Bond exposure for 2017

Bond markets in 2016 were set by central bank monetary policy and record low rates, but 2017 will see a step change. Monetary policy is out and fiscal stimulus is in. Out is zero inflation and in will be higher inflation in the UK and radically scaled up expectations in the US. Meanwhile, endlessly debated interest rates could really start to rise.

New terrain

“It feels as though the government bond rally could be over,” says Rob Ford, portfolio manager at TwentyFour Asset Management.

We have grown used to a regime of ultra-loose central bank policy, which has kept yields low and caused government bond prices to keep soaring, even as they pay out less income to investors. But there is “a widespread feeling among investors and policymakers that extreme monetary policy is reaching the end of the road”, says Stephanie Flanders, chief UK and Europe market strategist at JPMorgan. In its place are reflationary fiscal spending plans in the US and potentially the UK, too.

President-elect Donald Trump looks set to have a major impact on long-dated bonds due to his massive pre-election fiscal stimulus pledges. If he follows through on his vocal reflationary plans to spend as much as $1 trillion in a major infrastructure spending plan, it would continue to erode the value of longer-dated bonds, whose yields would no longer look acceptable. Treasuries plummeted more than they had in 40 years in the day following the US election and remain way below their 2016 peaks.

In the UK, after years of stubbornly low inflation, the Bank of England has forecast that it could reach 2.7 per cent in the final quarter. Factors pushing up inflation include the dollar price of oil and weak sterling and, according to Ms Flanders, “for the first time in several years we are also seeing wages and other domestically-generated costs creeping up”. As a result, forecasters expect US and UK consumer price inflation to be running significantly above 2 per cent by early 2017, and to keep rising for much of the year.

The controversial talking point is interest rates. The September Federal Reserve meeting signalled that a 0.25 per cent interest rate hike is on the cards in December, which is now being priced into markets. Mark Dampier, head of investment research at Hargreaves Lansdown, says a rate rise is “unlikely”, although acknowledged that any sudden change in the US could result in rises elsewhere.

Ditch government bonds

Whatever 2017 has in store, the consensus holds that government bonds are bad value today and will probably continue to be poor buys in 2017.

Ms Flanders says: “The crucial takeaway for investors is that we should not expect capital gains on bond holdings to compensate for low interest rates in the future as they have in the past. People have been predicting a turn in the bond market for several years, only to see bond prices reach new highs. But in the past few years, inflation was heading down, not up – and policymakers still believed in the transformative power of extreme monetary policy. This time it really does look different.”

Mr Dampier says: “Whether the bond bull market is over is difficult to predict. The current rise in US bond yields [following Donald Trump’s] victory has to be put in the context of the huge fall in bond yields seen this year. None of this means bonds are good value. They have just gone from being unbelievably expensive to being just extremely pricey.”

Peter Doherty, chief investment officer at Tideway Investment Partners, says: “Even though yields have picked up from their rock-bottom lows in 2016, they do not represent good value. Inflation is on the horizon in the UK – heading towards 2 per cent and potentially 3 per cent in the new year – and so 20-year gilt yields at below 2 per cent would mean it could be challenging to keep your money in real terms.”

Positioning for 2017

The best places to be in 2017 are in corporate credit and high-yield bonds, which pay out more in income than government bonds. High-yield bonds – debt issued by companies further down the quality scale – arguably look the most appealing, although it is a higher-risk area. The sector is dominated by US companies and tends to have a high exposure to the energy and infrastructure sectors, which could also benefit from US fiscal spending.

John Pattullo, co-head of strategic fixed income at Henderson, says: “We like high yield generally. The falling oil price meant that the sector got punished by the falling oil price and, in February 2016, spreads (the difference in yield between high-yield and treasuries) rose as high as 888 basis points. Spreads are now back at 500 basis points, which is not bad, although not cheap either. But in a world with fairly low risk of company defaults and not many alternatives, I would argue that is not bad value.”

Mr Pattullo prefers debt issued by domestic-facing US corporates with stable cash flows, including companies such as funeral operator SCI. Currently, more than 30 per cent of Henderson Strategic bond fund (GB0007502080) is invested in high-yield bonds and it is 40 per cent weighted to the US. However, he is concerned that markets might be getting ahead of themselves. “We are a bit sceptical of Trump’s fiscal boost and whether he’ll be able to deliver it. We don’t know whether this regime change really is going to take hold, but we are not fighting it. We are holding a high cash position (around 10 per cent) and buying US domestic-facing high-yield at reasonable prices.”

Adrian Lowcock, investment director at Architas, says: “On a relative basis, the better opportunities might end up being in high-yield, given its quasi-equity characteristics and the fact that much of the global high-yield universe is represented by the US, where a boost to domestic growth and support for energy independence might prove positive for credit ratings and outlook.”

Mr Ford agrees: “Bonds in the high BB credit rating space are yielding between 3.5 per cent and 4 per cent, which isn’t that high, but these are less sensitive to interest rate movements than sovereign and corporate bonds. There is also little risk of default from the companies issuing these bonds. The issue is really just whether the market has been overbought.”

