analyst at Charles Stanley Direct, said.

“The main problem is that very high quality bonds pay precious little income so some view them as ‘return-free risk’. A sudden jump in inflation could cause a meltdown. Government bonds in particular are highly valued.”

“However, I think people need to accept the global economy is not growing very much and an inflation spike is only an outside possibility.”

As such, Morgan says investors who need fixed income exposure should turn to strategic bond funds – and this something FE Trustnet readers seem to be doing.


 

The survey showed that half of you prefer using strategic bond funds, considerably more than any other vehicles within the world of fixed income.

 

Source: FE Trustnet

Morgan added: “There are merits to investing in corporate debt in particular. It pays a higher income and is generally less sensitive to changes in inflation and interest rates than government debt.” 

“In what could be an environment of very low growth or even deflation it could represent a decent level of income and balance out more adventurous or volatile areas such as equities. Stock picking is crucial though.”

“My pick in this regard would be Henderson Strategic Bond due to flexibility of the fund’s mandate, as well as the depth of resource and experience of the managers.” 

According to FE Analytics, the £1.4bn Henderson Strategic Bond fund – which is co-run by John Pattullo and FE Alpha Manager Jenna Barnard – has comfortably outperformed the IA Sterling Strategic Bond fund sector average over 10 years with returns of 60.11 per cent.

It has also outperformed in eight of the last 10 calendar years.

Performance of fund versus sector over 10yrs

 

Source: FE Analytics

The fund currently yields 4.3 per cent, with the managers favouring investment grade corporate bonds – which make up 47.5 per cent of the portfolio. Pattullo and Barnard also hold 28.3 per cent in high yield bonds with the rest of the portfolio split between government bonds, loans, preference shares and asset-backed securities.

Henderson Strategic Bond has a clean ongoing charges figure of 0.7 per cent.
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