Fixed Income  

Bonds are under the spotlight again

This article is part of
Bonds vs Equities - May 2014

With concerns about rising interest rates and the great rotation into equities, many investors are questioning whether bonds can deliver the stable, solid returns we have become used to.

This may explain why corporate bonds were the poorest selling UK retail sector in Q4 2013, according to figures from the IMA. The pressure is certainly on bond managers to reduce volatility and squeeze extra margin. So what techniques can be brought to bear on this challenge?

Many investors think of bond portfolios as either investment grade or high yield. But blending the two can deliver powerful benefits. In very positive markets, high yield gives an extra kicker to returns, but investment grade comes into its own in risk-off periods.

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This, coupled with the fact that high yield and investment grade are not perfectly correlated, means that combining the two may significantly reduce the volatility of a portfolio. However, other factors also come into play that are worth exploring.

A popular way of managing risk – particularly the risk of future interest rate rises – is to reduce duration, but this does have the effect of reducing yields too.

A shrewd fixed interest manager can find ways to recover yield surrendered by a focus on shorter duration, exploiting the ‘roll down’ effect.

Most of us are aware of the depreciation of a new car. It starts the minute you drive off the forecourt and is at its sharpest in the first year, but then the depreciation slows down.

Bond yields usually experience a similar effect. So a short duration European bond with a yield of just more than 2 per cent will typically generate more than the stated yield the first year, less the second year and barely anything by year three.

This is the roll down effect and its scale is dependent on the shape of the yield curve. The steeper the curve (and it is unusually steep in Europe at the moment) the sharper the depreciation of yield in the early period.

In our experience, there is still appetite from money market funds for bonds approaching their fixed maturity date. Their yield may be low but so is their volatility, which means it is possible to sell them and start the process again, enjoying the enhanced returns at the point when the yield curve is at its sharpest, and disposing of them as it flattens out.

The European Central Bank (ECB) keeps reiterating that interest rates are to remain low, which has had the effect of holding down short-term yields to historically low levels, and has also had the above mentioned steepening effect of the yield curve.

At the short end of the bund, which is the benchmark for euro-traded corporate bonds, the historic average yield is 4 per cent (and 6 per cent at the long end). As of March 25, the short end was just 10 basis points (bps) to 30bps.

It is unlikely this is going to change for some time. People have become accustomed to (and therefore dependent on) low mortgage rates and the recovery is still not secure. The ECB will be very tentative in moving us out of this environment.