Bonds – where to go next?

With the turmoil in Europe, the credit market saw record inflows of more than £911m in the year to January 31 2011, while equities, which are seen to be at the top end of the risk scale, faltered.

However, some areas of credit were more popular than others. Short-dated bonds, which were popular pre-2007, came back into favour, as investors’ attitude toward risk flagged, and their anxiousness to be able to make a quick exit increased.

Jozef Prokes, a member of BlackRock’s fixed income portfolio management group, who focuses on covered bonds, says: “When you see inflows into short-duration bonds, that’s when investors believe that their rates are at the lowest and they want to protect themselves from inflation risk and to get short-term exposure that they can roll over quite quickly.

“What we’re seeing at the moment is that markets think rates will stay very low for the foreseeable future. We’re seeing clients becoming interested in these types of bonds, not because they’re expecting rates to go up, but because they’re expecting rates to be on hold and they want to get exposure away from money markets and go to slightly longer, still short duration, but between 1-3 years.”

Mr Prokes adds that the yield environment is quite attractive for these bonds and is not expecting any losses because of the slightly lower duration.

Long-dated government bonds have outperformed in the past year, with the iBoxx Sterling Non-Gilts 5-15 year index returning 9.3 per cent in the year to February 24 2012, compared with the iBoxx Sterling Non-Gilts 1-5 year index, which only returned 4.29 per cent.

However, according to John Hamilton, manager of the Jupiter Corporate Bond fund, this year could be the start of a turnaround.

Global growth

“A lot of people have been saying that last year was the year to be in long dated, therefore this year probably isn’t going to be,” he says.

Jeff Keen, fixed income fund manager at JO Hambro Investment Management (Johim), agrees. He argues that the prospect of global growth slowing, the Greek crisis and the global banking crisis saw the worst type of environment for short-dated bonds last year. However, as the situation improves, short-dated bonds could flourish once again.

Short duration credit offers the opportunity to invest in fixed interest instruments with shorter maturities that tend to exhibit lower volatility than bonds with longer to wait until maturity. This lower volatility comes about because duration risk, and to a lesser extent credit risk, are somewhat mitigated. Typically, investments are made in bonds that mature in the next one to five years, which means they are less sensitive to changes in interest rates than longer-dated bonds.

Bryn Jones, fixed income director at Rathbone Unit Trust Management (Rutm), believes that if investors are worried about interest rates rising, then short-duration bonds are the place to be.

“Yes, you do get paid more for taking more maturity risk, so if you want to buy a 6, 7 or 8 per cent yield you’re going to have to go further. What people have to understand about buying short-duration assets is it’s not necessarily going to give them a better return, but it’s protecting their mark to market losses from an interest rate rise.”

Mr Jones adds: “The gilt index, for example, has a duration of roughly nine or 10 years and the corporate bond index has a duration of six or seven years, so any 1 per cent rise in interest rates or yields will mean that market will fall approximately 7 per cent. If the income is 6 or 7 [per cent] you’re not going to get much return if yields rise 1 per cent. In a short-duration asset, if you can get a 5 per cent yield with a duration of about 2 years and yields rise 1 per cent, you’re going to get a positive return. So it’s not necessarily going to give you a bigger return, it just means losses aren’t going to be as great should yields rise.”

Of course, as Mr Keen rightly points out, no bond investment is risk free, and he claims investors have forgotten the risk of investing in yields or US treasury bonds, as they can fall in value pretty quickly. This is where he says it pays to invest in quality corporate bonds.

Ben Seager-Scott, senior analyst at Bestinvest agrees: “Credit risk remains, but with a shorter duration, arguably default risk is mitigated, as there is greater visibility on the company’s short-term operations. Since there is less sensitivity to perceived default risks and interest rate changes, there tends to be relatively little fluctuation in the bond price so the majority of the return comes in the income yield. As a result, a lot of funds will focus on the high-yield bond market.”

According to Mr Prokes, the type of investor best suited to short-duration bonds is the one who is a little more risk averse than the average, but is seeking a better yield than the money market.

He says: “The credit type of investing has moved into the sovereign space and we are seeing the curves flattening in a bearish environment, like in Italy and Spain. Obviously it has reversed slightly with the liquidity provided from the central bank. But I think it’s something that will stay riskier for a while, so you are not only getting a protection against duration losses or an increase in yield, but you have to realise that you’re taking a certain amount of exposure to a riskier investment, so that by definition carries a risk premium.

