The one asset class investors have worried about most over the past year or two is bonds. Yet, as I write, equities have stumbled.
Tensions between Russia and Ukraine along with worries about stretched valuations for technology and biotechnology shares have hit the whole market.
Bonds have been remarkably stable, despite constant cries of a ‘bond bubble’ over the past two-to-three years. Investors should not be complacent though. With interests rates at 300 year lows you do not have to be Einstein to know the next move in interest rates will be up.
Given the enormous amount of private and public debt, I find it hard to believe interest rates will go up very far, perhaps hitting 2 to 3 per cent at most; although even this could cause some turbulence in bond markets.
Jupiter Strategic Bond fund manager Ariel Bezalel says even after an exceptional run of performance European high yield bonds remain attractive. In a world of low interest rates, low inflation, and a respectable economic recovery he does not see any catalysts for the market to reverse.
Bezalel is not complacent though. The strong performance has driven yields down (and prices up) with the main European high yield bond index now yielding just 3.67 per cent. He sees little scope for this to fall much further and notes power is shifting to the borrower, with companies looking to borrow money now including less protection for lenders – effectively leaving the bond holders with higher risk. He says we are not yet in a situation similar to 2006 / 2007 though where a lot of highly risky companies issued bonds (and investors were prepared to buy them).
Presently, around two-thirds of the portfolio is invested in high yield bonds, which includes 25 per cent in subordinated bank debt. These bonds rank lower in the pecking order if a bank defaults on its debt. They are therefore higher risk, but tend to offer a higher yield to compensate. Approximately 15 per cent is invested in bonds issued by UK banks, with A further 20 per cent of the portfolio is invested in floating rate notes issued by similar companies.
The remainder of the portfolio is invested mostly in bonds secured against specific assets, such as property or oil rigs.
Bezalel has taken some profits from bonds that have performed well and the fund’s cash holding has risen to around 7 per cent. The fund’s ‘duration’ (sensitivity to interest rate rises) is down to 1.8 compared with 7.5 for the Markit iBoxx Sterling Corporates index. This means the fund’s overall performance should not be affected heavily by a rise in interest rates. Bezalel achieves the lower duration position by using the flexibility afforded to him to invest in derivatives – in this case a short futures position on the US government bond market.
For investors who still want exposure to bonds this fund is one to consider. It currently offers a yield just under 5 per cent and Bezalel believes his strategy could offer some protection and be less volatile than others when interest rates rise. However, if he is wrong the opposite could be the case and with this fund investors are placing their faith in the manager to make the right calls.
I do not believe the bond story is over, but I do believe it is increasingly important to focus on flexible funds run by experienced managers and I continue to rate Ariel Bezalel highly.
Mark Dampier is head of research at Hargreaves Lansdown