Hot money from cash and cash-like instruments will continue to flow into fixed income funds throughout the rest of the year and early next year, according to AJ Bell’s Ryan Hughes (pictured), despite the asset class already rapidly increasing in popularity.
The managing director tells Portfolio Adviser that, despite interest rates across the developed world already beginning to fall as inflation tempers, fixed income funds will remain popular among investors for their higher returns and attractive yields relative to cash.
According to the latest flow data from the Investment Association, fixed income funds attracted £1.8bn throughout the month of August, pulling overall sales of investment funds to £804m despite losses across equity, money markets, mixed asset and property.
“At the moment, our lowest-risk portfolio has a 15% allocation to cash and money-market instruments. Is this likely to be as high next year, or will this weighting come down and get partially moved into fixed interest? Given the yields on offer, I suspect it will be the latter,” Hughes says.
“This is a trend that we are already seeing now – albeit money market yields are still quite appealing in the short run – but I expect this to continue over the medium term, as this will start fading at the end of the year and early next year.
“I would absolutely expect money to flow out of money market funds and into the fixed interest market.”
See also: What does the gilt yield spike mean for UK bond prospects?
The question remains, according to the managing director, as to which types of fixed income propositions investors will favour. For instance, investors could move “one step up the ladder” and buy into short-dated corporate bonds, or they could “eke out a bit of extra return” by taking on more duration risk and moving into standard markets.
“I think it’ll probably be a bit of a mix of the two,” he reasons. “People will remember being burnt while holding bond funds only a couple of years ago, when they saw drawdowns of 15-20% in what is supposed to be a ‘safe’ asset class. So, I suspect people will be nervous about taking lots of duration risk at the moment, even if it might be the right thing to do.”
Portfolio rebalancing
Hughes has been positive on fixed income “all year”. In January 2024, when the firm was updating its portfolios with the team’s overarching views, it added “quite a bit” to the asset class on the expectation of interest rate cuts throughout the year. “We also thought the yields on cash were going to fall as well – which is two sides of the same coin,” he explains.
“So, we started moving out of cash and adding duration in January; we were doing this in a couple of places. We were adding to UK gilts and UK corporates. We thought that UK investment-grade corporates looked like the sweet spot to us – given the yield pick-up we were getting over cash and government bonds, as well as an incredibly low default rate.
“We were seeing an average 100 basis-point return over cash, maybe more at various points.”
See also: Three ways asset allocators are buying bond funds
This was during the first half of 2024, and Hughes admitted it “didn’t really work like that” given stickier-than-expected inflation data, and central banks “kicking rate cuts further down the road”.
“Bonds actually underperformed cash during the first half of the year. But in the second half, we saw inflation data start to fall backwards quite sharply, with some employment data from around the world coming in slightly weaker. Then, we saw rate cuts come through in the eurozone, the UK and the US, which has clearly fed through to bond yields.
“This position started to work quite nicely for us in the second half [of the year].”
UK corporates and US treasuries
Hughes has a preference for UK investment-grade corporates because yields are higher than in the likes of the US or Europe. AJ Bell also reaps the benefit of them being sterling-denominated as opposed to receiving sterling-hedged yields.
“Compared to the likes of European investment-grade bonds, we are getting about a 1% yield pick-up on that,” he explains. “However, in our international bond bucket – our non-hedged bucket – we overrode using global government bonds as a core asset class and instead bought US Treasuries.
“The reason is that the global government bond index has some US bonds and some UK bonds, but it also has a lot of European and Japanese government bonds.
“Across both of these regions, the yields have been artificially supressed by government and central bank action. At the start of the year, you could get a 1% yield pick-up by owning dollar bonds rather than global government bonds.”
The managing director says there is the “added attraction” of the US dollar serving as a “safe haven hedge, if things get ugly out there”.
“Now, sterling has strengthened against the dollar, but it really matters. We were getting paid a higher yield, while benefitting from having a hedge in the portfolio if things got difficult. For us, it looked like an attractive trade and it has worked out exactly like that
“US treasuries have outperformed global government bonds this year. I think this is a subtlety that quite a few people might have missed, that they benefit from the yield pickup and keep their edge without getting exposure to the likes of Japan and Europe.”
High-yield headwinds
One area of fixed income AJ Bell has been reducing its exposure to is high-yield fixed income. At the start of the year, the team had a 10-12% position in the asset class, but this has since been halved due to tight spreads.
See also: Square Mile: Are falling US interest rates the panacea for bond funds?
“We didn’t think we were being paid suitably for the risk we were taking,” Hughes says. “We have been wrong on that, because spreads have become even tighter. High yield has actually performed very well this year, largely on the back of strong equity markets, too. We had some exposure but not as much as we did have – that cost us a little bit.
“However, we’re very comfortable with the fact we took some of that risk out of the portfolios, because the risk-return trade-off did look weak at the end of August. On the day that the Japanese stockmarket suffered a big correction, high-yields spreads blew out by 1% in a day.
“This just shows what can happen when you’re trading at very, very tight spreads. As soon as any kind of shock or uncertainty rears its head, the risk of drawdown can be high.
“Therefore, we are perfectly happy parking that capital in investment-grade bonds – obviously while being paid a lower coupon, but having a much lower risk at the same time.”
