Chapter 3

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Stability in a sea of uncertainty

by Cherry Reynard

The 60:40 model – time for a review?

by Cherry Reynard

“The flow of money created by quantitative easing has been artificially suppressing volatility, but this is coming to an end.”

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Fixed income: The wider view

“Bond managers are looking to high-yield and EM debt markets for better yield opportunities…they are also seeking more defensive positions”

Income is another important consideration. Bonds were the mainstay for income portfolios for many years, but this has shifted as yields have fallen. However, there are still parts of the bond market that pay attractive yields, such as emerging market debt. There is also the possibility that investors will return to the bond market as yields rise. Lowcock says: “In the past few years of the bond bull market yields were getting incredibly low and in some instances negative, so this pushed income hungry investors into other assets, including equities and infrastructure. A combination of recovering bond yields and expensive valuations in those equities – tagged the bond proxies – has meant investors previously forced to buy shares have taken the opportunity to reverse that position and get the income they need at lower levels of risk.” The 10-year Treasury yield is at over 2.7 per cent. This puts it ahead of inflation, meaning that investors are receiving a positive real return from government bonds. While UK and eurozone investors are yet to catch up, it is edging in that direction. The bond market may increasingly offer opportunities for income investors. That said, although there are many reasons to hold bonds, any fixed income allocation in today’s market needs to be carefully managed. The risk profile of bond markets has changed and there are pockets of real danger. At the same time, most advisers do not feel confident enough to allocate between the different types of bonds themselves. This is likely to be behind the popularity of strategic bond funds. These funds offer the broadest exposure to the market and allow managers the flexibility to take advantage of changes in bond prices and yields as the markets adjust to an environment of rising rates. Both Woods-Smith and Lowcock favour this approach. Lowcock likes the MI TwentyFour Dynamic Bond fund, which is run on a team basis, with each team member a specialist in a particular area of fixed income. Overall, the bond market looks to be a more dangerous place at the start of 2018 than it was at the start of 2017. While there is no catalyst for a sudden sell-off, the slow grind higher of interest rates and inflation will influence returns from here, and is likely to threaten its status as a safe haven. That said, the bond market is not without its opportunities. Not all bonds are alike, not all are exposed to the interest rate  cycle, and there are still diversification and income advantages. Advisers will have to work with their clients to show the merits of considering an allocation to bonds in today’s climate.

Given this, many strategic bond managers have been more concerned with preserving capital rather seeking out value opportunities to maximise returns. One way of achieving this is through shorter duration holdings. Over the past year there has been a growing number of short-duration bonds launched in the UK, global and high-yield fixed-income sectors. Chelsea Financial Services managing director Darius McDermott says: “This has been due to demand from the industry. Many people have to hold bonds within their portfolios, their benchmarks dictate that they need to have some exposure to this asset class. “At a time when there is a lot of downside risk in bonds, short-duration is an attractive alternative as it limits the interest rate risk.” Informed Choice managing director Martin Bamford says: “Fund managers are cutting duration in their portfolios to reduce interest rate sensitivity – although this can introduce other risks.” For example, if the economy takes a turn for the worse – not an impossibility given the uncertainties around Brexit – this could raise potential credit risks. Despite this, McDermott says fixed income specialists are right to be concerned about interest rate risk. The interest rate rise in November last year – from 0.25 per cent to 0.5 per cent – may not have had a marked effect on the UK gilt or corporate bond market. But as McDermott points out: “In the UK we’ve simply gone from emergency-emergency levels back to the emergency level. “In the US rate rises were more pronounced, and US bonds did take a hit last year with some negative returns.” He welcomes more choice in the short-duration bond market. “There are a few of these funds that have been around for some time, and some have launched for sound reasons. Smith & Williamson, for example, launched one for their private wealth business to protect their own portfolios better.” However, he cautions against some “me too” launches, which may be driven more by marketing objectives rather than a clear investment strategy. There has also been an increase in the number of funds offering exposure to emerging market debt and high yield bonds, as the mature bond markets of the US, UK and Europe look increasingly overstretched. Yields are certainly more attractive in these regions, but this has to be balanced against currency risks, as well as the credit risk inherent in any fixed-income environment. For advisers, the primary choice is whether they use a strategic bond fund to offer diversification and flexibility or whether they invest in a number of specialist bond funds across the credit spectrum. Connelly adds: “In theory strategic bond managers have the best opportunity to outperform in rising markets and to protect investors’ money when fixed income markets are under-performing.” However, this relies on the fund manager making the right decisions and avoiding the more over-priced assets that may be subject to revaluation. Connelly says that Chase de Vere uses a number of strategic bond funds, including Janus Henderson Strategic Bond, Jupiter Strategic Bond and Fidelity Strategic Bond. But Bamford adds: “In terms of how we advise investors to access the bond markets, we continue to favour having control over the asset allocation to gilts, index-linked gilts, corporate bonds, high yield bonds and global bonds. Our asset allocation consultant helps us set up these strategic positions, which we then populate by recommending single asset class funds.” He adds: “It’s good to give fund managers a degree of flexibility to move up and down the yield range, depending on their view of the economic cycle, but ultimately risk control should rest with the investor and their advisers.