“What you would have seen three years ago is that yields in this area yielded nothing, but now you are seeing more of a return as these bonds are perceived to be riskier. Obviously investors are still willing to pick these up because of the safeguards put around the financial system and sovereign market in Europe. But in spite of being in a low-yield environment, when you’re at the front end of the curve and very core type of duration market, investors are still able to get some kind of yield because there is a risk premium built into the market.”

In this space, Mr Seager-Scott recommends the Muzinich Short Duration High Yield fund, which takes advantage of high-yield bonds in the US. Nevertheless, he adds, that away from the high-yield area, Smith & Williamson offers a Short-Dated Corporate Bond fund, which primarily invests in investment-grade corporate bonds.

Corporate bonds

Mr Hamilton agrees that there are attractive short-dated corporate bonds available. “There are some good quality companies that issue debt on something like 2-3 per cent over gilts, so you can get some quite attractive yields and if there is a curve change in gilts, you’re not as affected.”

However, the big differentiator will be what kind of bond are you buying.

Mr Prokes argues: “If you’re buying a two-year bond, it is different if you buy a government, corporate or financial [bond], as they will have different behaviour and profiles. It’s correct that it should be a very important part of an investor’s portfolio, but we have seen a lot of shifts in the past 18 months in terms of risk appetite of investors and what they’re willing to take into their portfolio.

“If you strictly stripped out the safest investments, then your yield is looking very low and it would make sense to allocate less to these types of yielding investments in this environment. But if you take into account decent bonds – big institutions that are just carrying risk premium because of the situation in the market – then it makes sense to stay in short duration. There will be decent returns on short duration, but we have seen the curve steepen in the last few months.”

In spite of yield curves for short duration in the west being steep – in other words, longer-dated bonds have much higher yields than short dated – Donald Amstad, director of business development of Aberdeen Asset Management Asia, says that they are fairly flat in the east, and therefore there is a lot of opportunity for short-dated bonds in Asia.

“Unlike the west, which is in a recession and has been since 2008, economies in Asia are strong. Inflation has been the problem, but short-term interest rates in Asia looks good. You can get a yield maturity of 3.1 per cent on short-duration bonds, which when compared with a 2 per cent yield on US treasuries is pretty attractive.

“I’d hate to say three is a large number, but if you’re talking to bond investors, three is a good number in the bond space and obviously Asian bonds are good quality as Asian governments are very solvent, unlike many governments in the west. So you’re lending money to governments that are solvent and in currencies that are undervalued and set to appreciate. You can get 13 or 14 times more yield than you would get on a two-year US treasury,” he adds.

Mr Amstad says that, in comparison, long-duration bonds are only yielding roughly 0.4 percentage points more, so short duration in Asia makes particular sense.

However, with interest rates in the west expected to remain low for the considerable future, what does the next 12 months hold for short-dated bonds in general?

Mr Keen says: “Investing in quality is a good idea. If you think the world’s going to get back to a normal environment when we get reasonable economic growth and inflation that is under control, inflation at 2 per cent in the developed world and real yields of, let’s say, 2-3 per cent, that would imply interest rates back up to 3 or 4 per cent and bond yields to 4-5 per cent.

“If we move back to that sort of environment, it won’t matter if you’re in a government bond or high quality corporate – you’ll be subject to that negative duration affect in a long-dated bond. This is why people are being hasty by buying short-duration bonds.”

According to Mr Hamilton, however, this outlook for short-dated bonds is already factored or priced in to the market. He says that if the outlook starts to unravel because we start to see a slightly better growth outlook, the market as a whole is vulnerable. “In that environment, you’ll lose more, because if there was a move to higher rates, the short end of the curve would adjust quite sharply.”

He admits that this is unlikely to happen in the short term, but warns that investors shouldn’t get any more optimistic about rates than they are now.

“I suppose the best you can hope for on short rates is that it works out the way we expect, so we have a period of low interest rates lasting for 18 months. That would enable short-dated government bonds to give you the low yield you’re on, which is not particularly mouth-watering.”

However, Mr Amstad argues that regardless of the outlook, there will always be a market for short-duration bonds. “If you take the US markets for example, short duration in the US has always had a place whatever stage of the cycle. There will be times when it’s more attractive and when it’s less. At the moment you have a situation where central banks have slashed official rates to zero or close to zero and you have a lot of money still sitting in cash, so there’s a pull from cash into short duration.

“One way to look at it is that central banks are printing money, therefore inflation will be a problem, therefore you don’t want to be buying long duration. If you want to stay in bonds you then go down to short duration to protect yourself from interest rates going up.”

Mr Keen concludes: “In the absence of any other alternatives, I could see that short-dated corporate bonds are going to be relatively attractive.”

Simona Stankovska is features writer at Investment Adviser