What an auspicious time to be writing about fixed income. The UK 10-year gilt yield almost touched an incredible 0.5 per cent in August after the Bank of England provided its monetary response to the EU referendum result. At the time of writing, the yield stands at 1.45 per cent, removing all the price gains seen in the spring and early summer.
The broad gilt market index over the quarter to date has dropped around 5 per cent, while sterling corporate bond indices have lost around 4 per cent. Nonetheless, positive price moves at the beginning of 2016 mean the year-to-date picture for UK government and corporate bonds remains rosy, with both markets still showing a return of 8 per cent, even after the short-term price action.
Fixed income managers have been anticipating the low point for yields for months, if not years, and managing a corporate bond fund through this most abnormal of economic cycles has been frustrating.
The majority of bond managers have been relatively light on interest rate exposure, even as yields have fallen. Those managers that have held out for the change in trend are now beginning to be rewarded in relative performance terms.
Bond mathematics is particularly unnerving when yields are as low as they are. The fixed income team at Invesco Perpetual has espoused a negative view on interest rates for many months, which has been in keeping with their high conviction, value-driven approach. Like others, their concern has been that even a modest reversal in gilt yields implies meaningful capital loss.
They point out an increase in yields of 0.5 per cent from current levels causes more than a 2 per cent drop in the price of a five-year gilt. In the case of a 10-year gilt, the impact is more than a 4 per cent decline. Clearly, there is precious little in the way of yield to compensate investors for such capital falls. At the same time, the duration of the broad gilt market has marched onwards and upwards, and now stands at over 11 years compared with around 5.5 years 20 years ago.
The Bank of England breathed life into the sterling credit market back in August, reigniting its bond-buying programme with a plan to purchase £10bn of sterling investment grade debt over an 18-month timeframe.
Although £10bn is a relatively modest amount (especially when you consider the size of the largest corporate bond funds in the UK), it was enough to give the market a strong bid and foster improved liquidity, allowing managers to realign their portfolios after the disruption of the EU referendum.
The programme created a positive aura that boosted bonds from across the credit spectrum and explains the sterling market’s outsized returns over the summer period.
However, with markets already sizing up the chance of a rise in US interest rates before the end of the year, Donald Trump’s election win last month was the signal for a turning point in yields.
President-elect Trump is expected to enact a range of tax cuts and boost infrastructure and defence spending, which is likely to boost economic growth, at least in the short term. Embarking upon such a fiscal expansion brings with it the risk of inflation, particularly so at a time of low unemployment. Bond markets around the world gulped in response.
As macro and political themes are likely to continue to dominate bond markets, duration positioning will be the key driver of relative performance for the foreseeable future. In terms of the yield available in the sterling credit market, there is a reasonable pick-up over government bonds, with managers highlighting opportunities to capture more generous yields in financials and asset-backed securities. Some of the spicier subordinated financial issues offer yields (to call) in the upper single digit range but selectivity is of the essence.
Although fund mandates are more homogenous in this sector compared with others, variations in guidelines and approaches generate differences in the journey for investors.
Fidelity MoneyBuilder Income and M&G Corporate Bond are featured within The Adviser Centre as more constrained funds in terms of duration and credit positioning.
BlackRock Corporate Bond, Legal & General Managed Monthly Income and M&G Strategic Corporate Bond are managed with greater flexibility but with the benchmark still in mind.
Invesco Perpetual Corporate Bond and Kames Investment Grade Bond are the most flexible of our featured funds, with the managers of the former known for expressing strong views in their portfolios and those of the latter looking to deliver highly competitive performance through flexible positioning and a broad investment palette.
Gill Hutchison is head of investment research at The Adviser Centre