He says advisers need to look under the bonnet of the fixed-income funds they recommend to understand the manager’s approach and the specific fixed- interest assets it invests in. “Getting this wrong could mean that clients are taking on more risk that they realise,” he says. Over the past year, these different slices of the bond market have produced varying returns. The average UK gilt fund produced a return of 1.72 per cent in 2017, according to FE Analytics. Although still positive, this is significantly less than the 11.06 per cent total return seen the year before. The average fund in the IA Global Bond sector produced a total return of 2.03 per cent last year. For many UK investors returns were dampened by sterling’s weakness. Again, this was markedly less than the average return of 16.79 per cent recorded the year before. But investors could still get inflation-beating returns in other parts of the fixed income universe. The average total return in Global Emerging Market bonds was 4.54 per cent and in the sterling-denominated corporate bonds sector it was 5.06 per cent. The strategic bonds sector did better still with average total returns of 5.31 per cent, while sterling denominated high-yield bond funds produced average total returns of 6.05 per cent. While one would have expected the more aggressive parts of the bond universe to have delivered superior returns in 2017, more defensive parts of the market, such as gilts and investment grade corporate bonds continued to deliver positive returns. This is despite interest rate rises and central banks starting to roll back their asset-buying programmes. Doom-mongers have long been predicting that the end of the world is nigh for the bond market. This bubble hasn’t burst yet, but there are concerns about how long it can continue to defy gravity.

The bond market has become more complex and diverse in recent years, with a vast range of fixed income options now available to advisers and their clients. This is unsurprising, given the unprecedented economic conditions of the past decade. Quantitative easing programmes, rock bottom interest rates and low inflation has stimulated demand for these securities, pushing prices upwards and yields downwards — in some cases into negative territory. Government bonds in particular have looked increasingly expensive in recent years. This has turned on its head the conventional wisdom that fixed income is a more cautious investment, ideal for those seeking a reliable income in retirement or providing some ballast against more volatile equity markets. Those buying into fixed income markets at today’s inflated prices run the risk of significant capital losses if or when a bond sell-off occurs. But investment managers and financial advisers have broadened their fixed-income horizons to successfully hedge against these fears. This has been a two-pronged approach. On the one hand, bond managers are looking to high-yield and EM debt markets for better yield opportunities and pockets of value. At the same time, they are also seeking more defensive positions – particularly in short-duration bonds – where assets may not be as vulnerable to negative sentiment on future interest rate rises. Chase de Vere head of communications Patrick Connolly says: “Despite very real concerns about bond valuations, fixed interest clearly still has an important place in most investment portfolios. By utilising the full range of fixed-income options now available, advisers can help mitigate some of the risks in this market at present.” But, he says, to do this successfully, advisers need to understand the risk profile and potential rewards across the bond spectrum. Connolly adds: “There is now a wide range of bond funds that take very different approaches to this market. These funds vary considerably in terms of the amount of freedom given to the fund manager, the types of bonds they invest in, where they invest geographically, the number of holdings they have, and the term remaining on individual holdings.”

By Emma Simon

The traditional bond market, often viewed as an investment class of relative stability, may no longer offer the old certainties, reflecting the upheavals in the broader financial markets

March 2018