There are more signs than ever that the 35-year bond bull market is finally turning, according to Waverton’s Joshua Oakley and Jeff Keen (pictured), who warned that there is too much market complacency regarding inflation risk. 
Given strong economic fundamentals combined with rising volatility and low interest rates, the manager and assistant manager – who run the four crown-rated Waverton Global Bond fund – are focusing on providing decent levels of income while protecting against any unfavourable surprises for bond markets.
“My very broad view of the world is that, eight years since the financial crisis, we have had an extraordinary amount of monetary accommodation and increasingly you’re seeing signs that we’re coming out of that period of sluggish growth,” Keen explained.
“It’s not wholeheartedly convincing yet but certainly in terms of the labour cycle, capacity utilisation and recovery in the European economy – these are all positive for growth and lead us to think that capacity is tightening. That, all things being equal, should lead to less deflation risk and more inflation risk.”
While the managers don’t believe inflation will suddenly rocket any time soon, their main concern is that markets are still pricing in an ongoing deflationary environment.
Not only has this pushed bond prices to concerning levels, Keen said wholesale agreements within market behaviour tends to spell trouble.
“Just because we haven’t had inflation in the last eight years during a period of very easy monetary policy, that doesn’t mean to say that it’s not going to come through in the near future,” the manager warned.
“Most central banks are targeting 2 per cent inflation, but gilts yields are at around 1 per cent, bund yields are at 0.3 per cent and Japanese bond yields are at zero; none of these markets are discounting any kind of normalisation of inflation rates.
Performance of index since 2008
Source: FE Analytics
“It isn’t helped by the fact central banks are buying corporate bonds and pushing the yields down - that creates a lot of complacency in terms of interest rate risk. Bond prices are often sensitive to changes in yield, so any investor in this asset class has had a pretty good run for the last 30 years and more.”
Not only this, Keen and Oakley are concerned that so-called ‘bond tourists’ are contributing to toppy valuations in the asset class, as low returns on cash have driven people to put their money elsewhere.
They warned that fixed income assets are no longer the safe haven they once were, contrary to the beliefs of many bond tourists. For instance, if an index-linked UK bond were to jump from a negative real yield of 1.5 per cent to zero, they managers pointed out that its value could fall by 25 to 30 per cent.
“Complacency levels are very high and that is one of the reasons why we are very heavily hedged in terms of duration,” Keen continued.
“Our average duration is one year. But, the way that we have structured our duration is that we have an option which protects us if we have it completely wrong.
“If bond yields in fact collapse from here, we have an option which will appreciate in value and will help us if there are any negative consequences for our credit portfolio.
“That option on its own is worth nearly three years – if you took out that option, the rest [of the portfolio’s duration] is minus two so that gives you a sense of where we are at the moment.”
The $100m (£77m) fund – which uses US dollars as a base currency – has complete flexibility in terms of asset class, region and quality allocation. While it is predominantly a long-only fund, it is also able to have a negative duration of up to minus-3 and can take some short positions across currencies.
The managers said that this, combined with the fund’s small size and subsequent ability to buy into smaller issuers, means they have the freedom to navigate difficult market conditions however they see fit.
The fund has comfortably outperformed its average peer over one, three and five years and, had an investor placed an initial £10,000 into the fund five years ago, they would have received £3,636.73 in income alone.
Performance of fund vs sector over 5yrs
Source: FE Analytics
A significant portion of the portfolio is currently held in credit at more than 70 per cent and almost one-third of the fund has a ‘BB’ credit quality rating.
Oakley said: “When we look at credit spreads and different tiers of credit, the only conclusion is that spreads are tight. It’s not until you start getting down to some of the very low-rated credits – such as the CCCs – that you could argue there is value there but that certainly isn’t our bread and butter.
“It is very difficult to find good credit opportunities in names that aren’t disrupted. When we break down sector performance this year, I think oil services and retail are the few sectors that have widened.
“It is very tough. I do think that the energy sector is perhaps under-owned and I think a lot of these companies can still make very decent returns even when oil is $45 to $50 per barrel.”
He added: “Because the oil price has collapsed and the default rate spiked in the US – the default rates have come down massively and are continuing to do so. That’s an area we’re fishing in at the moment although we don’t have a lot of exposure at the moment at all.”
An overwhelming majority of the credit held by Waverton Global Bond is in financials at 64.3 per cent of the overall portfolio.
While Keen said this exposure is well diversified across various sub-sectors, the largest weighting within this is to banks which account for 35 per cent of the fund.
“The thesis there is that banks have gone through quite a painful process of recapitalisation since the financial crisis – financial ratios have risen three or four times,” the manager reasoned. “It wasn’t uncommon to have a Tier 1 ratio of 3 or 4 per cent in 2007 and now the more common number is between 12 and 14.
“Banks are a lot better capitalised, their businesses are much less risky in terms of the activities they tend to be involved in and, in recent times, the bad debt experience has been coming off. Some of these conduct issues are beginning to tail off too.
“Relative to 2007, banks are probably safer today than they’ve been for many, many years.”
While the managers admit it is tough to find new opportunities in today’s market environment, they pointed out that they adopt a low turnover, high-conviction approach to investing which has stood them in good stead over the years.
For instance, the fund currently holds around 50 credit positions.
“Something that sets us apart from most of our peer group is that we regard ourselves as very active in the sense we’re not fussed about the constituents of indices – we invest according to how we can deliver a positive return,” Keen concluded.
“We are very flexible – we can be short duration and currency. We think it’s going to be essential to have that in this next part of the bond cycle given we have been in a bond bull market for more than 30 years. We think the signs are showing that this is about to turn.”
Waverton Global Bond has a clean ongoing charges figure of 0.71 per cent and yields 5 per cent.