Investment View May/June 2015
May was a busy month. Every pre-election poll and prediction was wrong. The Conservatives won the UK general election with an overall majority, paving the way for a potentially unsettling referendum on the UK's European Union membership. Annual UK consumer price inflation fell to -0.1% in April – the first annual fall in the UK since records began in 1996, and the first time since 1960 based on comparable historic estimates. The financial press were consumed with writing epitaphs for bonds once again as a sell off mid month troubled the market and unsettled investors.
The sell-off in bonds has been mainly in government bonds where spreads haven’t actually moved that much despite the drama Valuations remain satisfactory when compared with the long-term mean and the strong move is built on very limited news-flow. As one manager told me “In the end, it would seem to us the press have jumped on the band wagon and are distressing the situation”. Another of the bond manager’s we work with stated “We believe the long-term fundamentals haven’t changed, and thus will be sticking to our knitting of investing with good strong companies that will last the cycle and who are trying to improve their balance sheets. But, we will continue to watch how this is playing out and if opportunities present themselves, it might be fruitful hunting ground, as the market discriminates against good companies”.
Undoubtedly, the last six years have been something of an extraordinary environment for bond fund managers. From the unforgettable experience of the credit crisis and its immediate aftermath when liquidity vanished, to the introduction of untested quantitative easing (QE) programmes, fixed income has been anything but slow and steady. Alongside QE, record low interest rates since 2009 across the developed world have helped economies to heal and rescued many borrowers who were over-indebted. They have also helped fixed income funds achieve some truly stunning – and, this is the crucial point for investors to remember, above normal - returns, with annual double-digit gains becoming commonplace.
Is all this under threat now from our very own Bank of England? Some certainly believe so, predicting an imminent change in the interest rate cycle over the next year which will wipe out fixed income fund performance and leave them nursing losses. The maths is unquestionable. If rates were to rise by 0.5%, for example, a fund with duration of five years would lose 2.5%. (Duration is a way of measuring how much bond prices are likely to change if and when interest rates move. In more technical terms, duration is measurement of interest rate risk. Duration is measured in years. Generally, the higher the duration of a bond or a bond fund, meaning the longer you need to wait for the payment of coupons and return of principal, the more its price will drop as interest rates rise.)
To look at it in this way is far too simplistic. Firstly, there is no guarantee rates will go up this year. Expectations for the first rate rise have been pushed back so many times they have lost credibility, and managers who strategically shorted fixed income have suffered more than most. Perhaps a more important point to consider is that any rate rise, when
Undoubtedly, the pollsters will be back on the trail predicting the outcome of the EU Referendum and no doubt they will be listened to. A swift outcome would be helpful for Sterling to take away any uncertainty. Thankfully, the election provided certainty for equity markets, which has been helpful. Next Investment View we will again take a broader look of asset classes and perhaps consider value, as next to bonds that is a hot topic. Equity managers are looking closely at banks as massively undervalued so maybe government Bonds and Treasuries will be back sooner than we might imagine. Never say never.
it finally comes, is almost certainly going to be marginal and more of a token gesture than a reversal of the accommodative stance central banks have been forced to adopt for the last six years. With that in mind, funds which still pay out a high yield look well placed to continue delivering inflation beating returns. One of our preferred funds, The Royal London Sterling Extra Yield Bond Fund returned around 9% in 2014, 7% of which was from income and just 2% of which was from capital growth. As the fund manager asks “Where do the sceptics think this income is going? Simply put, they have disregarded it, but they do so at their peril because funds which have high yields can use them to offset any capital losses if rates do rise. In short, such a small rise in the base rate would not prevent us having a positive year. A greater threat to funds like ours, which are primarily invested in sub-investment grade debt, would be a decline in the economic outlook and a turn in sentiment”.
But given central banks appear supportive of growth and are willing to ‘kick the can down the road’ in terms of future inflation problems, we feel the recovery looks reasonably entrenched. Of course prices are now higher than they were, but it does not mean they are unattractive, given the lack of inflation pressure. While there will undoubtedly be volatility as markets try to predict the first base rate hike, it presents active managers with the chance to exploit price moves. It may be a challenging year for bonds, but while markets try and price in a hike they cannot time, they will keep looking for the best opportunities for investors.
The picture is well summed up in a recent article in the Financial Times. It stated “Global bond and equity markets remain largely oblivious to the relentless rise in indebtedness. The commonly accepted but also questionable narrative is that the Federal Reserve is severely constrained when it comes to raising policy rates, the European Central Bank and the Bank of Japan remain committed to quantitative easing, and China is accelerating the pace of monetary accommodation. Cheap money, therefore, is around for the foreseeable future, and asset price inflation, even with occasional wobbles, is a given”.
I have devoted all of this month’s Investment View to looking at bonds as there has been much noise and adverse comment about the asset class. Bonds remain a key component of a well balanced pension portfolio and that view is unlikely to change despite the noise and alarmist comment. It is certainly true that they have provided way above normal returns taking advantage of the remedies employed to solve the global crisis but it may not be long now until they revert to the role of providing a bit of income, a bit of growth and boring. It may be, and more than likely it will be, that government bonds will feature in portfolios but at present that isn’t looking like any time soon, but then again who’d be a forecaster.
Undoubtedly, the pollsters will be back on the trail predicting the outcome of the EU Referendum and no doubt they will be listened to. A swift outcome would be helpful for Sterling to take away any uncertainty. Thankfully, the election provided certainty for equity markets, which has been helpful. Next Investment View we will return to take a broader look at asset classes and perhaps consider value, as next to bonds that is a hot topic. Equity managers are looking closely at banks as massively undervalued so maybe government Bonds and Treasuries will be back sooner than we might imagine. Never say never.