AXA IMMar 15 2017

Bonds keep appeal to minimise risk

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Bonds keep appeal to minimise risk

Markets across the globe are poised for hikes in interest rates and thus a downward pressure on principal values on fixed-income investments – but we have been here before.

Numerous industry analysts forecast a hike in interest rates at the beginning of last year. Of course Brexit and the ensuing uncertainty over the UK’s economic performance scuppered the potential hike in base rates.

On the other side of the Atlantic, sluggish economic growth and productivity were among the more pertinent reasons behind the delay in interest rate rises last year.

But times have changed. Newly elected President Donald Trump’s rhetoric of looser fiscal policies via tax cuts and bumper spending on infrastructure is predicted to lead to the tightening of monetary policy.

Markets have in turn factored in the potential of numerous interest rate rises, according to economists. It also means bond yields are likely to go up.

However, exclusive research carried out by Financial Adviser suggests that the turbulent outlook for bonds has not dissuaded intermediaries from recommending the traditional hedger of equity risk to their clients.

More than 51 per cent of the 176 advisers with investment provisions surveyed said they are very likely to recommend a bond fund over the next 12 months. Nearly 36 per cent answered “potentially” compared to just over 13 per cent who said they were not at all likely to do so.

Dennis Hall, chartered financial adviser at Yellowtail Financial Planning, said he favours short-duration bonds at present because they are less likely to be affected by increases to interest rates than longer term ones. This is because investors recover their initial investment more quickly.

“Some of these longer term bonds and high-yield bonds carry greater risk than some equity investments, but people generally seek to invest in bonds to reduce the risk level in their overall portfolio,” he said.

For a less sophisticated client, the majority of the sample (nearly 59 per cent) said they would prefer to invest in fixed income as part of a multi-asset portfolio, while only 28 per cent said the opposite.

Mr Hall said access to fixed-income assets through a multi-asset portfolio could also work for more sophisticated clients, adding: “Sophisticated is not synonymous with complicated. The suitability of this is wholly dependent on the client’s investment aims. If the individual wishes to simplify their portfolio, accessing bonds through multi-asset funds could be a good solution.”

An unnamed respondent said: “Some types of bond funds still have their place, but given markets’ apparent likely direction and the fact that most clients invested heavily in them are 'low risk’ it seems imprudent to have significant exposures to areas such as gilts, treasuries and investment-grade corporate bonds, other than in very short duration cases.”

Strategic bond funds are often touted as a good investment solution for clients amid periods of mounting uncertainty in bond markets.

This is because these products use wider investment mandates – including below-investment grade high-yield corporate bonds, and even derivatives – to achieve investment objectives, regardless of broader market conditions.

According to FE Analytics, the IA Sterling Strategic Bond sector returned almost 30 per cent over a five-year period to 3 March.

The largest group of survey respondents (nearly 37 per cent) said strategic bonds were an important part of their clients’ portfolio and they intend to make more use of them this year, while only 17 per cent said otherwise.

However, more than a quarter (over 26 per cent) neither agreed nor disagreed with the sentiment.

Jason Hollands, managing director of London-based Bestinvest, said: “Strategic bond funds have increased in popularity over the past decade. They can be good solutions providing that the fund managers of such strategies get their calls right.

“Rather than an adviser making the call on whether their clients should have exposure to investment-grade bonds and government bonds for example, strategic bond funds enable advisers to completely offload this responsibility to the fund manager.”

He added: “One thing advisers should keep in mind is some of these strategies operate solely on a total return basis, which may be fine for some clients, but not those who invest in bonds for an income.

Almost 65 per cent of survey respondents said bond funds attribute to between zero and 25 per cent on their clients’ income, on average, while a third cited between 26 per cent and 50 per cent. Only four survey participants said bonds attributed to between 51 per cent and 75 per cent.

What is more, nearly 70 per cent of advisers sampled cited the need to diversify from equity in general portfolio construction as one of the reasons behind their investment recommendations into a bond fund.

However, the usual inverse relationships between bonds and stocks have reversed and are trading in greater synchronicity at present, according to Mr Hollands.

Programmes of quantitative easing in tandem with the persistence of a low interest rate environment have distorted bond and equity prices, resulting in greater correlation between the two assets, he said.

He added: “People typically invest in bonds for one of two reasons. Investors have historically flocked to bonds for income purposes, but bonds are not yielding as much as they have done so in the past. Secondly, bonds have historically been a solution for risk-averse investors.

“Investment in the Alternative Investment Market is not an adequate replacement for bonds because investments in the market tends to be highly illiquid and of significant risk. Whereas absolute return investments meet the income and the risk requirements.”

Absolute returns funds use strategies generally associated with hedge funds to meet investment objectives.

Such products have proved popular if Investment Association figures – to the end last year – are anything to go by. The IA Targeted Absolute Return sector was the best retail seller of 2016, pulling in £5.1bn. Fixed income was the second best selling with net retail sales of £3.8bn, after an outflow of £2.1bn in 2015.

However, the Targeted Absolute Return sector has generated somewhat unimpressive lowly returns in recent history. It returned 3.4 per cent over a year to 3 March this year.

Paul Gibson, managing director at Aberdeenshire-based Granite Financial Planning, said: “I have never recommended an absolute return strategy. I have always found them too complex and difficult to explain to my clients. I am not convinced that funds can deliver targeted returns regardless of the investment environment and the returned generated by some of these funds has reinforced my belief.”

The track record of a fund manager and the appetite for a cautious investment in volatile times were the second and third most popular reasons for investment recommendation into bond funds – attracting nearly 45 per cent and 42 per cent of the vote respectively.

Interestingly, about 38 per cent of respondents highlighted inflation as a contributing factor – despite its impact on interest rates and, not least, real or inflation-adjusted returns.

The future direction of interest rates and inflation was deemed by respondents as the second most important factor for deciding a client's allocation to bond funds – ahead of the age of the client (nearly 12 per cent) and changes in central bank policies (more than 3 per cent).

Darius McDermott, managing director of London-based Chelsea Financial Services, said: “If inflation continues to creep up, it might lead to more than two rate rises or a substantial increase of 0.5 per cent when rate rises occur. At this point fixed income assets would be heavily sold off.

“If you holding a higher yielding asset, you should be recompense for taking on that risk. We are underweight in fixed income because of inflation and interest rate risk, but where we have exposure to fixed income, they have a decent yield attached to it to make it worth our while.”

The most important factor when it comes to clients’ allocations to bond funds, according to nearly 43 per cent of the sample, is other assets.

Mr Gibson said: “Investment recommendations should be driven by clients’ financial plans. We would look at the return a client requires and have a look at the different asset classes for a number of invests with the potential to generate the target return and adheres to the client’s attitude to risk.”

Myron Jobson is a features writer of Financial Adviser

 

Key points

  • Global markets have factored in the potential of numerous interest rate rises.
  • Turbulent outlook for bonds has not dissuaded intermediaries from recommending them to clients.
  • Strategic bond funds and Absolute Return strategies are touted as a good investment replacement for conventional bonds.