Advisers have been urged to rethink the role of bonds in clients’ portfolios as market conditions are brought to bear.
New US fiscal policies, the start of the Brexit negotiations, a weaker pound and rising inflation are set to create problems for investors in government bonds in particular.
A recent adviser survey from Royal London Asset Management found firms see government bonds as the most worrying asset class over the next 12 months, just above UK equities.
While investors have been worried about the effects of rising yields for many years, Gbi2 managing director Graham Bentley says we are at a “turning point” for bonds.
Speaking at Money Marketing Interactive earlier this month, Bentley notes how discount rates have made bonds yields fall dramatically and prices increase since 30 years ago. He said: “In the 1950s the discount rate was 5 per cent so a bond that promised to pay £100 would have cost me £78.35. By the time I get through the mid-70s, now that bond would have been worth £22, because the discount rate was 35 per cent.
“But then the discount rate went straight down to the point where in 2016 that bond is now worth £90. That is why you have had this performance driver for the past 30-odd years. Are you likely to still get that from bonds going forward?”
Aegon investment director Nick Dixon told delegates the expected low bonds returns result from rising inflation.
He said: “We need to think totally differently about how bonds play a role in advisers’ clients portfolios and we need to think of bonds in the low-risk end being low return, rather than low risk.
“The risk-free rate is about 1 per cent, inflation target is 2 per cent so if you invest a pound in the gilt market today and you maintain a 10-year gilt fund, in 10 years time in real terms it will be 90p. If gilt yields go up to 3 per cent, which is very plausible, given inflation is 2 per cent, the capital value will fall and in real terms your one pound is now 75p. To maintain the real value of your capital over 10 years, gilt yields have to go down to zero, from 1 per cent.”
But Bentley argues the fall in bonds could be a renewed opportunity for “good” banks, which could offer an alternative to bond funds.
He said: “The great thing about bonds is you can find them and buy them at issue and hold them to maturity. If it’s a reasonably good business like HSBC you can buy subordinated debt or similar so you can get high yield, but most people don’t do that because they buy funds.
“As bonds fall away, banks that have not been in this market for a long time will come into this market because they’ll recognise there is a strong opportunity.”
Wychwood Financial Services director Rob Wood says his clients have been prepared for lower medium term returns than have been achieved in the past.
He does not tactically allocate within fixed income because he says he does not dare predict the future for the asset class.
Wood says for the longer term, investment grade and gilts are a better bet than strategic bond, high yield and emerging market debt when in market stress conditions as they are more positively correlated to equities. in periods of market stress.
Capital Asset Management chief executive Alan Smith argues one of the first problems with bonds is the attempt to second guess and time the exit and re-entry to the asset class. While he retains exposure to bonds, these are primarily high quality and low duration. He argues there is “no better asset class” than index-linked bonds to protect against market volatility
As bonds fall away, banks that have not been in this market for a long time will come in because they will recognise there is a strong opportunity
Smith says: “We have stress-tested a number of potential scenarios as yields rise and find although investors would face a short-term capital loss on the bond holding, rising yields over the next few years provide compensation for that and investors who hold to maturity can, in fact, be better off as capital losses are recouped in a rising interest rate environment.”
In spite of record low interest rates, experts argue there is still an increasing role for cash in portfolios to offset lower returns for bonds.
Dixon says with all asset classes looking highly valued, advisers should think about going back to natural yield-driven returns, which means living on dividends.
He said: “While we are not predicting imminent crash, there is a rising role for cash in portfolio management. With interest rates at 0.25 per cent this would seem counter-intuitive, but, given the alternatives, it may be quite a good idea.
“Bonds are not raising your capital value and we should make the same assumption on equity, with the return will driven by the dividend.”
But Square Mile head of investment Jason Broomer warned replacing bonds with cash risks “desensitising” the equity position in portfolios.
He said: “If you strip away bonds from balanced portfolios, you must be very conscious of the role bonds have to play in that. They are an offset to risk assets. Bonds actually work as a counter-balance so you need to be very careful of the overall risk levels if you don’t have them.”
Phil Reid, head of wholesale at Royal London Asset Management
When we speak to our clients in the advisory space, one of their concerns is what happens as and when interest rates and therefore bond yields eventually back towards more normal levels. Growth looks strong, equity markets are buoyant and yet bond values remain stubbornly high. While the US is the only major economy raising rates, advisers are inevitably asking us not if, but when it’s going to happen elsewhere.
With this in mind, we are actively heading out and speaking to advisers, both through regular contact and a series of educational roadshows, to help highlight the options available for their asset allocation in the current fixed income environment.
Although choosing the most appropriate blend of fixed income assets varies depending on the risk and return profile of individual clients, one particular area of focus that advisers are highlighting to us is what they can do as yields move back towards normal levels and corresponding bond prices fall.
From gilts to global high yield, this could be one of the biggest challenges which advisers face in the coming year.
Regardless of how long bond yields remain depressed, we believe that advisers should avoid simply chasing income by moving unnecessarily higher up the risk spectrum, instead focusing on bond funds which place a genuine focus on active management to deliver this income.