A chief investment officer has warned of the impeding crisis caused by advisers populating portfolios with junk bonds, as the UK’s fixed income market is threatened by inflation.
Bonds are valued high at the moment, while yields have plummeted to all-time lows, meaning investors who are desperate for some kind of income have been piling cash into riskier parts of the fixed income market.
Christopher Peel, chief investment officer at Tavistock Investments, said: “It is very clear to me that advisers don’t fully understand the risks they are running by populating portfolios with low-grade long-duration bonds.”
He said the record-low interest rates are unsustainable given the level of expected inflation, which many industry professionals have claimed could jump to as high as 5 per cent over the next 12 months.
The investment veteran, who has spent 30 years in the industry, said he is seeing advisers build portfolios of junk bonds, which they are calling Strategic Bond funds.
“Strategic Bond funds tend to be pretty misleading in terms of what is under the bonnet, and tend to be made up of low-grade corporate bonds.”
He said asset allocation models force advisers to have a certain amount invested in bonds, but these models “grossly underestimate” the amount of risk in the asset class.
“Advisers are trying to generate an income of 4 to 5 per cent for their clients, which is unrealistic unless you go down the credit curve quite markedly, which is what is happening.
“The clients that can least afford to lose money in the quest for 4 per cent income have been funneled into very low-quality low-grade investment portfolios,” he said.
“As we go into a higher interest rate environment, those companies which have issued debt will be looking to refinance those bonds and might not be able to, which means the default rate will go up.”
Mr Peel, who has worked for Citibank in London, Salomon Brothers International, and Cardinal Asset Management, said the fixed income market is “in trouble” as inflation rises and the bubble begins to pop.
Simon Torry, chartered financial planner at SRC Wealth Management, said Mr Peel’s comments highlight the risks unwary advisers could be taking with their clients' investments.
He said his firm outsources the investment process.
Mr Torry said: “We do of course 'look under the bonnet' of the products we recommend as we consider it our responsibility to understand how returns are achieved. As always, 'due diligence' is essential.”
Ben Willis, head of research at Whitechurch Financial Consultants, admitted that the hunt for yield may have caused advisers to seek out higher yields in higher risk areas for their clients’ income needs, but added he has seen no evidence of advisers wholesale allocating to junk bonds within client portfolios.
“In most cases, Mr Willis said advisers are spreading the risk across the fixed interest spectrum, with strategic bond managers continuing to attract inflows.
He said: “By their nature strategic bonds tend to have a ‘go anywhere’ remit and you are trusting in the manager’s expertise in identifying opportunities within global bond markets.”
Mr Willis said there have been talks about the bond bubble bursting for a few years now.
“Indeed, we could be on the cusp of a change, as we have seen some inflation numbers picking up and we have seen widening of yields on government bonds.
“However, we are still in a low growth, low-interest rate, low-inflation world, so unless we see a shock spike in inflation and aggressive interest rate hikes over the next 12 to 24 months, then I still feel bond markets will remain supported by investors.”
Ben Yearsley, investment director at the Wealth Club, said some advisers might have to populate with junk bonds to meet the yield criteria, adding however, that allocating to bonds leaves a broad spread of different options.
“Strategic Bond funds are the obvious sector that could benefit, as these funds typically have the ability to vary duration dramatically and even go short.
“If we are in a rising rate environment, then this is where I would be allocating,” Mr Yearsley said, pointing to funds such as Jupiter’s Strategic Bond fund and the Artemis Strategic Bond fund.
katherine.denham@ft.com
