Despite the lower yields on offer in fixed income markets more recently, investors can find some pockets of opportunity for alpha generation, according to Liontrust Asset Management’s David Roberts.
Roberts, who co-manages several strategies including the £139.3m Liontrust Strategic Bond fund and is head of global fixed income, said bond investor behaviour has changed in recent years but is beginning to change.
“For several years now, those blindly buying bonds may have made a small nominal return: chances are however, that when adjusted for inflation, that return became negative,” he said.
“Now investors own bonds for a variety of reasons, purportedly as a store of value, a safe haven, or to hedge liabilities. When you lock in a negative real return though, it is difficult to claim they fulfil any of those objectives.”
According to the bond fund manager, monetary policies executed by central banks since the global financial crisis meant investors “seldom had to think”.
“Central bankers gave us a pile of money and simply asked us to spend it – not in any meaningful, real-world way that would lead to growth and inflation or course, rather we were all told to go and buy financial assets, make ourselves rich and allow the trickle-down effect to move the real economy,” said Roberts. “And we wondered why growth, inflation and efficiencies were hard to find?”
Total assets by all Federal Reserve Banks since 2007
Source: St. Louis Fed
But, as the Federal Reserve began to remove liquidity from the system in 2016 – as a response to the solid performance of the US economy and a return of more normal inflation rates – and with other central banks following suit, the picture has now changed.
However, the Liontrust manager said he believes investors can generate alpha in the current market environment.
“It is very old fashioned I know, but buying cheap stuff and selling expensive stuff is often the best long-term strategy,” he said.
The manager is currently finding opportunities in US bonds, where he said investors are being compensated for inflation, and in the high yield market, previously an underweight but where exposure has recently been tripled.
“The part of the market we like best on a raw basis – or before you adjust the risk is the high yield market. We think investors will get a positive total return of somewhere close to 8 per cent in 2019,” Roberts said.
“We think there will be a small part of capital gains, there are two reasons for that: number one is because we are a long way from the start of any meaningful default cycle, which is quite constructive for high yield.
“Secondly, the high yield market has had a technical positive, which is basically that there hasn’t been a large amount of supply, not many companies have been issuing high yield bonds, they have been going to the levered bond market, which has exploded in size.”
He added: “So, in the high yield market there is scarcity of quality companies to invest in and, as a result, the downside for high yield will be limited because there is still demand but certainly not the amount of supply that we saw two or three years ago.”
Other areas the veteran fixed income manager is currently favouring include floating rate notes – where shorter maturity bonds provide some protection against rising rates, US inflation securities, New Zealand bonds and short-dated securities – because long-dated bonds are generally expensive and “a crowded trade”.
Fixed income areas he is avoiding include UK, Japanese and European government bonds, low-rated highly levered credit, subordinated financials, Canadian bonds, loans, and illiquids.
US interest rates since 2007
Source: St. Louis Fed
In his outlook for 2019, Roberts said it would be an “okay year” for investors although he believes central banks will further tighten monetary policy.
“Our estimate is that people are now too dovish: they don’t expect anything from the US central bank from December of this year,” he said. “But that is still wrong, we think with the quality of the data and the breadth of strength in the global economy we should see the Federal Reserve tightening again next year.
“So, anyone who expects the Fed to be on hold, we don’t think that’s going to be the case.”
Roberts added: “At the same time we thought rates would get to 3.5 per cent in the market in 2018 but they reached 3.25 per cent and then just came back down.
“So, although we think the Fed will hike once or twice more, we don’t think that US Treasuries are necessarily going to sell off hugely.
“We think in 2019 they can reach that 3.5 per cent level before following the same pattern of this year and starting to fall as we move into 2020.”
Despite the turbulence seen in markets recently, the Liontrust manager said the macroeconomic outlook for 2019 looks quite constructive, with growth an inflation data suggesting the global economy is likely to perform around trend.
“I expect 4 per cent nominal growth for developed markets. Add in a little productivity and decent G7 equity performance should see nominal bottom line growth in the 6-8 per cent range,” said Roberts.
“Under such circumstances, you do have to wonder why central banks continue to favour easy monetary policy. Well, actually central bankers have long told us the period of easy money is coming to an end but until recently markets didn’t really believe them.”
David Roberts has co-managed Liontrust Strategic Bond since launch in May 2008. Over that period, the fund is down by 0.59 per cent compared to a 1.38 per cent loss by the average fund in the IA Sterling Strategic Bond sector.
Performance of fund vs sector since launch
Source: FE Analytics
It has an ongoing charges figure (OCF) of 0.70 per cent and yields 2.5 per cent.