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Graham Bentley: Young gun advisers should be prepared to change tack

New asset allocation strategy needed to address bond issues and unfamiliar interest rates trend

England’s 6-1 World Cup defeat of Panama unsurprisingly raised expectations among younger fans who have been brought up singing “you’re not fit to wear the shirt”. They believed a trend was broken.

The Times reported a variety of enthusiastic comments from under-30 football fans, describing Gareth Southgate’s “young guns” – no matter how prematurely – as potential competition winners.

Indeed, Joe Grant, a 23-year-old “broker from Essex”, gave us the benefit of his experience when he gushed: “No England team has given more since Bobby Moore in ’66”.

Gary Lineker and the 1990 team may well have argued a two-game streak against minor opposition in the group stage was not on a par with their fourth place overall, but such is the exuberance of youth.

History in detail matters less.

Young guns is the cliché of choice to describe any new generation in business, sport and politics. Indeed, at a recent investment committee meeting a client described an industry event he’d attended for “under-35 young guns” – by definition aimed at, and presented by, those born since 1983.

Given our subject was a broader discussion on asset allocation strategy, the irony was not lost on the crinklier members of the committee when the subject turned to bond exposure.

In 1965, US and UK consumers were enjoying inflation rates of 1 per cent and 5 per cent respectively. By 1980, they were 14 per cent and 18 per cent. Stock markets were depressed and oil prices off the charts. In the most widely-discussed and visible macroeconomic event of the past 50 years, new Fed chairman Paul Volcker took the radical step of switching policy from targeting interest rates to targeting the money supply, to rein in the “Great Inflation”.

Volcker turned off the tap of easy credit and the prime lending rate rocketed to 21 per cent, while unemployment reached 11 per cent. The dollar depreciated significantly, and the tough medicine led to two recessions before prices stabilised. The subsequent rate cut in 1982 signalled the start of a dramatic, three-decade-long decline in interest rates, inflation and unemployment across Western economies.

The discount rate (in investment analysis terms, the interest rate plus inflation) has fallen by around 35 per cent over the past 36 years, a huge driver of asset re-rating.

Economists call this the Great Moderation. Since the financial crisis 10 years ago, many economists have opined that monetary policy ensures that we will never see such periods again. Low volatility and low interest rates seem to have become the norm.

Today’s trends pose a threat to investors focused on income generation and capital preservation who think bonds are low-risk investments

When that inevitably ceases to be true, a systemic shock for lower-risk retirees, court of protection and personal injury clients cannot be ruled out. Over the past 20 years, we have seen the rise of the now-ubiquitous risk-profiling process, leading to supposed matching asset allocations. These portfolio weights are calculated using received wisdom about the relationship between equity and bond markets.

We are persuaded by 36 years of market performance; for decades, successive bond issues have produced excess capital returns as their higher coupons have attracted ever more investors as interest rates fell. A generation of vulnerable UK retail investors are collectively exposed to hundreds of billions of pounds worth of bonds in single strategy, multi-asset funds and associated segregated pension funds.

Yet bonds are not designed to provide excess capital returns, which are driven by arbitraging the recalculation of bond yields as prevailing discount rates change. After 10 years of the exact opposite of Volcker’s monetary tightening, or quantitative easing, bond holders are facing a world without a central bank safety net and young gun managers are unfamiliar with a trend of rising interest rates.

This poses a real threat to investors focused on income generation and capital preservation, and who believe bonds are lower-risk investments.

Many of these portfolios are heavy in investment-grade bonds to match the lower-risk requirements suggested by client risk profilers.

As interest rates rise, fixed-rate (as opposed to floating-rate) bond prices fall and cash becomes more attractive. Bonds’ sensitivity to interest rate movements is measured by modified duration – a number of years that in effect equates to the percentage fall in a bond’s price for every 1 per cent rate movement.

The result is dependent on the bonds’ time to maturity, coupon and yield to redemption. The longer the maturity, the higher the interest rate risk. Perhaps counterintuitively, the lower the fixed-rate coupon, the higher the interest rate risk.

In other words, the safest place to be is short-term high yield, while longer-dated, lower coupon bonds carry the highest risk.

Take Nestlé’s 15-year bond with a 2.25 per cent coupon, yielding 1.52 per cent to maturity. A 1 per cent rise in rates would see the price fall by more than 13 per cent. Wessex Water, meanwhile, has a 5.75 per cent coupon over the same maturity, but its price would fall by less than 11 per cent. In effect, investment grade would be riskier than high yield.

More than 50 per cent of the market has a maturity of over 10 years. Advisers might do well to check the bond funds they hold and managers should be clearer about their modified duration.

Young guns betting on future England glory believe the past trend of failure is broken. Young advisers and portfolio managers should be as prepared to change tack on asset allocation.

Graham Bentley is managing director of gbi2

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