Investors would be wise to avoid core fixed income exposure in the near term following a significant change in tone from the US Federal Reserve (Fed) last week over when it is looking to raise interest rates, according to Charles Hepworth, investment director at GAM.
Despite a brief rally in January, fixed income has been largely disappointing asset class for investors in 2015 with markets preoccupied with an opaque but ‘certain’ view of rising interest rates (firstly in the US and secondly in the UK) and how such an event would affect bond markets.
Performance of indices in 2015
Source: FE Analytics
That ‘certainty’ was destabilised by August’s Black Monday crash as, shortly after the falls, the Fed made it clear they would delay a rate rise over worries that global growth was under threat from a China-led crisis.
However, last week this was again turned on its head as the Fed said in its latest meeting that a December rate rise is back on the cards, causing fixed income markets sell-off following their brief rally.
However, a recent poll from FE Trustnet shows while majority have not been adding during this period, about one in 10 have seen it as a chance to buy more exposure to bonds.
Hepworth, who manages GAM’s range of funds of funds, is not one of them. He thinks bond funds are likely to see flat performance at best until the Fed raises rates, with the possibility of a further plunge now more likely since last week’s statement.
“You have seen a lot of investors swarming back to traditional fixed income. We have been out of this to our pain in particular parts of the year, but overall I think we have done better. It is not something to chase at this point. It does not make sense,” he said.
Hepworth adds he is still not anticipating a rate move this year but thinks inflation could start to pick up, increasing the chance of a yield spike for those who have increased exposure to core bond funds.
”If [Fed chair] Janet Yellan does delay and delay and delay you are going to get these little pops in prices as investors flock back in. As there is a short to medium term move back into it, even at these depressed levels people are buying more duration and credit risk but there is a flat horizon for at least the next few months.”
"You're betting that you can sell it on to someone else at higher price, you're not looking to hold it to maturity so it becomes very short term. If they then hike in December they will get stuck in that position."
He added: "How can you trade around a two, three month horizon?"
Hepworth is by no means the only one who thinks those upping fixed income exposure are playing a risky game, especially given the yields now on offer following a multi-decade rally in government bonds.
Performance of sector over 25yrs
Source: FE Analytics
For example, Miton’s David Jane recently described bonds as a ‘lose-lose’ for investors.
“Bonds are a market where avoidance of loss looks to be the better option. The risk is all to the downside. Maybe spreads could narrow back to where they were last August and rates could go back to their January lows or maybe lower, but in either case there is not enough money to be made compared to the risk that you might have got it terribly wrong,” Jane told FE Trustnet last month.
John Bilton, global head of multi-asset strategy at JP Morgan Asset Management, says the likelihood of a rate hike in December has ramped up leaving many investors to continue to question the attractiveness of bonds.
“The negative correlation between stocks and bonds seems to be reasserting itself to a degree, but with the start of rate hikes still in play for December, many investors will continue to question how attractive bonds are as a portfolio hedge to stocks. The upshot is a continuation of the tempered risk appetite we’ve seen since the summer.”
Mark Woods, investment strategy officer at Fairstone Private Wealth is also bearish and advises investors to ignore bonds due to this “key macro risk”.
“Bonds are supposedly a ‘low risk’ asset class but have experienced significant increases in volatility,” he said.
“We make no bones about our views on conventional medium to long dated bonds - they represent a very high risk to investors at this moment in time whilst yields are compressed and the most probable direction for interest rates is up.”
“Should rates rise, these markets are likely to begin a correction phase and there is no accounting for what investors might do. If they flee the asset class en masse, liquidity will be squeezed and we could see the destruction of capital values.”
Falls in key sterling bond markets since last week’s announcement demonstrate how much investors are watching the Fed’s plans for raising rates, according to Russ Koesterich, global chief Investment strategist at BlackRock.
He says the prospect of higher rates will be a key driver for markets, positively for equities and negatively for bonds.
Performance of indices since 28 October 2015
Source: FE Analytics
“With the possibility of a December hike in U.S. interest rates back on the table, bond yields rose last week as prices fell, and investors continued to favor stocks, despite already high valuations. The Fed issued a statement last week that acknowledged continuing concerns around international developments, but also left the door open to a December rate hike,” Koesterich said.
The decision by the Fed to pursue this will depend on the next several weeks of US data on wages, inventories and corporate purchasing, he says.