Where does fixed income now fit in a portfolio?

Christine Johnson, manager of the Old Mutual Corporate Bond and Monthly Income Bond funds, says: “With the current largest threat to the fixed income market being the likely increase in government bond yields - the route to the best yields in fixed income are to dump the ‘fixed’ bit.

“The good news is that if you are genuinely interested in ‘yield’ rather than just pure total return – selling the fixed portion, with yields close to all time lows, is a relatively cheap thing to do.

“For traditional fixed income investors, shorter-dated, lower-rated bonds offer the best yields because the majority of the yield is coming from the credit spread rather than the underlying government bond it prices off.”

Following positive market sentiment for most of the first half of 2013, the recent sell-off in government bonds has had a knock-on effect, particularly on riskier markets such as emerging market debt, explains Nick Hayes, manager of the Axa Global Strategic Bond fund.

He notes: “Emerging market has sold off between 4-8 per cent, while high yield has been more protected and hasn’t fallen quite as much. In the fund I run the yield would have been 3.5 per cent four months ago and now its 4 per cent, so overall yield levels are much more attractive.

“We still prefer credit and high yield to government bonds, but certainly the argument is probably less convincing since we’ve seen such a big back up in government bond yields.”

He adds the main driver in May and early June for the sell off is growing concern about what will happen when QE tapering begins.

“Clearly we think we’re coming towards the end of the bull bond market but we still think there is a bit more to go and don’t think the global economy is strong enough to handle the end of monetary easing and the end of QE.

“This is a little taster of what is to come further down the line, certainly a couple of years further down the line when you have a normalisation of government bond yields and have a lot of volatility.”

Where to invest

In terms of areas that look attractive Mr Hayes points to some parts of the investment grade and high yield market where spreads have sold off, while the inflation-linked areas have previously been pricing in low levels of inflation and so they have felt “a lot of pain, particularly in the US, and that makes them more attractive”.

Ms Johnson is looking towards the lower-rated corporate bond sector, as she explains: “A ‘B+’ rated, six-year bond, such as packaging company Albea, achieves nearly 90 per cent of its 9 per cent yield from its credit spread and only 10 per cent from the underlying government [bond].

“Contrast that with ‘A’ rated AT&T’s 2044 bonds that receives only 30 per cent of it’s nearly 5 per cent yield from the credit spread and all the rest from the underlying [government bond]. Clearly selling the ‘interest rate sensitivity’ from Albea will leave you with a lot more yield than doing the same for the AT&T bond.

“And if government bond yields are rising because developed market growth is improving, that puts the spectre of defaults to bed.”

Paul Smith, manager of the Premier Strategic High Income Bond and Premier Corporate Bond Monthly Income funds, points out it will be a challenge for bond funds to repeat the strong performance of 2012, and as a result managers are looking to non-traditional fixed income products in their search for yield.

He notes: “The trend towards companies issuing hybrids is increasing; these are cheaper than issuing equity for the company and yields on hybrids are equivalent to what they were on seniors one to two years ago. Hybrids partially count as equity and so can be issued while protecting the company’s credit rating.

“Solvency risk exists although we expect default rates to remain low; and given recent capital raising corporates have significant cash to allay any concerns over liquidity. However, we are seeing more issuance of long-dated paper and this increase in duration will lead to a greater fall in prices should yields rise.”

Mr Hayes points out in spite of the recent volatility and drivers behind the moves in bond markets, “there are pockets of value”.

He adds: “It’s been a volatile year and that’s what we expected. There has been a lot of pain in emerging markets, a little bit less in high yield. Unfortunately we have a period of volatility but that gives us the opportunities to buy bonds at higher yields.”

Beyond the yield

Darius McDermott, managing director of Chelsea Financial Services, adds that while bonds are not particularly attractive in the current environment, but they will continue to have a role because people still need income and high street interest rates remain at low levels.

He explains: “They [bonds] also act as a good diversifier - most asset classes have gone down in recent weeks with Asia and emerging market equities hit much harder than bonds, so they are still working in a wider portfolio.

“I think government bonds are very over-valued and yields are so low at the moment there is much more downside risk than upside. Just a whiff of QE ending has seen yields rise and prices fall. I’m also not so keen on quality corporate bonds, so the value that is left seems to be mainly in the high yield space and on a sector level in financials.”

With the second half of 2013 looking to increase in uncertainty as central banks closely monitor their monetary policy action, investors need to be willing to search within sectors that may have been previously overpriced that are now more attractive and at the same time look to expand their horizon away from the traditional fixed income areas.