The allure of bonds

Posted by Liz Rees in Latest insights category on 19 Sep 19

Over the summer bonds were in vogue, with strong fund inflows as protracted trade disputes hurt global growth. As central banks put interest rate cuts back on the agenda, bond prices rose. Bonds are certainly no longer cheap, and in September have surrendered some of their gains, so do they still warrant a place in a diversified portfolio?

Negative yields but positive returns

Bond performance this year is among the best for two decades, particularly from government bonds. Investment grade bonds in the US and UK have also delivered stellar performance.

The bull market in the asset class has now lasted for 35 years. This has left yields very low and quantitative easing programmes have magnified the trend. At the end of August around a third of government bonds worldwide had a negative yield, guaranteeing a loss if held to maturity.

However, with the longest-dated bonds, even a small drop in yields can produce large capital gains. For example, the price of a 100 year bond issued by the Austrian government in 2017 at a coupon of 2.1%, had almost doubled by August this year as its yield fell below 1%. Even UK 10 year gilts have made low double digit gains in 2019, as their yield declined from 1.3% at the start of the year to 0.5% by the end of August.

Interest rates still falling

The European Central Bank (ECB) recently reduced rates further into negative territory and will resume its bond buying programme. Others are set to follow. This should underpin low yields for now but with limited ammunition in reserve, it may not be enough to kick-start the economy.

ECB President Mario Draghi acknowledged the problem, commenting on the need for fiscal stimulus as a catalyst for change. He called on Eurozone governments to cut taxes and spend more which would require the issue of more bonds.

The US has more potential to cut rates and while Donald Trump is keen for action, Federal Reserve Chairman Jay Powell appears less enthusiastic and is more focused on the growth and inflation outlook, which for the US remains stable.

Nevertheless, with the global economy slowing, interest rates do seem set to remain lower for longer. Other factors supporting this scenario are ageing populations and high debt levels in developed economies. This is evident in Japan where a falling working population has constrained growth and inflation, justifying low interest rates.

The outlook for bonds

Government bonds look expensive on traditional valuation yardsticks. However, although many experts have been calling the top of the market for a number of years, the bull market has continued.

A reversal of recent monetary easing will probably require an improvement in economic data, a US-China trade deal, a resolution to Brexit and further fiscal stimulus. When interest rates do eventually rise, the impact on bond prices could be significant. Investors should also bear in mind inflation and defaults. Inflation can reduce the real returns of fixed income while defaults can occur if companies face a squeeze on profits and cash-flows.

It is worth pointing out that the UK 10 year gilt yield is currently only around 0.7% compared with the yield on the FTSE 100 of 4.5% (FTSE Russell factsheet 31/08/2019). However, active bond management strategies have the potential to generate positive total returns, even from low or negative yielding debt instruments.

Bond categories

Government bonds, especially long-dated ones, are often regarded as a safe haven. However, they are the most sensitive to changes in interest rates. If the bull market is brought to an end by rising inflation and interest rates, they could experience volatility.

Investment grade corporate bonds have less default risk than high yield bonds but their sensitivity to interest rates is higher. There has been a focus on balance sheet improvements but lower quality companies have had their credit ratings downgraded and been demoted into the high yield category.

High yield bonds would be most vulnerable to defaults in the event of recession. However, although we are in the later stages of the economic cycle, company fundamentals in general remain relatively healthy. The more vulnerable businesses tend to be concentrated in certain sectors, such as energy and retail.

Emerging market debt includes both government debt and corporate bonds issued in hard currency (usually $ denominated) and local currency. Unlike other countries, most sovereign debt is rated below investment grade so yields are attractive. Fundamentals are positive while valuations are less stretched than other bond classes.

Choosing a bond fund

Investment Association bond sectors contain funds with varying characteristics and risk profiles. Within these, bond managers adopt a range of styles.

For investors with a low appetite for risk, UK Gilt funds invest mainly in sterling denominated, AAA rated government backed securities. At least 80% is invested in UK government gilts. Morningstar bronze rated Royal London UK Government Bond currently has one of the better yields in its sector at around 2.4% after fees.

The Corporate, High Yield and Strategic Bond sectors invest over 80% of their assets in sterling denominated bonds. M&G Corporate Bond, managed by bond veteran Richard Woolnough and his extensive team, has a silver rating and currently yields around 3.5%. A high yield fund with a disciplined approach is Threadneedle High Yield Bond, managed by Barrie Whitman. It currently yields around 4.3% and is bronze rated.

Strategic Bond funds are the most flexible, adjusting positions through the economic cycle. They can invest in government, investment grade, high yield and emerging market bonds as well as other fixed interest investments. The latter includes convertibles, preference shares and permanent interest bearing shares (PIBs).

Silver rated Jupiter Strategic Bond fund is cautiously managed by Ariel Bezalel. His strategy of blending short duration high yield (including emerging market bonds) with long duration safe assets has a strong track record. The fund currently yields around 3.9%.

Global Bond funds have more than 80% fixed interest investments outside the UK or emerging markets. Silver rated M&G Global Macro Bond, managed by Jim Leaviss, has a go-anywhere approach and incorporates multiple themes to deliver a yield which is currently 3.2%.

Emerging Markets Bond funds invest at least 80% of their assets in emerging market bonds. This is the highest risk category but has supporting tailwinds at present.

In summary, although government bonds may have the lowest correlation with other asset classes, they are expensive. For a well-diversified portfolio, investors should also consider exposure to different bond types and geographic regions in line with their risk appetite.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.