Fixed IncomeJan 27 2014

Is flexibility the key to success in 2014?

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Last year was a landmark one for fixed income. Headlines were dominated by the prospect of an end to quantitative easing (QE) in the US and, while this did not materialise until the very end of the year, bonds still incurred heavy losses as investors pre-emptively headed for the exits.

Very few areas of the bond market escaped the sell-off induced in mid-May when the US Federal Reserve first hinted it could end QE. UK and US government bonds sold off, pushing yields to their highest levels since before the eurozone crisis. Corporate bonds – which are priced relative to government bonds – suffered a similar fate, while emerging markets bonds, the hot asset of 2012, were hit hardest with many funds posting double-digit losses.

Now that we have a degree of certainty of how ‘tapering’ will play out in 2014, the immediate prospects for most areas of bonds do not look good. As economic growth in developed markets improves, QE will continue to be unwound, putting further downward pressure on government bond prices and, subsequently, corporate bonds.

Asoka Wöhrmann, co-chief investment officer of Deutsche Asset & Wealth Management, says US Treasury bond prices have already discounted the effects of tapering the Fed’s QE programme, but adds that yields “should gradually move higher if further tapering is announced” as the US economy is seen to improve.

Franklin Templeton’s fixed income director Roger Bayston points out that yields and falling prices “should simply be seen as a normalisation that mirrors optimism about the ongoing, rather unspectacular recovery of the US economy and the unlikelihood that short-term interest rates will go up anytime soon”.

Old Mutual Global Investors’ investment director for fixed income Stewart Cowley – who has long spoken of his bearish outlook for his own asset class – goes further.

“Coming to terms with the idea that ‘it’s over’ will be one of the biggest challenges in 2014,” he says. “In 2013, we learned that the corporate bond markets, emerging markets and global equity markets are the creatures of a swirl of money flowing around the world as the result of American quantitative easing. As the life support machine is gradually closed down, and an attempt is made to return to free markets, we will find out to what extent these markets have been propped up in the past seven years.”

Longer-dated gilt funds were among the worst performers – aside from emerging market debt funds – as the longer a bond has until it matures the more sensitive it is to changes (or speculation over changes) to interest rates. Baillie Gifford’s £41.7m Active Long Gilt Plus fund lost more than 8 per cent in 2013, while the average fund in the IMA UK Gilt sector lost 5.1 per cent.

Given predictions of almost guaranteed losses in some areas, is there really a place for traditional fixed income products in a client’s portfolio in 2014?

For those using ‘low risk’ model portfolios, there may not be much choice. Government bonds and other fixed income assets have traditionally been used to dampen volatility while also producing a predictable income. Multi-asset managers running such portfolios argue that it is still appropriate to hold fixed income provided you choose the right areas.

Premier’s head of multi-asset David Hambidge argues that gilts will still give investors “a relatively smooth ride”, even if they do lose money.

“You’re not going to lose your shirt in gilts,” he says. “They are being likened to overvalued tech stocks, but they are not. You are getting paid 3 per cent a year on a 10-year gilt. I still argue it would do a job in all sorts of portfolios.”

James Klempster, portfolio manager at Momentum Global Investment Management, says investors who are forced to hold gilts “should be considering trimming their duration” in order to reduce sensitivity to movements in interest rates.

Meanwhile most multi-managers are turning to strategic bond funds to maintain fixed income exposure through more flexible products. Last year Aberdeen’s multi-manager team overhauled their fixed income exposure, turning to the likes of L&G Investments’ Richard Hodges and his Dynamic Bond fund.

Jupiter’s Strategic Bond fund, run by Ariel Bezalel, Ignis’s Absolute Return Government Bond fund and Mr Cowley’s Old Mutual Global Strategic Bond fund are all popular with multi-managers keen to keep their bond holdings as flexible as possible with the ability to hedge out interest rate sensitivity and even buying equities in some cases.

With the outlook for fixed income as uncertain as ever, it is those flexible products which stand a better chance than most of outperforming and, crucially, limiting losses.

Nick Reeve is deputy news editor at Investment Adviser

US TAPERING
Timeline of events

The plan for the US Federal Reserve to reduce or ‘taper’ its quantitative easing programme has sent ripples through markets. Here we look at the key dates.

December 2013

In Ben Bernanke’s final meeting as chairman, the Fed lays out a detailed plan for reducing QE, beginning with a $10bn (£6.1bn) reduction from January, with the expectation that QE will have ended by the end of 2014.

September 2013

The Fed decides not to begin tapering in spite of much talk that improving US economic growth supported such a move. The Fed by this point had bought more than $1trn in assets through the programme.

May 2013

Speaking to the US Congress, Fed chairman Ben Bernanke (pictured) unexpectedly admits the US central bank may begin to reduce the pace of bond-buying in the next few months. A five-month equity rally at the beginning of the year is brought to a sudden halt as all asset classes sell off.

September 2012

The US Federal Reserve introduces its third and biggest round of quantitative easing since the financial crisis in 2007-08, deciding to pump $85bn a month into the economy through the purchase of government bonds and mortgage-backed assets.