Discretionary fund managers have warned that investors moving from government bonds into investment grade and high yield debt in defensive portfolios could be set to suffer in 2014.
Many investors have moved away from UK government bonds, known as gilts, which have traditionally been the bedrock of defensive portfolios but lost money in 2013.
Investors moving away from gilts have invested in investment grade or high yield bonds but now those assets are increasingly looking expensive compared to gilts.
Harry Morgan, head of private investment management at Thomas Miller Investment, said that investment grade bonds had suffered a poor 2013 but rallied towards the end of the year.
As a consequence, he said the spread between investment grade bonds and gilts, which is the difference in yield between the two assets, had narrowed sharply in the past four weeks.
He gave the example of a five-year bond from British American Tobacco, which has a yield of only 0.68 per cent more than its corresponding gilt.
Charles Hepworth, investment director at GAM, said that investors had been “chasing into investment grade and high yield” as they abandoned gilts.
He said this meant the yields on corporate debt had rallied so much he did not think they could fall any further, meaning prices, which move inversely to yields, were now unlikely to make further gains.
Therefore, if gilt yields trend higher during 2014, which the discretionary managers thought would happen, that will also push up the yields on investment grade and high yield bonds, prompting capital losses in those asset classes.
Mr Hepworth warned that investors who had moved from gilts to high yield hoping to see the same returns seen in that asset class in recent years “may well be sitting on a capital loss in six months’ or 12 months’ time”.
Michael Lally, investment director at Thesis Asset Management, said he had been surprised by investors that have moved from gilts to high yield in defensive portfolios.
He said the risk and return characteristics between the two assets were so different and warned that even if managers generated outperformance to their peers from buying high yield, they could still be fined by the regulator if they took on too much risk to do so.
The pressure on several parts of the fixed income asset class has meant discretionary managers increasingly using less conventional assets to generate returns in their low-risk portfolios.
Many are snapping up floating rate bonds, where yields rise as interest rates move up, some thing experts expects them to do in the next few years.
Mr Hepworth said the “vast majority” of his exposure to fixed income was now in the form of floating rate bonds.