Fixed IncomeAug 28 2014

Bond bonanza

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Driven by very low deposit rates and low yields on government bonds, investors have been piling into corporate bonds. In the first half of 2014, inflows into bonds totalled some $273bn (£1.64bn) comp­ared with $222.9bn (£134.3bn) into equities, while money market funds, which are a proxy for cash, suffered outflows of $112bn (£67.5bn).

Last year, the inflow was into high-yield junk and government bonds from the peripheral eurozone countries such as Portugal, Spain and Italy.

This year, the inflow has switched to investment grade bonds as strong inflows pushed down the yields on euro bonds. Many big corporates have taken advantage of this demand to issue new bonds, which has further fuelled demand.

The value of European investment-grade corporate bonds issued recently have topped $20bn (£12bn), the first time it has done so for nearly five years, according to Dealogic.

In the UK, the inflow has seen a number of bond funds grow rapidly in size; Richard Woolnough’s M&G Optimal Income fund has now passed £20bn. In the three months to 31 March, the fund took in a net £2.1bn, according to FE estimates, compared with £3.3bn over the previous nine months.

The growth in bond funds and the high levels of inflows have caused enough concern for the regulator to raise concerns about liquidity in the market, and fund managers such as Richard Woolnough have been forced to defend their funds.

The inflow has been in spite of a slight flattening of the yield curve in 2014 (although there has been little movement at the short-dated end of the market) and increased volatility following the concerns around slowing of US quantitative easing last year.

So what should investors be doing? First of all, asset allocation should drive investment decisions rather than yields or market timing. Diversification is important and bonds have an important role to play.

However, it is important to remember that while bonds can provide some returns (as they have done over the past few years), their main function in a portfolio should be to reduce volatility and provide a counterweight to equities as can be seen in Chart 1.

At times of extreme volatility in equity markets, typically, fixed income assets will rise in value and counterbalance the falls in equity prices, as they did in 2008.

Real diversification, however, works best between high-grade investment bonds/gilts and equities. High-yield bonds and equities are much more closely correlated, and should be viewed as part of your risk segment than the defensive part of the port­folio. In 2008, many high-yield bonds fell by as much as the more defensive-placed equity funds.

Secondly, it is important to remem­ber that just as sub-sectors and geographic regions in equity markets have different cycles, the bond market is not uniform. It therefore pays to be geographically diversified within your bond exposure.

Data shows hat while the UK and US bonds have followed a close pattern, returns from European bonds vs UK/US bonds have greatly diverged. Overall returns would have been smoother if a portfolio has exposure to all these markets.

It is worth noting here that investing in global bonds would carry an element of currency risk. I do not like to add unnecessary risk to our bond exposure, and so prefer funds where the currency risk is hedged.

The hedging slightly increases costs, but the increase is relatively modest and much smaller than the margin charged by actively managed funds over more passive funds.

Thirdly, it is important to remember that bonds carry not only credit risk but also duration risk, with longer-dated bonds and gilts being much riskier than shorter-dated bonds. With interest rates set to rise over the next few years, duration risk will come increasingly into play. This has led to the launch of more shorter-dated bond funds from the likes of Vanguard and Axa. These have added further sub segments into the bond marketplace and greater choice for investors.

Finally, there is the liquidity risk, with the bond market seeing such strong inflows over the past six years. There is a concern that when interest rates rise and prices fall, there might be panic selling by retail investors, which in turn might force funds to dispose of their bond holding at whatever price they can obtain.

The main defence against this is to ensure that your portfolios are invested for the longer term and that you would not be a forced seller at times of volatility.

This can be achieved by ensuring that you have a good cash buffer. Yes, this will have an impact on overall returns, but that could be far less damaging than having to sell when the market is at rock bottom.

So when making a decision, its worth bearing in mind:

■ The issue of rising yields has been much talked about in the press and market commentators for more than three years. Sitting in cash over that period would have given up almost 1.5 per cent a year in yield

■ There is no way of knowing when future interest rate rises will occur, and trying to time such a move is likely to be a futile exercise

■ Owning short-dated bonds provides a mitigant, but periods will exist when short-dated bond returns provide poor and potentially negative returns

■ Cash is not a safe alternative, as it has lost more than 3.2 per cent a year in real terms. This translates into a loss of more than 15 per cent on a cumulative basis over the past five years

■ Last year’s market concerns of slowing of US quantitative easing is a reminder that bond prices are likely to remain volatile

So in summary, while bond returns are likely to be lower over the next five years than they have been in the past five years, bonds still play an important diversification and risk manager role in portfolios. Short-term volatility can be managed by ensuring sufficient cash is retained to meet any short-term need.

Anna Sofat is a director of Addidi Wealth

Key points

■ Investors have been piling into corporate bonds driven by very low deposit rates and low yields on government bonds.

■ In the UK, the inflow has seen a number of bond funds grow rapidly in size.

■ Real diversification works best between high-grade investment bonds/gilts and equities.