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Fixed Income Investing – August 2016Looking beyond the UK’s bond market
Investors spent the first half of 2016 piling into fixed income in a bid to protect their portfolios in the run-up to the EU referendum, as the domestic equity market in particular appeared to be a more risky investment proposition.
Fixed income funds were the best-selling asset class in May, according to Investment Association data. Within that, the best-selling fixed income sector was the IA Sterling Corporate Bond sector, which clocked up net retail sales of £264m, followed by the IA Sterling Strategic Bond sector with net retail sales of £131m.
In the aftermath of the referendum, the outlook for bond markets has altered slightly. Central banks are intent on keeping interest rates at low levels for even longer, and there is even the possibility of moving further into negative territory in Japan’s case.
All of this means investors need to consider the regional variations when deciding whether to look further afield than the UK.
Jonathan Platt, head of fixed income at Royal London Asset Management, says: “Broadly speaking, the strongest performance trends in fixed income after the Brexit result have mirrored those in equities. The clearest bifurcation in performance is between financial and non-financial sectors.
“UK banks are already facing a number of challenges from the long-term effects of low interest rates and tend, in general, to be more sensitive to market movements. These concerns, however, have not been confined to UK banks – much greater spread widening has been seen in the subordinated debt of weaker European banks, especially Italian banks.”
| EXPERT VIEWS |
Neil Williams, group chief economist at Hermes Investment Management, observes: “The referendum outcome is only the latest chapter in a protracted story of lower for longer bond yields. The overriding force, quantitative easing (QE), is global, and Brexit and its ripple effects are an extra incentive for central banks to keep the liquidity taps on. This should support growth assets. However, further QE would only intensify the pressure on pension funds. “In the rating agencies’ eyes, Brexit is also putting the UK’s creditworthiness back under the spotlight. S&P and Fitch have been quick to downgrade the UK’s sovereign ratings. Nonetheless, with the UK’s government debt being local-currency denominated, the Bank of England waiting in the wings, and the UK Treasury in 2014 (during the independence referendum) pledging to honour all gilts should Scotland break away, UK sovereign default-risk still looks, in reality, close to zero.” Wouter Sturkenboom, senior investment strategist, EMEA, at Russell Investments, says: “Fixed income investors should continue to keep their expectations with respect to gilt yields low, and our range for the 10-year gilt yield at the end of 2016 is now 0.8-1.4 per cent, down from 1.5-2.0 per cent. There is little in terms of growth, inflation or monetary policy that is going to drive yields higher in a sustainable manner.” |
This leaves investors wondering, where are the regional opportunities in fixed income?
Guy Monson, chief investment officer at Sarasin and Partners, makes several observations after sifting through the “political wreckage of the Brexit aftermath”.
He suggests: “UK gilts have rallied dramatically, with their yield against German bunds and US Treasuries narrowing rather than ballooning. Indeed, the weakest government bond last month was actually Italy’s, suggesting that investors may still worry more about the durability of the Italian banking system than they do about the survival of the UK government.”
Many managers advise investors to have some exposure to US fixed income in the current climate, though.
Janus Capital’s director of fund fixed income strategies, Robert Griffin, points out: “Given unconventional monetary policy from the European Central Bank and Bank of Japan, interest rate markets have become highly artificial. With negative rates in Japan and much of continental Europe, we believe there is strong relative value in US fixed income, including investment-grade and high-yield corporate credit.
“Issuer selectivity is critical, however, as we are in the later stages of the credit cycle and the reward for being right is less than the risk of being wrong.”
Adrian Hull, senior fixed income investment specialist at Kames Capital, believes that in a world where 10-year Treasuries are yielding 1.5 per cent, 10-year gilts are yielding 1 per cent and 10-year bund yields are negative, it’s hard to believe investors would not want US exposure in their portfolios.
“Opportunities-wise, yes, the US,” he notes. “I think people will be slightly distracted in the UK so this is an opportunity for people to feel a bit more cautious from a global perspective. A very defensive but solid bet was clearly in Europe but I think the most likely value is going to come out of the US market.”
Mr Platt agrees: “In high-yield markets, US issues are faring better than their EU counterparts, showing that, for the moment at least, the impact of the Brexit vote seems to be mostly contained within the UK and Europe.”
But he cautions any performance divisions should be seen in the context of UK government bond yields having fallen to record low levels, declining by more than in other core government bond markets.
“While there is variation in sector performance within the UK, investors still consider UK government bonds to be a ‘safe haven’ asset, despite the prevailing political and economic uncertainty, which is likely to remain in place for some time,” he concludes.
Ellie Duncan is deputy features editor at Investment Adviser
