Fixed IncomeMar 13 2014

Superman, Superbonds

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Outwardly a normal human being, the original super human has used his remarkable abilities to protect and serve the people against foes like Atomic Skull, Lex Luthor and General Zod.

Toiling against adversaries, and the dreaded Kryptonite, there have been moments when all has seemed lost only for him to fight back and topple his enemies.

Bonds have followed a similarly remarkable path. Although perceived as dull, their super powers have shielded savers from the volatility of stock markets, helped them accumulate wealth, guarded returns from the effects of deflation and even paid a handy, regular income (something not even Superman could do!).

But, just like Superman, bonds have faced challenges.

Those unlucky (or lucky) enough to be part of the bond market shocks in 1979 and 1994 will know just how quickly things can turn around. In 1979 the US$1bn bond underwritten for IBM was hailed as a corporate finance master stroke, yet it is now considered one of the biggest underwriting fiascos of all time.

The 1994 bond massacre is remembered for the sudden hike in interest rates, which led to a 200 basis points rise over nine months, and the bankruptcy of Orange County coupled with the ripple effects that were felt in Mexico. These events hammered investors at the time and wrong-footed the bond bulls when they were firmly in their stride.

The villain’s (heroes to some) were the US Federal Reserve (Fed) Central Bankers of the time, namely Paul Volker in 1979 and Alan Greenspan in 1994, although their powers fell short of General Zod and Bizarro.

Superman’s other perennial challenge is Kryptonite, the radiation of which significantly weakens the Man of Steel, neutralising his super powers. The Kryptonite for bonds are rising interest rates and inflation. Rising rates will lead to a fall in bond prices and potential capital losses for bondholders while inflation erodes the all-important yield of a bond.

So Superman and super bonds, what’s next? As we enter a rising interest rate cycle, and with many commentators signalling the end of the 30 year bull market in fixed income, could bonds be rendered surplus to requirements?

Well, despite both bonds and Superman experiencing bouts of weakness from their kryptonite nemeses, both have bounced back and enjoyed long periods of superior returns.

The creators of Superman, the late Jerry Siegel and Joe Shuster, developed a character that forms part of our popular culture 80 years on; equally impressive is fixed income’s track record of delivering returns with low levels of volatility in core asset classes. In fact the US aggregate index has delivered a negative return only three times in the past 38 years.

While we may be at a low point in the investment cycle, the reality is that we are still in a highly levered economy that is vulnerable if borrowing rates rise too quickly.

Deflationary effects, which are potentially threatening Europe and the wider global economy, are reminiscent of Eradicator, the villain set on turning Earth into a new Krypton. And unlike many of Superman’s short-term threats, Eradicator was a lingering one that needed to be addressed with a proven antidote.

As China continues to slow and commodity prices fall, coupled with weak external demand in Europe and rising unemployment, the long-term threat of deflation is very much on the horizon. Fixed income has proven itself to be investors’ first line of defence in a crisis and a source of diversification throughout the investment cycle.

While inflation remains low, and deflationary threats linger, maintaining a balanced portfolio that includes an allocation to fixed income remains key.

Rising interest rates are also not good for bonds, but we have been here before. The years of 1979, 1994 and 2013 were tough for bonds with many government markets delivering negative returns. There is a temptation for investors to look backwards and avoid the markets that disappointed them in the short term. However, we believe it’s a mistake to doubt the power of bonds; just as it’s been foolish to forecast the end of Superman even when there seems no way out for him.

Fortunately investors have greater choice and flexibility to choose what ending they prefer. Higher yielding fixed income segments, such as credit, emerging markets and high yield are but just a few options available to those looking to shield themselves against a rise in rates. After all, history has shown that bonds share the same resilience as Superman and can provide investors with superior returns over the long term.

Both Superman and bonds will endure for years to come.

The value of investments and the income from them can go down as well as up and your clients may get back less than the amount invested.

Joanna Gilbert is fixed income investment specialist at Aberdeen Asset Management.