As AXA Investment Manager’s Chris Iggo beautifully misquoted David Walliams recently: ‘Computer says hike.’
Indeed, there is an argument that the Fed will cause the next recession by persisting with higher rates and, in the ensuing equity sell off that would surely follow, there would be a flight to safety, which is still bonds in most peoples eyes.
We may not have seen the end of the 30-year-plus bond bull market just yet, but a mindless rotation from equities to bonds could be a risky trade – especially if liquidity risk is as high as the Bank of England suggested recently.
It’s exactly five years since Mario Draghi gave his ‘whatever it takes’ speech and since then, his every word has been analysed intently. So when he announced “deflationary forces have been replaced by reflationary ones” earlier this month, markets took note. The euro rose, European government bond yields spiked and equities took a tumble.
The movement in European government bonds has been perhaps surprising given nothing has actually changed yet. For example, 10-year bund yields doubled from 24 basis points to 56bps, which is a huge percentage increase and, as the guys at TwentyFour Asset Management pointed out, in price terms it’s a 3% move on a supposedly risk-free asset.
And there has been little resistance to the move. Credit spreads on US and European high yield credit default swaps are wider too, as are emerging market credit spreads. The market is indeed spooked.
Bond investors need to consider carefully what may happen with monetary policy over the next few years and the impact this will have on bond returns. Markets seem to be already pricing in some unwinding of QE, but there could well be further sell-offs.
This poses quite a dilemma when it comes to bond allocations. In this column back in November I talked about short duration bond funds like AXA Sterling Credit Short Duration being one possible solution and high yield bonds, like Baillie Gifford High Yield Bond and Aviva Investors High Yield Bond, being another.
A third solution, if you want bond exposure, is simply to buy well-researched credit and be prepared to hold it through the inevitable dark days.
GAM Star Credit Opportunities is a ‘safety first’ fund with very low turnover, as the managers’ process looks for bonds they can buy and hold for 10 years. Very little of what they own yields less than 6% at the initial purchase point and this gives them far less interest rate sensitivity than many of their peers, which is particularly valuable in the current environment.
Invesco Perpetual Corporate Bond is another I like. It has been positioned cautiously over the past few years, which has hurt relative performance as interest rates have continued to fall until recently. Their ‘early’ call could well pay off now though.
TwentyFour Dynamic Bond has a very flexible approach and its yield is usually one of the highest in the sector. It is managed with an emphasis on credit risk to ensure protection of investors’ capital and income wherever possible, and it has a consistent weighting to asset-backed securities, an area in which they specialise.