The asset class as a whole remained broadly out of favour among UK investors last year, as Investment Association (IA) figures prove. Fixed income saw a record net retail outflow of £519m during 2015, compared with a net retail inflow of £1.5bn in 2014, but so far in 2016 things have changed, with fixed income funds being some of the most popular with investors.
According to the most recent data from the IA, April saw fixed income as the best-selling asset class in the month, with net retail sales reaching £679m. Both the Sterling Corporate Bond and Sterling Strategic Bond sectors were the fourth and fifth best-selling sectors with £205m and £191m in net retail sales, respectively. Strategic Bonds in particular saw a great leap in just one month, from £35m in March – a 445 per cent increase.
The volatile start to markets this year could be a reason behind people flocking to bond funds that are generally more stable than their equity counterparts.
Table 1 shows the top 20 performing fixed income funds over the past five years. It compares all funds from the UK Gilts, UK Index-Linked Gilts, Sterling Corporate Bond, Sterling Strategic Bond, Sterling High Yield, Global Bonds and Global Emerging Markets Bonds sectors using FE data.
Performance across the sectors has been broad and not one specific space stands out as being an outperformer. The best performing fund is the Ireland-domiciled €64.7m (£49.6m) Pimco GIS Euro Ultra Long Duration fund, managed by Lorenzo Pagani, which saw a £1,950 return over five years based on an initial £1,000 investment – 14.3 per cent annually. The fund sits in the Global Bonds sector, and has the majority of its holdings (79.4 per cent) in European vehicles while 29 per cent are AAA-rated bonds. The fund’s objective states that it invests in high-quality, very high-duration global fixed income instruments which are benchmarked against 25-, 30- and 35-year swap indices with an average 27- to 33-year duration.
This year brings many uncertainties, which started back in December last year, when the US Federal Reserve raised its rates by 25 basis points to between 0.25 per cent and 0.5 per cent – the first move since June 2006 – which brought an end to the zero interest rate. Now the focus lies on how fast, rather than when, the Fed will raise rates again.
The UK’s referendum on EU membership has also been one of the biggest headwinds of the year so far. And with both the European Central Bank (ECB) and Japan continuing their quantitative easing programmes, there are still many issues that lie ahead. But with this in mind, has the fixed income space had to change at all, and are different asset classes within the space becoming more correlated?
“The element of downside risk management in fixed income has been on display in recent years, leading to a fairly decent annualised return. In addition, average correlations to equity markets have been low,” Arif Husain, head of international fixed income at T. Rowe Price says.
He adds that fixed income has “done its job”, but questions whether this will remain the case. “Coupon levels have fallen considerably, while lower bond yields could have an impact on downside risk management.
“Diversification is still there, but this has not always been the case. August 2015 was a good example, when fears over China gripped global markets. At a time when equity markets were hammered, bond yields also spiked. The real pain point in markets is when fixed income stops behaving the way it should.”
Correlated assets
Many analysts have said fixed income securities are becoming more closely correlated with each other, but is this really the case?
Gareth Isaac, senior fixed income fund manager at Schroders, says, “I think correlation across asset classes has gradually been increasing since the financial crisis. It’s a function of a number of factors, and one of the major factors is liquidity within the system. What we are seeing is risk assets as a whole – equities, high yields, investment grade bonds or emerging markets – in periods of risk-on, and even the spreads of those tend to widen out because there is a lack of liquidity in the market.”
“With gilts it is slightly different. Apart from the ‘taper tantrum’ back in August 2013, you still have a good offset in buying duration for a risk-off event. But I think with the level of yields where they are, you don’t get the full protection that you would have done pre-crisis.”
However, Jon Cunliffe, chief investment officer at Charles Stanley does not entirely agree that bonds are becoming more correlated. “I think it’s perfectly possible to imagine a world where high yield bonds do quite well whereas sovereign bonds – particularly short- to medium-dated maturities – don’t do so well.
“That might be in an environment where growth is reasonably solid and policy normalisation takes place via higher short rates. It’s perfectly possible to imagine high yield performing like a pro-risk asset.”
“I think there are different uses for fixed income in the context of a balanced portfolio that has exposure to a number of asset classes,” he says.
Attractive investments
According to Mr Isaac, US dollar-denominated emerging market bonds look attractive. He says this is because “Countries like Brazil, Mexico and Argentina are looking interesting”.
“Brazil looks particularly attractive because there is a temporary new leader. While the economy is in a poor state, it is showing signs that it has bottomed out and it is going to improve. But we are not investors at the moment.”
For Mr Husain, one of the themes he incorporates through his processes is behavioural finance. “What this tells us is forecasting has been proven to underestimate volatility. Every forecaster underestimates volatility, over both the short- and the long-term. Sterling at parity to the dollar would be a 2.8x standard deviation event. This is not a crazy scenario,” he adds.
While Mr Husain believes fixed income has done well in meeting its traditional objectives, given the current environment of low rates and divergent policy, he says it will be difficult for fixed income to continue to service its purpose in a traditional way.
“Investors are at a crossroads. If they turn left, it means using fixed income as a return and income-seeking asset class. By turning right, investors are accepting fixed income’s role as an anchor: a diversifier. If you turn right, you cannot be heavily invested in areas such as high yield or emerging market debt.”
Elsewhere, Mr Cunliffe says, “we like the idea of having long-dated sovereign bonds and short-dated corporate bonds. It works well because if central banks are not really in a position to deliver, then if it turns out to be much less favourable, they can do quite well.”
However, he tends to prefer investment-grade corporate bonds of a shorter-dated maturity. “We also like global high yield, but we are mindful of the fact that high yield has has a high energy sector component, but within a global portfolio allocation it is somewhat less.”
“We like long-dated UK gilts. They are particularly attractive from a historical basis given how long-term rates are. But against the backdrop of moderate growth, low inflation – and there is no obvious likelihood of central bank rate hikes for some time to come – we think they work well.”
The year ahead
One of the challenges around retail funds, is that market liquidity can “evaporate”, Mr Isaac says, which makes it very difficult to trade, buy or sell. “What happens is the price of the assets is marked down because of liquidity in the markets, bid-offer spreads are widened and the prices of those fall. So investors see a fall in the value. When liquidity is back, they bounce back to where they were.
Investors have to get used to more volatility; the function of the market has been compromised to a certain extent because of the lack of investment banks taking the other side of the market and a general lack of liquidity in assets.
“The low volatility nature of fixed income is something we are not likely to see until we start seeing more normalised monetary policies and the return of risk-taking from investment banks,” he adds.
Meanwhile, the end of June brought the UK’s EU referendum, followed by Spain’s general election, both of which have affected markets so far this year. But worries do not stop there. The US presidential election in November will have a huge impact, and France and the Netherlands have general elections the year after. Many have observed a move away from the centre in politics, and more toward extreme political ideas. If that is the case the consequence will be greater uncertainty in global markets, which will have an effect on economic growth and investments.
The key point for fixed income in the future will be to be flexible. Markets are more extreme than before the 2008 crash, and mistakes in diversification can be expensive.
