Fixed income is a risky asset class at the moment but that is not to say it does not have a place in portfolios
Commentators have been calling the end of the bond bull market for years – myself included. After all, with yields so low for so long, surely the only way is up? Yet, each time we have a wobble and bonds sell off, they bounce back, and the asset class remains expensive.
But are things finally changing? In the recent US Federal Reserve meeting, new chair Jerome Powell raised rates by 25 basis points to 1.75 per cent and suggested there will be two more hikes throughout the rest of 2018. These are in addition to the three rate rises we also saw last year.
This trend is not limited to the US either, with UK interest rates rising at the end of last year for the first time in more than a decade. Meanwhile, in Europe, the central bank is still on track to taper its bond-buying programme during the first half of this year.
If we have finally reached a turning point in our economic cycle, does this mean investors have to diversify their portfolios without holding any bonds? Not necessarily. There are still ways to reap some benefits from the asset class while navigating a potential bear market.
US treasuries are still viewed as a safe haven and, with yields of 2.8 per cent, they are looking slightly more attractive now.
FundCalibre Elite Rated M&G Episode Income fund manager Steven Andrew has started buying into US treasuries with 10-year maturities for the first time since launching the fund in 2010.
He says this is because their yields do indeed look more attractive and, while they could keep rising if economic expansion continues at a steady pace, they will still offer downside protection during tough times for equity markets.
Similarly, Elite Rated Rathbone Strategic Growth Portfolio manager David Coombs has been buying UK gilts in a bid to build up the fund’s defensive assets, due to concerns regarding a potential hard Brexit and an uncertain economic outlook.
He says: “For about a year, we held no gilts, preferring cash as a defensive asset. But with yields on 10-year gilts rising above 1.5 per cent recently, we used some of that cash to start dipping our toes back in to gilts, which are looking like a better bet than they have for some time as portfolio protection.”
Elite Rated Fidelity Strategic Bond fund manager Ian Spreadbury is also holding government bonds for diversification and protection purposes. Just under one-third of his portfolio is allocated to government bonds.
Despite inflationary and interest rate-related pressures, he expects a good degree of resilience due to the scarcity of global safe haven assets and downside risks to growth at this point in the cycle.
High yield bonds are better equipped to cushion the blow of any potential rate hikes. Also, in a positive global growth environment, companies issuing the debt should remain stable. We like Schroder High Yield Opportunities, which offers a yield of 5.93 per cent – attractive both in absolute terms and relative to its peers.
Alternatively, emerging market debt could be a good allocation. Not only do the yields tend to be higher in this area of the market but interest rates are actually falling rather than rising in most emerging market countries.
Here, we like M&G Emerging Markets Bond, which has a completely flexible approach to investing in the asset class and, thanks to manager Claudia Calich’s expertise, currently offers investors a historic yield of 5.36 per cent.
Another way to navigate rising rates is through floating rate notes, which have a variable yield and a spread that remains constant. Essentially, their yields are calculated by taking the base interest rate, for example, and adding their quoted spread on top. The Elite Rated Church House Tenax Absolute Return Strategies fund uses floating rate notes to hedge against interest rate rises.
Investors may also wish to look at making ‘roll-down gains’ when it comes to investing in fixed income at the moment. The team at TwentyFour, whose Dynamic Bond fund I rate very highly, do exactly that. The ‘roll-down’ is the gain that can be made along the curve as yields fall after the point of purchase. The team believes the best gains to be had are at the three to four-year part of the yield curve on a risk-versus-reward basis.
There are plenty of risks associated with buying into fixed income in today’s environment but that is not to say bonds should be left out of investors’ portfolios. On the contrary: it is about finding the best active managers for the job.
Darius McDermott is managing director at Chelsea Financial Services and FundCalibre
For an in-depth look at the fixed income market in 2018, check out Money Marketing’s recent special supplement with Axa IM by following this link.