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The bond fund fear factor

Bonds, once a safe port in a storm, are now an unpredictable asset class with record low yields. Should you be scared?
April 15, 2015

Storm clouds are continuing to build over bond funds as investors brace for US and UK rate rises and government debt yields head further into negative territory. After a thirty-year bull market the good days might be coming to an end, but what does the new landscape look like? And should you break up with bond funds or are they still your friends?

All change

Bonds might once have been watchwords for stability, safety and income but that is no longer the case. The yields on government bonds are plummeting, and fears are mounting over corporate bond overvaluations and a high yield bubble.

Traditionally bonds acted as vital diversifiers and stable income generators for portfolios, with predictable coupon pay outs a more appealing option than unreliable and often volatile equity returns. But an influx of cheap money from Central Banks in Europe and the US, combined with record low interest rates, have pushed bond yields to dramatic lows and sent investors flocking into riskier corporate and high yield products.

"We do live in utterly extraordinary times," says Nigel Cuming, chief investment officer at Canaccord Genuity Wealth. "Most investment managers have underestimated the extent over the past few years to which yields would decline as a result of quantitative easing (QE)."

Government bonds with negative yields, which mean investors in effect pay to own the debt, have soared in popularity in the last year due, in part, to the low inflation expectations and environment and. Over a quarter of European government yields are now in negative territory, worth $2trn according to JPMorgan. In February Germany sold five-year government debt at a negative yield and last week Switzerland became the first ever country to sell benchmark 10-year sovereign debt at a negative yield.

These low yields have sent investors hunting further down the credit scale in search of better returns, and pushed them towards corporate credit. But now concerns are mounting that corporate bonds are overvalued, and new swathes of banking regulation have led to a mass retreat from the bond buying sector, leading to concerns over a lack of buyers in the case of a fire sale.

The CFA, which represents 11,000 investment professionals, found in its most recent poll of 300 global fund managers that four out of five thought bonds were overvalued. Survey respondents said corporate bonds were more overvalued than ever before, and the majority - 81 per cent - thought that government bonds were the most overvalued asset class.

Jeremy Roberts, head of UK retail sales at BlackRock says: "Building bond portfolios has rarely been more complex. Global government bond yields, already at historic lows in the wake of the 2008 crisis, have been pushed even lower by the recent actions of central banks.

"With yields at such low levels, it has become increasing difficult for investors to seek out returns from fixed income. Meanwhile, the prospect of surprise central bank actions (for example, the Swiss National Bank's removal of the franc's minimum exchange rate floor in January this year) introduces the potential for bouts of volatility, nervousness and unseen risk into an asset class that has traditionally been viewed as a safe-haven in times of market stress."

This year could signal another major change for the markets if, or when, the US and UK choose to raise interest rates from their record lows. It is hard to predict exactly which assets will do what, particularly following the shock rally in long-dated government debt in 2014, which should be worst hit by rate rises. Despite gloomy predictions the asset class delivered stellar results, surprising many market participants.

 

What it means for you

Stephanie Flanders, chief market strategist for UK and Europe at JPMorgan Asset Management says: "We all know that a well-balanced portfolio can deliver higher returns at lower risk, but the market surprises of 2014 demonstrated this with brutal clarity. The lesson is you need to allocate your portfolio on the basis of what might happen - not just what everyone expects to happen."

Bonds give you capital appreciation and income, or focus on one or the other. Which bond fund you choose will depend partly on what you want from your fund. Andy Parsons, head of investment research & advisory services at the Share Centre, says: "We've always tried to emphasise that debt instruments are really very much a coupon clipping style investment: you want to receive the income and if you can get capital appreciation, that's good.

"Have a look at the sturdiness of the distributions. People can get easily sucked in by high yield but I prefer to look at what were the underlying payments in pence, and how level and sustainable the dividend is."

If, however, you are interested in capital appreciation over returns, look instead at the total returns.

Then there is the option of turning to newer, more niche products set up to reduce the impact of rate hikes, like funds investing in asset-backed securities (ABS), loans and short duration bonds. Duration risk is a measure of interest rate sensitivity. With rate hikes on the cards, funds with lower sensitivity (shorter durations) could be worth considering, as those with a longer duration or ones with a longer maturity will also decline in value in case of a rate rise.

In order to avoid putting all your eggs in one basket and backing one segment of the market, you could opt for a strategic bond fund. These have the ability to invest across fixed-income assets and can adjust to different macroeconomic conditions.

 

The options

Mr Parsons likes IC Top 100 Fund Jupiter Strategic Bond (GB00B2RBCS16). The fund aims for a high income and capital growth by seeking out the best fixed-income opportunities globally, and invests in higher yielding assets. Under Ariel Bezalel it has delivered positive returns every year since launch and has a dividend yield of 4.39 per cent, according to Morningstar. The fund has paid consistent dividends, paying out four in the 2014 financial year ranging between 0.823p and 0.779p. Dividends reached 0.880p the previous year and in 2015 to date it has paid a single dividend of 0.780p.

Mr Bezalel has been more cautious in recent months. He is most bullish on European high yield debt and has been distancing the fund from US junk bonds most associated with the riskiest parts of the energy sector as a result of the oil price fall. He uses derivatives for efficient management of the portfolio, for example, to hedge exposure to euro-denominated bonds back into sterling, which could add a layer of protection.

