Against the general consensus, so far fixed income as an asset class has been among the best-performing this year. Global government bonds have done well, while investment grade corporate bonds have had a stellar run, returning close to 5 per cent in just the past five months.
Expectation coming into the year was for a continuation of the outperformance of equities over bonds, which was witnessed during 2013. The general belief was that with the improving global economy and the US Federal Reserve starting to “taper”, it should have pushed core government bond yields higher. Instead, those same government bonds have rallied significantly, while equities have been volatile.
Many reasons have been suggested as to why the market has confounded expectations, ranging from emerging markets upheaval to anxiety about China’s shadow banking system to the uncertain impact of severe weather on US economic data. These have all influenced markets to some extent, yet the consensus positioning coming into the year of being overweight stocks versus bonds also needs to be highlighted.
As the reality of falling yields did not match people’s perception of how this year would start, the profits made from being long equities and short bonds during 2013 looked all too compelling to unwind and lock in.
Following this great start for the fixed income asset class across the board, how are the opportunities in various sectors and flavours of fixed income likely to play out? To get a broad sense, we can look to current trends in the market when comparing corporate bonds with a strategic bonds approach.
Looking first at high-quality corporate bonds, recently valuations have been resilient to stock market declines. When other “risky” assets such as stocks have underperformed, the investment grade corporate bond market has withstood the test and held up well.
In terms of the drivers for this behaviour, it is worth noting that global corporate bond markets are benefiting from an outstanding level of technical support.
This is particularly true for Europe, where a long-running theme of financial management from corporates has led to less debt being issued. We are now in a situation where, for the fifth year running, more bonds are maturing than are issued by investment grade companies in euros. Furthermore, on the demand side, even in the US where fears of interest rate rises dominate the news, flows into US high-quality bond funds have been steadily building since the third quarter of last year, despite rising government interest rates. This indicates that investors view these funds as both a source of return relative to government bonds and a safe haven in times of market stress.
We can also point to improving fundamental health of the companies issuing debt as another reason that higher-quality corporate bonds have done well. While companies are continuing to borrow, they are also holding more cash on their balance sheets, so their overall leverage has declined. Furthermore, mergers and acquisitions activity we have seen recently has been generally positive for bond holders, as companies have relied more on equity as the means to fund purchases. This is fundamentally supportive of bond holders.
The fact that higher-quality corporate bonds have held up so well in recent periods of market turmoil should embolden investors in the sector, not worry them. Demand has been strong and corporate fundamentals are still strong enough to keep the yield earned from corporate bonds, and thus returns, higher than that of government bonds.
So how does all of this compare to the relative outlook for a strategic bond approach? Compared to corporate bonds, investing in strategic bond funds (sometimes called unconstrained fixed income) offers investors a broader opportunity set, because these funds have the flexibility to allocate across all global bond sectors and are not tied to a benchmark. They have the ability to dial up risk when compelling investment opportunities arise and can be more nimble in managing duration and interest rate risk.
By their nature, bond benchmarks reward bad-behaving borrowers by giving the greatest weight to the most indebted. They are also sensitive to interest rate risk because of their duration. In an increasingly fragmented and idiosyncratic bond market, taking a global unconstrained approach to finding the best investments ideas can add significant value.
Strategic bonds are also attractive, because with UK interest rates still at record lows, investors can potentially find more attractive opportunities by broadening into global bond markets. Having a flexible investment strategy allows the manager to adapt to the changing economic cycle and be better positioned for the prevailing market environment.
For example, a strategic bond approach can adjust more readily to the economic climate. If growth is slower, it can maintain allocations to government bonds and investment grade corporate debt, while also moving to a longer duration as interest rates fall.
There again, if growth is strong the fund can raise exposure to riskier assets such as high yield and emerging market bonds, while favouring a shorter duration – particularly as the economy heats up and interest rates begin to rise.
To illustrate the advantages of a strategic bond approach, we can look at some current considerations and market themes from an unconstrained manager’s perspective. We believe that the two enemies of bond investing, higher rates and higher inflation, are some way off. We remain cautious on emerging market debt, for which we believe the risks are idiosyncratic.
In the long run, we are still positive on Italy and Spain, and expect core government bond yields to rise as growth expectations improve, particularly in the US. Finally, we believe we are in an environment where accommodative monetary policy and an abundance of cash-chasing yield makes fixed income, particularly credit and high yield, look attractive.
For the fixed income spectrum as an overall asset class, there are compelling opportunities for investors, whether they are taking a corporate bonds or a strategic bonds approach. As market conditions evolve, it can make sense for an investor to have exposure to both styles of investing, as they have different risk and return characteristics.
Iain Stealey is fund manager, Strategic Bond Fund and Andreas Michalitsianos is fund manager, Sterling Corporate Bond Fund at JP Morgan Asset Management
