This year could finally be the year that bonds make a negative return for investors, according to M&G Investments’ head of retail fixed interest Jim Leaviss, although the worst may have passed. 
However, most of the negative returns have already come through in the first half, meaning that the next six months should be more subdued.
“I reckon it is 12 years in a row now where in January everyone has said ‘sell your bonds because you are going to get negative returns this year’ and for the last 11 of those you have been proved wrong pretty much, said Leaviss (pictured).
“2017 [was the exception], depending on what you invested in you may have had negative returns.”
Indeed, while the Blomberg Barclays Global Aggregate index has made a loss in four of the past 12 years, the average fund in the IA Sterling Strategic Bond sector has made a loss in just one – 2008.
Performance of sector vs index over 12yrs
Source: FE Analytics
However, with each year that bonds outperform and yields continue to fall, the cushion investors have from the likelihood of yields falling is diminished and this year could prove to be a turning point, he warned.
The fund manager of the M&G Global Macro Bond fund said: “This year I think it is a bit different because, unlike the past 10 years where you have had very strong levels of quantitative easing [QE], this year we have moved from a net central bank buying of government bonds to a net issuance.
“That ought to have some significant impacts not just for the bond market but also for risk assets – equities, fine wine, vintage cars – all the things that have benefited massively from a world of QE will likely underperform in a world of quantitative tightening.”
As such, it is not unreasonable to suggest that investors may well see a negative return from their government bonds this year, Leaviss said.
However, investors may have seen the worst of it already, with the ICE BofAML 1-10 Year US Treasury index falling 63 basis points so far in 2018 in dollar terms.
The 10-year US Treasury bond yield got up to 3 per cent earlier in the year having been as low as 1.5 per cent in this 10-year economic cycle.
More recently the 10-year Treasury yield has come off somewhat and is now trading at around 2.85 per cent, with Leaviss noting that he bought some bonds when they got up above 3 per cent.
“While I think it is right to think ‘actually what is my upside in bonds from here’, it may be that if you didn’t own them in Q1 and Q2 then actually that was the right thing to do and a 3 per cent yield is approaching fair value,” he said.
He remains underweight government bonds, however, and noted that he is waiting for yields to push to 3.25 or 3.5 per cent before making a significant move.
Performance of index over YTD
Source: FE Analytics
“I think the risk/return of being short on government bonds has moved dramatically against you given that we have seen a big move in government bonds already,” said the M&G Global Macro Bond fund manager.
As well as this, political risks and numerous headlines around the world suggest that the market has now fully priced-in interest rate hikes as well as other risks.
These include trade wars and the impact that they could have on global GDP growth, geopolitical risk from Russia and North Korea and the fact we are probably due a recession as it has been the second-longest period of economic expansion in history.
All this combined means that “perhaps we are nearer the end of this cycle of rising rates than we are the beginning,” he said.
This should help to keep yields subdued and therefore less likely to push above the 3 per cent level. However, one thing that could see it break through is wage inflation.
“If we did see wage growth move that would give central banks a reason to deliver more rate hikes than are priced into the market, but in the absence of that we are not seeing any signs yet, I am not as bearish on bond markets as I was when yields were down at 1 and a bit per cent,” he said.
Turning to credit, Leaviss noted that there has been a bull market since the global financial crisis of 2008 as people forced out of government bonds to buy higher-yielding corporates and the people that bought corporate bonds have bought some high yield.
However, with Treasury yields almost doubling since their trough, a US Treasury investor who was forced out because they only yielded 1 per cent now they yield 3 per cent maybe they can sell some of their higher risk bonds.
At this time of the cycle, Leaviss said that credit is less attractive, as with government bond yields rising, lower demand for corporates should force spreads higher.
“Clearly if you looked at it on a long-term chart credit spreads are bang in-line with their 30-year average and a lot of people in my team are saying that as we are back to long-term average and default rates are extremely low maybe credit offers good value,” he said.
“There are areas but generally my view is that we should expect some reversal of these trends that we saw during the QE era going forwards.”
As such, with both government bonds and credit markets – and in particular high yield – looking unattractive, the only area that does look attractive is the emerging markets.
“So, I would say if you looked across global bond markets there is only one area where you could hand-on-heart say that yields look high and that would be emerging markets,” he said.
This is because concerns around US president Donald Trump’s protectionist policies as well as country specifics such as Brazil’s ongoing corruption scandals or Turkey’s rate hikes and weak banking system have forced developed market investors out of the market.
A year ago, however, many felt that the emerging markets were all converging with developed markets and all the risks had disappeared.
“That has left the valuations and inflation-adjusted yields that you can buy in all those countries ranging from 3-7 per cent whereas in the UK and US they are zero to negative,” he said.
“Mexico is an investment-grade country and yet it trades on yields that are commensurate with weak high yield. So that is the value that I think we need to look for.”
Leaviss runs the $2bn M&G Global Macro Bond alongside FE Alpha Manager Claudia Calich, which is so far this year up by 78 basis points versus the IA Global Bonds sector average of a 66 basis points loss.
Over the last decade the fund has been a second quartile performer in the sector, returning 101.31 per cent, beating the sector peer by 20.66 per cent.
Performance of fund vs sector over 10yrs
Source: FE Analytics
Currently it has a 43 per cent weighting to government bonds, with 23 per cent in emerging market debt and 20 per cent in investment grade credit.
The fund has a yield of 2.62 per cent and a clean ongoing charges figure (OCF) of 0.81 per cent.