As the US Federal Reserve prepares the tapered exit of its quantitative easing strategy, the outlook for bond markets feels jittery, at best.
Bond yields look set to rise in the immediate term with little mercy being shown as sovereigns, corporates, high yield and emerging market debt all looking precarious.
Equities aren’t escaping either. Pictet has drawn recent volatility comparisons with the nadir of the European crisis in 2012. Treasury yields have risen more than 50bps since May and the group expects a knock-on effect on the US stock market.
Against this backdrop, and inflation hovering close to the 3 per cent mark, where should income seeking investors be looking?
Corporate bonds and gilts have barely beaten cash returns, causing many to turn to strategic bond and high yield vehicles.
“But even these are starting to look twitchy now,” says Lee Robertson, chief executive at discretionary wealth business Investment Quorum.
“We are seeing a lot more of our clients chasing yield right now. Growth was just not where they wanted to be. Fixed income was doing a great job of delivering that yield, but we kind of knew it would end badly.”
Robertson says warning bells over excessive yields being delivered by sovereigns drove investors into corporate bond funds. This in turn, has fallen off, he said, and led to the more actively managed bond vehicles gaining popularity.
IMA statistics for April 2013 showed equity funds returning to the top spot, with £799m net retail sales, with global equity funds having led consistently since June 2012.
Robertson is bullish on emerging markets, despite the recent volatility.
“People are looking for good yields with the potential for capital growth. So we’re looking at emerging market debt and global equity income. We think there is something of a perfect storm brewing. With QE, the US looks to be rocking quite hard and emerging currencies are pegged to the dollar, which might raise some concerns, but in a globally diversified portfolio that isn’t something we need to worry about.”
Richard Parfect, who runs the £152m Miton Distribution fund alongside lead manager Alan Borrows, is also looking global.
He says: “Emerging markets don’t come without risks so we have been focused on the short end of those assets. However, we are now focusing more at the equity end of the risk spectrum, and had been looking global – with particular interest in some of the leading global dividend funds.”
Algy Smith-Maxwell co-manages Jupiter’s £9bn-plus Merlin multi-manager range. He explains his nervousness over people piling into EMD.
“Current spreads between Treasuries and emerging market hard currency debt may be presenting some value opportunities but it feels horrible.
“Bond yields are set to rise, there is pressure on the governments – both the developed markets and the emerging economies – which is increasing, and the effect of the significant amount of policy tightening means markets have also been worried. But policymakers are always quick to suggest that inflation isn’t today’s problem.”
Kames Capital’s head of multi-asset investing Scott Jamieson says: “In the current conditions and for the foreseeable future, many investors have not adjusted their expectations. There is no risk-free investment that will protect you from inflation. Cash is delivering nothing, gilts are delivering nothing, you are not making money in real terms.”
“Investors need to take risk to protect against inflation. It’s not necessarily a bad thing to seek higher yields but I am looking to dividend-themed equities for the long term.”
Could current valuations pose a threat?
Smith-Maxwell says: “In equities, you need to find those companies delivering decent dividends with strong balance sheets. Admittedly there is a risk of overpricing, especially in some of these consumer staples with a global reach, but for investors not going down that route – the likes of Neil Woodford and Stuart Rhodes – other sectors such as healthcare still look cheap.”
Property has traditionally been a good source of income, despite the extra liquidity risk being taken on. Jamieson says: “You are clearly taking a liquidity risk, you could have currency problems and you have void levels to think about.”
IQ’s Robertson is a fan of the asset class, lauding Ainslie McLennan’s Henderson Property Trust and its 4-5 per cent yield.
Smith-Maxwell says his team has been looking at possible property investments. He says: “Property is looking very interesting and is an area which we are taking into close consideration. If I could find a way of providing exposure to a broad spread of reliable, good property that yielded 5-6 per cent then at this stage in the cycle that would look very attractive. But we have not acted upon that.”
Another alternative possibly worth considering is convertibles.
While Jamieson raises concerns over the size and immaturity of this market, JP Morgan Asset Management’s Antony Vallee, who runs the recently launched closed-ended Global Convertibles Income fund, believes they can offer the best of both worlds.
He says: “When you buy a convertible bond you are buying a bond – you know the coupon and you know the maturity value. The worst that can happen is that you get your money back and if the company does well, you will be able to sell your convertible bond at a premium, resulting in a capital gain.”
Duration risk seems to be a key another concern, with bond fund managers reducing exposure to interest rate sensitivity.
Miton’s Parfect says: “We’re specifically looking at the shorter end of the yield curve, lowering interest rate risk and credit risk – so looking at two-three-year duration risk.
“We get the argument of using strategic bonds for this, but we’re looking at some of the smaller vehicles that can be more nimble in terms of picking up new issuances.”
But size doesn’t necessarily matter, according to Jupiter.
Smith-Maxwell owns both M&G’s £5.6bn Strategic Corporate Bond fund, run by Richard Woolnough, and Jupiter’s own Strategic Bond fund, run by Ariel Bezalel, £1.5bn in size.
Both are well within capacity and Woolnough reducing his duration risk has been reassuring, he adds.