Advisers are facing tough choices when it comes to picking bond funds for their clients’ portfolios.
Three top investors talk to Money Marketing to shed light on the recent market sell-off and how bonds have reacted to it. They also explain which features bonds need to have to survive a new environment of rising interest rates and inflation.
What should advisers consider when building a client portfolio including bonds in the current market environment?
BlackRock head of global fundamental fixed income strategy Marilyn Watson: The declining income cushion and lengthening of maturities witnessed in the corporate bond market, as well as in developed market sovereign debt, means many bonds in this space have become more interest-rate-sensitive and may therefore be more susceptible to an increase in yields.
This environment puts advisers in a tough spot. In our view, the first step should be to thoroughly and holistically understand the risks inherent in respective client portfolios. The lengthening of duration of standard benchmarks could mean that interest rate risk is much more prevalent than anticipated.
Equally, a reliance on high-risk income strategies could result in a greater-than-desired degree of correlation with equities held elsewhere.
Should the recent sell-off put advisers off recommending the asset class?
First State Investments senior portfolio manager Andrew Harman: We believe market volatility can create opportunities for flexible and dynamic investment managers.
We view government bonds in the UK and Japan as currently unattractive due to the combination of the economic outlook and valuations. We are avoiding these markets, or have strategies to benefit from higher bond yields.
Watson: No, it should not.
However, bond investing has changed and we believe advisers should consider unconstrained strategies that aim to keep these desirable traits while retaining the flexibility needed to thrive in today’s environment.
These strategies de-emphasise duration (or interest rate risk) as the main risk and return contributor, as is often the case with traditional fixed income strategies, and diversify across sectors, asset classes and regions globally
Which bonds performed well during the recent equity sell-off and why?
Insight Investment head of global rates Andrew Wickham: The recent spike in equity market volatility generally had a modest effect on most fixed income markets. Large flight-to-quality moves would usually be expected, but overall, government bonds have continued to sell off. In the US, the 10-year yield is at 2.9 per cent for the first time since early 2014.
Corporate bond performance was mixed. Unsurprisingly, the bonds that underperformed tended to be the most equity-like in terms of risk, such as subordinated financial debt, credit default swap indices and high-yield credit.
However, weakness in these areas has already reversed a great deal.
Harman: Within the fund, our constructive view on South African bonds has positively contributed to performance with falling interest rates. The fund also holds relative positions, where we favour US bonds versus the UK, with US bonds holding up better than gilts in the recent sell-off and providing a positive performance contribution.
What’s your outlook for bonds considering higher inflation and rate rises expected in the US?
Watson: While we anticipate some inflationary pressure in 2018, our work suggests that the rise in inflation will not be nearly as quick, or ultimately as high, as in prior cycles. This will allow the US Federal Reserve to continue normalising policy on its well-telegraphed path.
In this market, as investors continue to consider the implications and timing of further rates hikes in the US, as well as the potential end of asset purchases in the eurozone, beta, risk and spreads do not hold as much upside as in prior years.
It will be important to hold diversified risk coupled with cautious interest rate exposure. Flexibility truly is key, and a strong risk framework ensures we take risk in a deliberate and measured fashion.
Wickham: 2017 was, in many ways, ideal for long-only ‘beta’ credit investors, but investors might do well to prepare for a trickier 2018.
Looking ahead, government bonds will likely have to contend with inflationary pressures, driven by rapidly falling if not multi-decade lows in unemployment rates and rapidly closing global output gaps.
At current levels, the possibility of a more severe correction also cannot be ruled out, meaning the flexibility to tactically hedge credit risk or even adopt short positions when attractive may be an appealing way of navigating the fairly complex environment.
We believe that short duration positions in the US and the UK could be attractive ways of benefiting from rising government bond yields. Long positions in inflation-protected bond markets can benefit from rising inflation expectations, particularly in the US where inflation markets look structurally mispriced.
Harman: We continue to view an inflation acceleration as likely in the current environment. We included global inflation-linked bonds in our portfolios in 2016, based on our outlook for inflation, where we found valuations attractive.
Within the fixed-income universe, we still see relative opportunities as monetary policies diverge across the globe – and that market volatility should provide opportunities to generate returns.