When the consumer bubble burst in 2008, the UK interest rate was rapidly reduced to the 0.5 per cent we have today, and sadly this has had major repercussions.
Think of bonds’ relationship with interest rates as moving in opposing directions at the expense of one another.
If you consider the 5 per cent gilts you own seems fair value when the rate is around that level, then if the rate falls the high cashflows on your bond now look seriously attractive and the price rises to reflect this. New investors have to pay more up front to get the same cashflows, so the yield drops.
This basic phenomenon has driven the bond market into a bubble such that yields are anchored at ultra-low levels.
To achieve a higher return you must take more risk. This can either be by buying bonds issued by less creditworthy issuers, or by locking yourself into fixed cashflows for a longer term and hence taking more interest rate risk, knowing that the rate will rise at some point.
Neither seems particularly appealing, so it’s worth considering alternative strategies.
The first is to consider whether clients actually need the cashflows? Many investors believe that fixed interest stocks are, in the main, low risk owing to their cashflows. But this thesis falls apart when you have to up the ante and stake more to chase the same return.
There are a host of hybrid assets that share the income-producing attributes of conventional bonds, but which knowingly encompass different types of risks.
Infrastructure is one such asset class where the schools and barracks they build under public-private partnership/private finance initiative contracts entitle them to the operating cashflows on these projects across a period of, say, 30 years.
Companies such as the HICL Infrastructure trust’s cashflows are often inflation-linked, and because they are continually reinvesting in new projects at new prevailing rates, they are likely to be less interest-rate sensitive than an equivalent 30-year bond. However, its shares trade at a 10 per cent premium to the value of the net assets. The yield is 4.9 per cent and you should expect income growth that you would not get with a bond.
Structured products are another hybrid asset class that can be an efficient tool to generate income. Investment banks normally issue these, so investors start off receiving a return equivalent to taking the same risk as if they were buying that bank’s senior bond on the open market.
There are usually more derivatives built into a single structured product to facilitate greater returns and engineer a payout. Of importance is that they will demonstrate equity-like characteristics in extreme scenarios, so structured products should be seen as a unique tool for a specific job.
Meanwhile, every so often we see a pioneer coming to the market, addressing a certain niche, which sometimes catches on. One such entrant is the UK Mortgages Ltd (UKML) trust, which recognised an opportunity borne out of the banks’ fully capitalised balance sheets.
Mortgage business is profitable for the banks and building societies, but they are fully laden. UKML realised that a book of mortgage loans could be offloaded to a third party.
UKML could take on a book of business that has low risk and modest returns. Based on an expected annual income from the vehicle of 7-10 per cent, this appears to be a compelling investment with few of the hallmark risks normally found with conventional client portfolios.
Kris Barclay is investment manager at Charles Stanley
EXPERT VIEW
Azim Meghji, manager of the Strategic Bond fund at Santander Asset Management, gives his view on the fixed income market:
“Fixed income markets in general have grown significantly in recent years as weak economic growth, low inflation and quantitative easing have led to strong performances in the asset class.
At the same time, the level of liquidity offered in the market has fallen. This has primarily been a result of regulation, making it more expensive for banks to trade and warehouse debt. As a result, we expect markets to overreact at points of stress, whether it be on the upside or downside.
After many years of monetary easing in the industrialised world and growth in emerging markets, we have entered a new phase of uncertainty where there is a prospect for monetary tightening in the US and the UK and a slowdown in emerging markets.
Our base case is that the world will not end and if there are signs of significant stress, monetary authorities will be quick to turn on the taps (or at least the rhetoric).
Bond yields are low for a reason and with the current outlook do not expect this to change materially in 2016. We expect idiosyncratic risks to increase and stress points to be more frequent and larger in size.
Credit valuations have improved and we see value in financials in particular, where growth concerns should be a second order effect for a sector that is still deleveraging and improving its liquidity and capital position.”
