Beware bond proxies – check under the bonnet

Nominal bond yields have plummeted across developed markets, with this trend fuelled recently by more quantitative easing (QE) in Japan and the European Central Bank’s newly-announced QE programme. The Reserve Bank of Australia recently became the 11th central bank this year to ease monetary policy via interest rates when it cut its overnight rate by 0.25 per cent to a new record low of 2.25 per cent.

Inflation rates have also tumbled in the developed world as a result of technological developments, efficiency improvements and a 46 per cent fall in the price of Brent crude in the past six months. All this has pushed down bond yields.

A year ago US 10-year Treasuries were yielding 2.68 per cent, while in February they yielded roughly 1.75 per cent. In the UK the yield fall is more marked moving to 1.46 per cent from 2.70 per cent for 10-year gilts to February 3 2015, according to data from Bloomberg. And throughout much of continental Europe, bond yields are in negative territory.

Investors have sought new sources of income. Exactly where their money has gone is shown by the £20.8bn of net retail sales for 2014 published by the Investment Association. The largest inflows occurred in the UK Equity Income Sector (£6.3bn), with Global Equity Income (£1.4bn) also reflecting the trend for alternative sources of income.

Property also proved popular, with net inflows of £3.8bn. It is also interesting to note that infrastructure debt-related investment trusts with good yields are at substantial premiums.

Many investors will have delegated asset allocation decisions to a multi-asset provider, but if correlations between asset classes are rising again then it is prudent to understand just how diversified a portfolio really is.

The assets that are acting as bond proxies can come as a surprise. For example, there is a high correlation between ASEAN (Association of Southeast Asian Nations) equity markets and US bond yields, illustrated in the graph below.

Since the US ‘taper tantrum’ in May 2013, those markets have been a major bond proxy. On the premise that bond yields could rise this year on better growth prospects, ASEAN markets could underperform.

The message for investors is clear: be alert to the fact that not all bond proxies are obvious and be prepared to lift the bonnet and ensure your multi-asset fund provides the diversification you require.

Peter Askew is senior fund manager at T Bailey Asset Management

GLOBAL MARKET PERFORMANCE

Which markets performed in the 12 months to March 3 2015?

25.99%

12-month increase in S&P 500 index

18.45%

Rise in the MSCI World index over 12 months

15.66%

One-year increase in MSCI Emerging Markets index

6.41%

12-month increase in the FTSE All-Share index