Bond funds in this space include Invesco Perpetual High Yield Bond fund (GB00BJ04GF14),

a global high-yield fund managed by veteran fund managers Paul Causer and Paul Read. Over five years it is one of the best performers in the Investment Association Sterling High Yield bond sector, returning almost 60 per cent, and it yields 5.85 per cent currently. The fund is relatively defensively positioned in higher-quality companies the managers feel are unlikely to default and around 30 per cent of the fund is invested in financials bonds. The fund is overwhelmingly invested in BB-rated bonds, at 36 per cent, and it has 147 holdings in total.

Over 10 years, the best performer in the sector on a total return basis is Baillie Gifford High Yield Bond (GB0030816713),

which FundCalibre counts among its elite-rated funds. The yield on this fund is currently lower than peers, though, at 3.9 per cent. It is invested in between 50 and 90 companies and it is a high-conviction fund, making it slightly more risky. It has large positions in financial services credit, with 11.7 per cent of assets invested in this space and 12 per cent invested in capital goods.

Corporate bonds, or investment-grade credit, are bonds issued by companies with a higher credit quality, so are lower risk than high-yield bonds. They yield more than government debt currently, but remain fairly expensive – particularly in Europe, where central bank buying has kept a lid on yields. German 10-year bond yields currently stand at just 0.23 per cent. French bonds are yielding 0.7 per cent and Danish 10-year bonds are yielding 0.4 per cent.

Mr Pattullo says: “We’ve got some time for American investment-grade credit because the spreads look okay, but in Europe Draghi has crushed volumes and spreads so we only hold American or sterling-denominated investment-grade credit.”

But Mr Doherty does not rule out European credit, which he says remains appealing for yield with low risk. “Corporate bonds are a bit cheaper than government bonds with more yield,” says Mr Doherty. “On a corporate bond you could probably add about another half or one-and-a-half per cent on top of a gilt yield.” Mr Lowcock agrees: “Credit will be the best area going forward, at shorter maturities.”

Corporate bond funds worth a look include Invesco Perpetual Corporate Bond (GB0033050690), which yields 3.97 per cent. Mr Lowcock says: “The managers (also Paul Causer and Paul Read, alongside Michael Matthews), are quite high conviction and tend to make early decisions on asset allocation. This is a short-duration portfolio and has a significant amount in financials.” The fund has returned 66.7 per cent over 10 years, beating its sector and benchmark. The managers are currently buying financial bonds, where they see the most value, and junior debt issued by European utilities, telecoms and insurance companies. At the end of October, the fund had a modified duration of 5.7, compared with the broader sterling corporate bond market (the Merrill Lynch sterling bond index) at 8.6, meaning it is more protected against a rate rise.

Bestinvest says: “The fund manager benefits from the vastly experienced partnership of Paul Read and Paul Causer, which has steered investors through numerous market cycles.” The fund famously protected investors’ capital throughout the financial crisis and has earned a reputation as a solid long-term performer.

Rathbone Ethical bond (GB00B7FQJT36) is among the highest-yielding funds in this area, yielding 5.8 per cent, and is also among the top performers over five years. It invests in investment-grade credit and has a higher income target than peers and also uses ethical filters in order to avoid mining, arms, gambling, pornography and other blacklisted sectors. That has not impeded performance, which has been top quartile over the medium term.

When it comes to targeting specific slices of the bond market, for example US corporate credit, exchange traded funds offer another route. Investors can buy US corporate debt via SPDR Barclays 0-3 year US corporate bond UCIST ETF (SUSC) and iShares $ Corporate Bond UCITS ETF (LQDE). The issue here is that you are not putting you money with an active manager able to sort through the range of bonds and are instead buying the whole market.

Stick to strategic bond funds

Ultimately, the safest place to be invested in 2017 is likely to be in a strategic bond fund, where managers can invest across the whole range of bond sectors in order to invest in whichever they believe looks the best value at any given time.

Royal London Sterling Extra Yield Bond (IE00BJBQC361) is a flexible strategic bond fund targeting a yield of 1.25 times the FTSE Actuaries British Government 15-year index and “at the higher-risk end of bond portfolios”, according to Mr Dampier. “But you are being compensated with a yield of over 6.5 per cent,” he says. “As such, this fund could be considered by investors looking for a higher level of income, but who are willing to tolerate potentially higher volatility in search of superior long-term returns.” It is currently most exposed to high-yield bonds and its largest weighting is to pub company Enterprise Inns.

MI TwentyFour Dynamic Bond (GB00B57TXN82) is a highly flexible fund from a boutique bond house and has been among the best performing in its sector since launch. It differs from other funds in this area by having exposure to asset-backed securities, which the house specialises in, and yields 4.75 per cent with an ongoing charge of 0.8 per cent. The fund is currently most exposed to high-yield bonds, which make up 30 per cent of its portfolio, and has an effective duration of 4.17.