Roger Webb is building up his defensive positions in the Swip Strategic Bond fund as he fears the growing risks in the market could trigger a full-blown correction.
Mr Webb, who manages a range of Scottish Widows Investment Partnership (Swip) funds on behalf of new owner Aberdeen, has hedged out a significant portion of the credit risk in the high yield portion of his Strategic Bond fund.
He has used derivatives to hedge a third of the risk from his high yield positions, which account for approximately 40 per cent of the portfolio.
The manager pointed to increasing signs of risk-aversion and volatility in markets as a reason for the increase in his defensive positioning.
“We have seen a bit more volatility in the market recently,” he said.
“There have been a number of idiosyncratic events, such as with Tesco and Phones 4U.”
Mr Webb predicted that the build up of risks in the credit market was getting to the stage that it could spark a full-blown “correction” in the market.
The collapse of Phones 4U’s bonds, which saw bonds issued at 100p temporarily trading at 8p per bond, had brought a “reality check” for investors and reminded them of the risks inherent in high yield, according to Mr Webb.
“The soft economic data recently, along with profit warnings in a few areas of the market, makes you a bit more mindful of the risks, given where valuations are,” he said.
Not only are the fundamentals proving risky for high yield bonds, but technical factors are weighing against the asset class, as a glut of new bond issuance in September has not been fully met by investor demand.
While individual events such as profit warnings and slightly weaker data would not be enough in themselves to knock markets, Mr Webb pointed out there was currently a huge “consensus” trade to have a long position in credit risk.
He said it was “probably the right thing to have on” in the current environment of supportive central banks and economic recovery.
But he warned that if enough factors knock investor confidence in either the recovery, or the US, UK or European central banks, then the consensus trade could unravel very quickly as investors would likely move back to safe-haven assets.
Mr Webb said he had witnessed a slight movement out of risk assets at the end of September, sparked by factors such as the strength of the dollar, which is weighing on emerging market local currency bonds.
Another event that hit markets was the reaction to Bill Gross leaving Pimco, and the possible liquidity concerns if the $2trn (£1.2trn) asset manager sees significant redemptions from its funds.
However, in spite of the near-term risks, Mr Webb still has a “constructive longer-term” view of the high yield asset class, which is why he is hedging out risk with derivatives rather than selling bonds.
He said putting on and taking off a derivative position was much easier than selling bonds, which could see him forced to sell positions for less than they were worth or struggle to repurchase them when he wanted.
Artificially low bond yields cause a headache for investors
Throughout 2014 investors’ minds have been occupied with the question of when the UK and US will raise their base interest rates.
But in spite of strong hints that the first rise will be in the first quarter of 2015, the yield on US and UK 10-year bonds has remained stubbornly low, trending at roughly 2.5 per cent.
Roger Webb said the yield on 10-year US treasuries was somewhere between 50 and 75 basis points lower than it would normally be at this point in the market cycle. The surprisingly low yield has already caught out investors, many of whom had banked on yields rising from the 3 per cent mark at the start of 2014.
But Mr Webb said it was understandable that yields were so low given the low levels of inflation in the UK, US and Europe.
Europe has been suffering from disinflation for much of 2014, which has led some to be concerned about deflation, while inflation rates in the US and the UK have remained stubbornly below the 2 per cent level targeted by the central banks in both countries.
The level of inflation has been kept down by falling commodity prices, a lack of consistent wage growth in developed economies, and a price war in supermarkets and other retail sectors.
