However, this created the problem of how to generate returns that would at least provide protection from inflation.
Following promises by Mario Draghi, the president of the European Central Bank, to prop up the euro, investors felt reassured that this break-up risk had substantially reduced and embarked on a hunt for yield.
As a result, corporate bonds, and particularly high-yield bonds, have enjoyed impressive gains.
It is perhaps no surprise that this period has coincided with a sharp rise in the popularity of bond funds that can capitalise on both trends. The ability for strategic bond funds to allocate risk using the whole of the bond market has understandably become a major attraction.
The IMA Sterling Strategic Bond sector has expanded rapidly, and – with assets of £42bn – is now second only in size to the IMA Corporate Bond sector.
However, with gilt yields bumping around close to record lows and many now voicing concerns about a corporate bond bubble, how will bond fund managers make money in coming years?
In my opinion there are several key trends that a strategic fund manager can exploit.
First, the importance of stock picking will come to the fore. Since 2009, the trend has very much been your friend. It has been enough to generate returns simply by taking exposure to the corporate bond market as a whole and high yield in particular.
However, yield spreads over government bonds have narrowed considerably over this time, increasing the risk corporate bond investors face from rising government bond yields. This emphasises the importance of researching individual stocks. Finding companies that could be upgraded or face positive event risk will help to offset the impact of rising yields.
A strategic fund can also take more relative value trades, being short one company and long another – typically in the same industry – so market risks are minimised.
Increasingly, investors will also have to be wary of specific event risk. The recent upturn in risk appetite is leading to a rise in corporate activity. This does not always mean good news for corporate bond investors if deals are financed by more debt. The recent takeover of Heinz by Warren Buffett is a case in point. The deal will result in the global food giant doubling the amount of debt on its books and spreads in Heinz increased by a factor of four from circa 50 basis points to around 200bps immediately after the deal.
Derivative use continues to increase, allowing investors to take risk in very specific areas and reduce risk where and when it is not wanted. This has changed the way many funds are run, but in particular funds in the strategic bond sector should use derivatives extensively for asset allocation, relative value trades, risk reduction or as an efficient way of gaining exposure to a company where liquidity in the bonds is poor. However, it is worth noting that gaining exposure to a company through credit default swaps has long-term costs associated with it. This is due to the need to roll the contract regularly to ensure that the position can be exited at a reasonable cost. Even CDS markets become illiquid the longer you hold a particular contract and it moves off the run.
We are also seeing good opportunities to invest in hybrid bonds. Ranking between equity and normal senior debt, these have advantages both for issuers and investors.
Borrowers want to preserve their credit ratings, and hybrid bonds provide a mechanism that allows them to borrow money without jeopardising this. For investors, hybrids are attractive because the higher level of risk is rewarded with a better return than senior debt from the same issuer. That is particularly appealing in the current low interest rate environment.
Looking at other parts of the bond market, I expect to see further opportunities within high yield. Investors have already enjoyed a strong rally and yields in some parts of the market are not much above levels normally associated with investment grade debt. However, their main attraction is that default rates are set to remain low and as long as companies have access to funding, this should remain the case. Again though, it is vital to emphasise the importance of thorough research. Valuations have risen and yields fallen and investors need to be alert to event risks stemming from corporate activity. I am becoming more concerned with event risk in the US market than in Europe. A better economic outlook is likely to lead to a return of more of Keynes’ ‘animal spirits’ in boardrooms.
Meanwhile, with central banks (both tacitly and explicitly) targeting growth at the expense of inflation, the index-linked market cannot be ignored. This is a market we have traded on a strategic basis in recent months. Although some do not have a heavy presence in the index-linked market at the time of writing, it is possible they will probably adopt further opportunistic positions as they occur across different parts of the yield curve.
Overall, what is clear is that to generate returns in coming years investors will need to be increasingly nimble. I see plenty of opportunities for generating positive returns, although risks remain.
Therefore the ability to adjust asset allocation quickly, combined with the skill to generate stock-specific alpha, will be key to delivering returns from here.
Luke Hickmore is investment director in the fixed income team for fund manager Swip
Key points
- The ability for strategic bond funds to allocate risk using the whole of the bond market has understandably become a major attraction.
- Yield spreads over government bonds have narrowed considerably since 2009, increasing the risk corporate bond investors face from rising government bond yields.
- With central banks targeting growth at the expense of inflation, the index-linked market can not be ignored.
