During the past 20 years, the yield on a basket of gilts has dropped from 6% to 1.5%, while interest rate sensitivity in the form of modified duration has doubled from 6% to 12%. “That’s a doubling of rate risk for less than a third of the expected return,” says AJ Bell chief investment officer Kevin Doran.
“Add in that the expected return sits below the expected rate of inflation and it’s hard to see the investment case. So why does the industry corral cautious and conservative clients into investment propositions where the backbone of the product is these very same investments? It’s arguably the next mis-selling crisis.”
The US Federal Reserve ‘dot plot’, issued in June, forecast a total of four rate rises from the central bank in 2018, while a day later the European Central Bank revealed it could start hiking from summer 2019.
An insidious scandal
Mis-selling covers investors who received unsuitable advice, were not properly informed of a product’s risks or ended up with a product that wasn’t right for them, according to the Money Advice Service.
Seneca Investment Managers chief investment officer Peter Elston asks whether advisers who sell investors bond-heavy portfolios will point to the fact they are low volatility, while sidelining duration risk. “The real risk relates to permanent loss of capital,” Elston says.
“They’re going to lose you 1% of your capital over a year, it’s just that it will happen gradually. I’d say that makes them high risk. “Maybe this makes it an insidious mis-selling scandal, because it’s a mis-selling scandal that isn’t a mis-selling scandal.”
Portfolio Adviser spoke to the chief executive of a boutique asset manager who says it is possible a bond mis-selling scandal may happen but it could be up to 15 years away. He raises concerns about advisers that use model portfolios and says if a mis-selling scandal comes to pass it could result in a bunfight between ratings agencies, the regulator and advisers. He believes the latter would ultimately shoulder the blame.
Duration confusion
Duration is a relatively complex subject for financial planners without investment expertise to grasp, according to GBI2 managing director Graham Bentley. “The majority of people who run model portfolios don’t run them because they love investment management but because they control clients’ capital and, as a result, can arrange to be paid,” Bentley says.
“You can bet your bottom dollar that if you ask the vast majority of advisers who are running model portfolios to explain how modified duration works they would stare straight through you.”
Bentley believes the significant inflows into the Sterling Strategic Bond sector in 2017 are a result of advisers outsourcing bond market concerns to a bond manager, who then makes their own decisions about how to respond to the difficult market. Fixed income was the best-selling asset class in 2017 with £7.5bn of the £14.3bn total entering the Sterling Strategic Bonds sector alone.
“It’s sort of a cop out,” says Bentley.
He questions if advisers are asking managers the right questions, such as how they will perform in a rising interest rate environment, rather than focusing on past performance.
Discus director Abbie Knight warns of a paint-by-numbers approach to risk profiling. “One of the biggest risks to advice firms right now is the mapping of risk-profiled outputs to risk-mapped portfolios,” she says.
“The regulator has made it clear that a mismatch might result in systematic mis-selling. That is, if investment personality is not correctly calibrated to investment portfolio risk the entire client base may not be suitably invested.”
Strong language
Orbis UK director Dan Brocklebank believes bonds are substantially overpriced and that duration risk will creep up on many in the financial advice industry, but is reluctant to state bond yields are destined to go down in the near to medium term.
“That’s strong language,” says Brocklebank when questioned whether bond-heavy portfolios represent a mis-selling risk.
“I know 10 years ago I would have said Japanese government bonds are crazy low at less than 1% and they’re still there now. Markets are such that they can persist in crazy situations for very long periods of time.”
Client dissatisfaction over bond portfolios could be five years down the track, according to Bentley.
He says: “There will come a point where people will look back and think bonds have been rubbish. Then they start saying, ‘If you’d been in this type of fund instead of that then you wouldn’t have had a problem’.”
But it will be astonishingly difficult to demonstrate mis-selling, because underperformance will be viewed as an investment decision, he adds.
