“The outlook for bonds has moved from bleak to dire”. That was the headline of a recent article I read – on an asset class which has been on an almighty rollercoaster ride in the past couple of years.
Support from central banks, governments loans and the fact that companies are contractually obliged to pay an income through their bonds meant that fixed income – for the first time in a decade or so – became attractive to investors in mid-2020.
However, the asset class is now expensive again, having gone back to pre-pandemic levels, with yields at historic lows. Simply put, no one can expect the unprecedented amounts of fiscal and monetary stimulus in places like the US to not have an impact on yields at some point.
Interestingly, however, money continues to flow into fixed income at a reasonable pace. In the first eight months of 2021 we’ve seen net retail sales of £9.5bn – although they have started to slow more recently.
Then there is inflation, which is coming as bottlenecks appear in supply chains as global economies have opened up.
Liontrust head of global fixed income David Roberts said the recent sell off has been driven by investor nervousness over inflation, particularly as central banks have admitted that price rises do warrant some sort of action, with yields rising sharply as a result.
He cites the 3.8% fall in the Bank of America UK Gilt index in September as evidence of the uncertainty.
The steady grind towards higher rates
What is clear is the past decade of free money has created an economic imbalance. This, coupled with the successful re-opening of the global economy, has prompted the Bank of England, US Federal Reserve and European Central Bank to look at reducing monetary policy.
The challenge is that this is a bit like playing with a loaded gun – with markets ready to react sharply to any change.
Janus Henderson fixed income portfolio manager Jason England said the US central bank knows transparent messaging is essential if it wants to avoid “own goals” like 2013’s “taper tantrum” and being caught flat-footed early this year as the yield on the 10-year US note rose to 1.74%.
Tapering of the Fed’s $8.4trn balance sheet is expected to start at the end of this year – although it can change quickly – with reductions between $15-20bn a month touted. The second part of the equation is when (and how fast) rates are expected to rise.
My original view was that even if inflation surged in the US, the Fed would do nothing. However, half of the Federal Reserve members now see the first interest rate hike in 2022, according to the central bank’s so-called dot plot of projections. It’s a view echoed in the UK, where Bank of England chief Andrew Bailey has warned inflationary pressures could result in a rate rise before the end of this year.
As we know, any rate hikes will eat into capital – the last thing anyone wants at a time when income generated by bonds is at such low levels.
England said the high valuation on corporate spreads is exacerbating the problems. He noted that the spread between yields on corporate bonds and those of their risk-free benchmarks is presently 35% below their 10-year average – adding that any economic setback could lead to a widening of credit spreads and headaches for investors.
Some positives amid the negativity
There are positives to consider, not least that whatever action central banks do take will be done slowly to make sure they do not pull the rug out from underneath the bond market.
The other important note is that while inflation in the US has taken off, US 10-year treasuries have plateaued somewhat at around 1.5-1.6%, having threatened to surge past 2% amid inflation fears earlier this year.
We also must remember that the likes of demographics and the growth of technology/digitisation could easily re-assert themselves on the market and reign in some of these inflation fears.
We’re by no means positive on the outlook for the asset class, but we do feel there are pockets of value to be had. We’d still look to the likes of Jupiter Strategic Bond for diversification, as well as a high yield offering like Man GLG High Yield Opportunities, which continues to yield a reasonable 5.1%.
Bonds with a total return mentality, like Nomura Global Dynamic Bond, also interests us. Manager Dickie Hodges uses the entire range of bond sectors including government bonds, corporate bonds, emerging market bonds and inflation-linked bonds.
Another to consider is the Artemis Target Return Bond fund, managed by Stephen Snowden. This is a ‘steady eddie’ targeted absolute return fund, with a heavy emphasis on controlling risk. It targets an annual return of at least the Bank of England Base rate + 2.5% after fees.
Darius McDermott is the managing director, Chelsea Financial Services. The views expressed above are his own and should not be taken as investment advice.