“If they focus too much on yield, they risk being over-exposed to riskier fixed-interest investments, and lower-quality high-yield bonds.
“While this would produce a higher yield, it also is likely to give greater levels of volatility and potentially significant, shorter-term capital losses.”
This is especially so in the UK, where inflation at 2.7 per cent now outstrips the yield on a 2-year and 5-year government bond (gilt), at 1.75 per cent and 0.5 per cent respectively, according to Bloomberg Data.
Data from the FT shows how the UK gilt yield has dropped off a cliff in recent months.
Gilt yield since 2014 on 10-year UK government bond (source: FT.com)
But while a good yield is hard to find in the more traditional markets, fixed income managers have been able to find some great opportunities by looking further afield and considering reducing duration to mitigate volatility and higher interest rates.
Chris Iggo, chief investment officer of AXA Investment Managers, says: “Investors could benefit from looking further afield for income.
“As well as high yield and financial corporates, today we see opportunities in emerging market debt, for its diversification benefits, improving macroeconomic picture, and the fact that emerging market yields and spreads appear attractive relative to developed markets.”
He adds: “If portfolio volatility is an important consideration, a short-duration approach could be particularly appealing to mitigate the impact of rising interest rates.”
Moving up the risk curve
Eugene Philalithis, portfolio manager of the Fidelity Multi-Asset Income Fund, comments: “Our favoured areas so far this year are local currency emerging market debt (EMD), US and European loans and [contingent convertibles] CoCos, which tend to be issued by European banks.
“Local currency EMD, for example, is a reasonably defensive way to play the ongoing strength in emerging market economies, with many currencies also relatively cheap compared to the past five years.”
Nicholas Wall, manager of the Old Mutual Global Strategic Bond Fund, likes looking further afield, particularly because many ‘hunt for yield trades are overcrowded and mature’, and volatility hasn’t been tested for a long time – so investors need to make sure they can ‘tolerate liquidation periods’ and are not forced into selling into these overcrowded and mature markets.
His fund likes “idiosyncratic opportunities where the narrative is compelling and the securities are under owned, so you are not caught in a squeeze for the exit.”
Mr Wall particularly likes Portugal and Argentina, and subordinated financials in Europe, but is avoiding investment grade bonds.
He adds: “If these sovereigns are too risky for your portfolio, then take advantage of the low implied volatility to hedge more conventional plays through options.”
Regarding his previous comment, Argentina has defaulted eight times since 1824, when it issued its first bond.