The role of bonds in the portfolio of a client in decumulation

This has in effect reversed the typical asset allocation rule followed by many investors, with bonds owned for income and equities for capital growth.

Traditional asset allocation rules therefore place a client who is many years from retirement predominantly into equities, as a way to grow the size of the pot, and then move the client into bonds as they grow older and their risk appetite declines, and when retirement happens, the portfolio has a majority of the capital deployed into bonds to provide an income.

But in the decade since the financial crisis, bond yields have been driven constantly lower by a combination of central bank bond buying, and low rates of economic growth and inflation, making equities relatively unattractive.

The usurping of the recovery from the global financial crisis by the new uncertainties of the Covid 19 collapse has not changed the trend in bond markets, with yields plunging lower since March, and the interventions of global central banks have occurred at a pace far greater than happened even in 2008.

This has pushed government bond yields to new lows, with the UK 10-year gilt now offering an interest rate of 0.21 per cent, and the US 10-year Treasury bond has an income yield of 0.66 per cent. 

Both of those yields are considerably below the prevailing inflation rate, and so do not protect the client’s purchasing power in retirement. 

Alternative income products

Peter Doherty, head of fixed income at Sanlam says he favours having fewer government bonds and instead using alternative income products such as certain investment trusts, to generate the extra income.

He invests in these trusts as they are more liquid than buying the underlying investments directly. The investments are backed by assets.

Dean Cheeseman, multi-asset investor at Janus Henderson investors says: “In many ways the role of bonds in a decumulation portfolio has not changed, they are still there to act as a diversifier.

"The market in March showed that bonds still act as a diversifier, which is one of the reasons they are in a portfolio.

"But an argument can also be made that bonds are the most expensive they have ever been in history, and that is causing us to move into alternative income assets. The other thing we are doing is moving out of passive investment strategies and into active, as the performance of different types of bonds will diverge sharply, so now is not the time to be in passive funds. 

He adds that right now he prefers not to own strategic bond funds in the current climate.

Strategic bond funds can invest in any type of bond. Mr Cheeseman says right now he prefers to invest in bond funds that are focused on a particular part of the market, as this means he knows what they are invested in.

He says with liquidity at a premium he is reluctant to choose a strategic bond fund that may be invested in niche products that are difficult to sell. 

Stuart Edwards, a bond fund manager at Invesco says the current crisis will lead to sharp divergence in the bond market between those companies which can pay and those which cannot, and with many idiosyncratic bonds likely to perform well relative to better known products. 

Paying the coupon

David Roberts, head of the global fixed income team at Liontrust says that away from government bonds, the outlook for income from bonds has improved in recent weeks, because the prices have fallen.

He says: “For those moving into the decumulation stage, there is good news.

"The vast majority of bonds will continue to pay their coupon, generating income for investors without the need to sacrifice capital.

"Although most companies can choose whether to pay dividends or not, almost all are legally required to pay coupons on their bonds – strictly speaking, if they don’t, they are in default and bond investors can often end up owning the company at the expense of shareholders.

The vast majority of bonds will continue to pay their coupon, generating income for investors without the need to sacrifice capital David Robert, Liontrust

"That level of bond income is also materially greater than it was a few weeks ago. If you are selling equities into bonds either to de-risk or generate income (as companies slash dividends), you might not raise as much money today as three months ago but each pound you put into corporate or high yield bonds can 'buy' more income than it did in January.”

Alex Pelteshki, bond fund manager at Kames says at present he regards the prices of Investment Grade corporate bonds are fair for the income received, while he regards high yield bonds as cheap in the current climate. 

Stephen Snowden, bond fund manager at Artemis, says that with government bond yields low, and the dividends paid by equities being cut, the importance of the income generated from corporate bonds is likely to rise in the years to come.

He says: “They are of growing significance to investors with an income requirement. Base rates have fallen from 0.75 per cent  at the start of the year to 0.1 per cent  today.

"Some estimates have dividend payments in Europe being cut in half in 2020 before recovering next year. The inflation backdrop is low and going lower.

"The pandemic will probably accelerate deflationary trends that were already in play, such as the greater use of technology.

"Corporate bond and high yield bond funds have higher yields now, post the blow-out in credit spreads. Bond funds have more relevance today than they have done for many years.”

Deflation is generally positive for the investment case for bonds, as if the price of goods and services is falling, then the fixed income paid by a bond is worth more. 

Matthew Yeats, senior investment manager at Seven IM says with the income from bonds being so low, his approach is now to aim for a positive total return from bonds and generate the income a client needs from selling those bonds for a profit if necessary.  

He says investors should be “agnostic” about whether the income they receive in retirement comes from capital or income.