Government bonds: stick or twist?

A bruising 2018 has left many investors seeking a silver lining, so here's a small one for DFMs: difficult markets mean wealth managers can, at last, more accurately assess the worth of their defensive holdings. And from absolute return portfolios to gold, not all assets have performed well enough at moments of volatility to warrant a place in portfolios.

The reason that many of these positions need to be tested is because the classic defensive tool - government bonds - have long since fallen from favour in light of the threat of rising rates.

Last year saw that narrative start to play out, but the asset class again avoided the worst case scenarios predicted for it. And by the end of December, yields on developed market debt had come full circle to sit roughly where they did 12 months before. 

That underlines the challenge facing wealth managers. Our chart below shows many do retain exposure to government bond funds within their Balanced model portfolios, but at lower levels than has been the case historically.

The data shows weightings to dedicated government bond funds - both domestic and international - across a sample of 25 wealth firms. 

Based on data from our MPS tracker, which monitors DFM asset allocations and fund holdings, the chart excludes both index-linked debt and EMD, as well as underlying strategic bond funds which have exposures of their own.

While some such as Morningstar still have a decent weighting to sovereign bonds, they tend to be the exception nowadays. Most weightings sit at around the 5 per cent mark.

But the question of whether government bonds should still be used for defensive exposure doesn't always have a simple yes/no answer - even for those with smaller positions.

LGT Vestra's Meena Lakshmanan notes that the firm, which has 5 per cent in conventional gilts, is among those which "actively trades" in and out of the asset class, shifting duration and yield curve exposure as well as moving between conventional debt and index-linked bonds when necessary. 

Another firm with an even lower exposure in its models - Premier Asset Management - did make a tactical call to buy treasuries for its unitised portfolios at the start of last year, then closed this position in December as yields dropped.

But the firm's Simon Evan-Cook will speak for many with his view of gilts in particular. For long-term investors, protecting against short-term shocks via the use of an overvalued asset remains an uncomfortable position:

In a nutshell, they look like a poor long-term investment, so we’re avoiding them, even if that means missing out on any safe-haven rallies that may happen in the near term.

The journey, not the destination

Those who completely zoned out over the past two weeks might be forgiven for thinking nothing has happened in markets: Friday’s rally means the S&P 500 is an unremarkable 1 per cent higher than it was on the morning of 20 December when we last published this newsletter.

But it’s the journey rather than the destination that matters. The big drawdowns and big rallies seen since that date have just about balanced one another out, but their very existence shows that investors remain on edge.

And there have been plenty of contradictory signals for wealth managers looking for clues to the year ahead. The confusion continued into last week via another flash crash which pushed the yen markedly higher. Most outlandish of all were the futures markets that briefly suggested the Fed was more likely to cut rates than raise them in 2019.

That prediction was quickly reversed on Friday when news broke of blow-out US jobs figures. But risk assets remained largely unmoved until Jerome Powell adopted a more accommodative tone later the same day. The overriding feeling looks like one of relief: the Fed is ready to pause its hiking cycle, yet the data doesn’t suggest the need to start cutting rates, either.

And there are signs that Friday’s rally may be a little different to other bounces seen in recent weeks. The most obvious of these is that credit markets also rallied notably: the CDX North America HY index had its best day in more than four years. 

A return to ‘goldilocks’ markets may be too much to hope for, but DFMs will be hoping that this kind of sentiment can take hold again in 2019. In the coming weeks we’ll be digging into our asset allocation database to show exactly how fund selectors are positioning themselves for the year ahead.

Make way for manager moves

The manager merry-go-round began early this year as JPM bond head Nick Gartside left for pastures new last week. His departure won’t be of great concern to most fund selectors - his firm isn’t the go-to place for bond fund picks, and JPM’s other fixed income managers tend to attract more attention in any case. But either way, it's a good time to give thought to what the year ahead may hold for manager moves.

Fund buyers concerned about key person risk have historically had to keep a close eye on the start of Q2: the end of bonus season is often the most logical time for managers to move on. This year could be different, because for the first time in a while neither asset growth nor market movements have been of much use to fund firms over the past 12 months. 

That means several things: businesses looking to cut headcount, lower bonuses, and no incentive to hang around for longer than necessary if an offer is on the table. 

So could we be about to see a surge in manager moves? A couple of points suggest otherwise, chief among them the difficulty of setting up on one’s own, or in taking in assets for a new proposition at an established firm.

But that’s not to say it couldn’t happen. A handful of boutiques still have the power to attract both managers and assets - and 2019 could prove a field day for those seeking to strengthen their offering at a time when many are hunkering down.