Fund selector: Flexible bond holdings a must in 2014

It is no wonder investors are obsessed with the US Federal Reserve’s quantitative easing (QE) tapering timetable which has now begun, albeit tentatively.

After all, since 2008, large swathes of liquidity have been used to prop up markets and reinvigorate flailing western economies. And while the European Central Bank and Bank of Japan may keep the taps going – or at least start in the case of Europe – investors still look to the US in order to receive their cues.

In terms of market performance, 2013 was a stellar year for equities – particularly in the developed markets. In fact, emerging market investors have had to draw upon the thick skin they have developed over the years of endured volatility and watch in envy as their more conservative developed-market-orientated peers raked in the returns.

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For instance, the FTSE 100 index returned more than 18 per cent and the S&P 500 index was up roughly 30 per cent compared with slightly negative returns for the MSCI Emerging Markets index.

And so with the spectre of continued Fed tapering looming large this year, investors are understandably concerned about where the best returns will come from.

On a relative basis, and in spite of the strong gains already seen this year, we still favour equities over bonds. However, any rotation away from bonds into equities is likely to be gradual as fixed income remains a critical part of investment portfolios.

Demographics, diversification and the fact that risk-modelling tools will continue to recommend large fixed income allocations all mean that fixed income will still be an integral part of investor portfolios. After all, as yields rise there will be a number of willing income-hungry and liability-conscious investors looking to take advantage of the higher yields, which move inversely to prices – i.e. there will be buyers and not just a gulf of sellers.

That said, with interest rate risk posing the greatest threat to bond investors, we favour corporate over government bonds as historically low default rates mean that credit risk is significantly diminished.

By increasing credit risk, interest rate risk can be reduced by shortening the overall maturity profile of the bonds in your portfolio. The extra yield spread above the government bond yield provides a form of cushion in a rising interest rate/yield environment.

This is important because the Fed’s tapering of quantitative easing will drive up yields as they stop buying and investors recalibrate their expectations regarding economic growth, inflation and central bank policy. We therefore believe that reducing the maturity of the bonds in a portfolio is a critical component of preserving client capital in bond funds.

So with this in mind, a more flexible approach to fixed income investing is required. Over a year ago now, we shifted towards more dynamic and flexible managers in order to best adapt to the changing fixed income landscape. It stood us well in 2013, and we expect it will again in 2014.