There have been few significant challenges to the generally positive environment for fixed interest assets in recent months.
US and UK central bank governors Janet Yellen and Mark Carney have both indicated that rate rises remain some distance away, while in Europe the possibility of deflation continues to present the most pressing test.
The European Central Bank kept interest rates on hold in May, then at the start of June moved to cut its benchmark rate to 0.15 per cent while taking its deposit rate for banks from zero to -0.1 per cent – the first major central bank to introduce negative rates in an attempt to encourage banks to lend to businesses. US Treasuries delivered solid returns and, in this environment, corporate bond returns were also generally healthy.
While Bank of England governor Carney continued to downplay the possibility of rate hikes in May, he made various references to the threat to economic recovery posed by the UK’s housing market. In his view, there is little the Bank can do in the face of the “deep structural problems” posed by demand for homes far outstripping supply.
While the consensus view at the start of 2014 may have been to avoid fixed interest assets, the first five months of the year have shown why an allocation to investment grade corporate bonds remains, in our view, a core part of any portfolio.
Investment grade credit performed particularly strongly at the start of the year in the ‘risk-off’ environment of weaker-than-expected US and Chinese economic data and a widespread emerging markets sell-off.
More recently, the overall tone of financial markets has been more benign, creating a generally positive environment for fixed interest assets.
Gilts have delivered, on average, 4 per cent in the year to date, while the sterling corporate bond market has returned around 5 per cent (as at 31 May 2014). Returns from European and US government and corporate bond markets have been similarly positive.
We believe that long-term performance with relatively low volatility is vital for investment grade bond funds and adapting asset allocation and duration positioning to capture changing opportunities across an economic cycle can drive these objectives.
The headwinds that persuaded us to moderate flows into two of our funds in summer 2012 have long since subsided.
Back in 2012, we believed that the so-called ‘Draghi put’ – when ECB president Mario Draghi said he would do “whatever it takes” to protect the eurozone from collapse – would not be effective.
In such a scenario, further challenges to the eurozone and its banks would have resulted in a rapidly shrinking investment universe.
In the event, the situation unfolded differently as the market took Draghi’s comments to heart. While there is still some way to go, Europe’s banks are now in a stronger position, having continued to recapitalise and grow their deposit bases as the region’s economy begins to pick up.
We are therefore far more relaxed today about the outlook for the eurozone.
Meanwhile, corporate bond markets have continued to evolve, growing in both size and dynamism. Markets today boast a far greater mix of corporate issuers than they did some years ago, both investment grade and high yield, while innovative structures, such as hybrid bonds and structured credit, reflect their sophistication.
While investment grade credit is unlikely to match the impressive returns of recent years, it is still lowly correlated to equities, well positioned for any further risk-off episodes, and attractive relative to cash.
Richard Woolnough is a fund manager at M&G Investments