Mr Parsons also likes IC Top 100 Fund Henderson Strategic Bond (GB0007495293), which also gets a nod from Tim Cockerill, investment director at Rowan Dartington. The fund invests in higher-yielding assets including high-yield bonds, investment grade bonds, government bonds, preference shares and other bonds. It may also invest in equities. It has distribution yield of 4.8 per cent based on expected income over the next 12 months and Morningstar says its 12 month yield is 5.64 per cent.

Returns from the fund have been slightly more volatile, reflecting its higher risk profile, but still impressive, with a return of 17.73 per cent in 2012. The fund is currently most exposed to high-yield non financial corporate bonds, for example, it has 1.8 per cent of its assets in a Lloyds Bank bond. It is mainly exposed to BBB-rated assets, unlike Jupiter Strategic Bond which is currently 23.9 per cent exposed to BB, 13.2 per cent in BBB and 23.2 in AAA rated assets.

Adrian Lowcock, head of investing at AXA Wealth, likes Artemis Strategic bond fund (GB00B2PLJS27) for a flexible approach. "The fund's manager, James Foster, looks to allocate over the credit cycle and adjust according to where we are," he says. "He doesn't run any structural restraints on the fund and combines top down macro analysis with bottom up fundamental stock analysis, so you get the combination of macro factors which are very important in bonds, as well as good fundamental analysis."

This is a reasonably high risk choice built on the strong conviction positions of the managers. The fund has so far paid three dividends in 2015 and paid monthly dividends throughout 2014 of between 0.163p and 0.182p, giving it a prospective distribution yield of 4.2 per cent. Its 12 month yield is 4.53 per cent according to Morningstar.

More cautious investors might want to turn to Fidelity MoneyBuilder Income (GB00B3Z9PT62). Mr Lowcock says: "Manager Ian Spreadbury is very experienced and invests only in investment grade bonds. The fund has a very low volatility and very tight benchmark constraints. It is a limited and risk averse fund with a very long term focus."

Amid uncertainty spurred by the UK general election, Mr Spreadbury has continued to focus on bonds issued by companies delivering steady cash flows, leading to a defensive bias. The fund primarily invests in BBB-rated bonds, which sit at the lower end of the high-quality investment grade, corporate bond spectrum.

Around 20 per cent of the fund is allocated to cash, government bonds and supranational bonds (debt issued by international organisations such as the European Union) which could offer an element of shelter against market volatility.

Investors wanting low volatility could also look to IC Top 100 Fund Kames Absolute Return Bond Fund (IE00B6SPX874), which aims to generate positive absolute returns for investors over a rolling three-year period, irrespective of market conditions. Don't expect this fund to shoot the lights out but do expect downside protection and a shelter from volatility.

 

Understanding yield

Bond fact sheets can mention more than one type of yield. The distribution yield is usually an estimate of the income expected to be paid over the next 12 months divided by the current unit price. The historic yield (ratings agency Morningstar calls this 12-month yield_ is calculated by adding together the previous 12-month income per unit share and dividing that number by the fund's month-end unit share price or asset value. Be sure to check on your fund fact sheet whether the yield is calculated on past or future data.

The underlying yield is a better indication of the income you will receive, though funds do not always publish it on fact sheets, as the figure is net of fund expenses. It shows the annualised income receivable (net of fund expenses) as a percentage of the fund's unit share price on the last working day of the preceding month.

Read more about the different types of yields

 

Performance (% total return) of mentioned funds

201520142013201220112010
Artemis Strategic Bond MR Dis TR in GB3.63.97.315.7-2.011.3
Fidelity Moneybuilder Income Y Dis GBP TR in GB3.112.0-0.411.27.28.7
Henderson Strategic Bond A Inc TR in GB3.76.03.917.7-2.24.6
Jupiter Strategic Bond Acc in GB3.33.86.016.14.511.2
Kames Absolute Return Bond fund0.42.11.72.1

Source: FE Analystics, Morningstar, as at 9 April 2015

 

Percentage change in government bond yields in 2015

Government bondChange in yield, YTD, basis points
UK 2-yr gilt 3.1
UK 10-yr gilt-12.2
UK 30-yr gilt-14.3
German 2-yr gov bond-17.7
German 10-yr gov bond-38
German 30-yr gov bond-76.5
France 10-yr gov bond-38.3
Portugal 10-yr gov bond-104.8
Ireland 10-yr gov bond-53.9
Italy 10-yr gov bond-61
Greece 10-yr gov bond163.9
Spain 10-yr gov bond-36.5

Source: Killik & Co, as at 10 April 2015

 

Duration versus maturity

Bond duration and bond maturity might look like the same thing and they are related to each other but they mean different things.

Duration is a measure of sensitivity towards interest rate rises, unlike maturity, which is simply the date at which your bond matures. The duration number is expressed in years but is a calculation including yield, maturity and coupon. It enables you to compare funds which mature at different times in terms of which is likely to see the biggest drop in capital value if rates rise.

As a rough rule of thumb when rates rise by 1 per cent the capital value of a bond will fall by 1 per cent for each year of duration - the longer the duration, the bigger the risk.

Duration and maturity are closely linked. Longer dated bonds have a higher duration risk because there is a greater probability that rates will rise over a longer time period and your bond's value will be eroded.