October’s Bank of America Merrill Lynch Global fund manager survey revealed that with a net 80% underweight position, allocations to bonds have slumped to an all-time low.
Based on inflation concerns and pessimism towards China, October’s survey shows that for the first time since April last year, global growth expectations turned negative, with a net 6% of managers predicting the global economy will weaken in the next 12 months.
Against this backdrop, allocations to cash and commodities surged, equity positions were unmoved but investors continued to head for the exit door in bonds. So is now the time to be giving up on bonds, or are there still opportunities within the asset class?
Inflation woes
Chris Metcalfe (pictured), investment and managing director at Iboss, says at the start of the fourth quarter last year, it expected most, if not all, fixed income to produce negative returns in 2021.
“We have systematically decreased duration across the asset class,” he says. “At the same time, we removed our explicit holdings in Treasuries and hold the smallest allocation to gilts since our inception in 2008.”
According to Metcalfe, Iboss’ fixed income stance is predicated on its belief that inflation is not transitory, and while nothing goes up in a straight line, he believes future inflation remains underpriced in bond markets.
“This doesn’t mean yields have to move up to more than, say, 3% plus on the 10-year gilt or Treasury, but it does mean there will be more upward pressure in the coming quarters,” he says.
Metcalfe adds the factor that makes him most uncomfortable about sovereign bonds more generally is that, unlike the period since the global financial crisis, he says central banks could find themselves “impotent” in their ability to hold down yields.
“Governments and central banks alike are at pains to point out they are happy with higher inflation, and while they need to be careful what they wish for, upward pressure on bond yields is likely to continue,” he says.
Where Metcalfe does see some opportunity within fixed income is with strategic bond funds. He says Iboss currently uses three active funds across its core range: Baillie Gifford Strategic, Rathbone Ethical and Twentyfour Corporate Bond.
“These are supplemented by passive shorter-dated UK bond funds and passive global funds,” he adds. “With interest rates still at near zero, it remains challenging in the short-term bond space for active managers after fees to outperform their passive peers, hence allocating to passive funds.”
Under pressure
Adrian Lowcock, independent wealth consultant, says fixed income has been under pressure in recent weeks owing to several factors that impact the outlook for bonds.
“The Evergrande default in China is weighing on the market but seems to be a slow default,” he says. “While the global market has largely taken the crisis in its stride, the risk of contagion is a concern.”
More importantly for fixed income investors in the west, says Lowcock, is the potential for higher inflation and the subsequent response by governments and central banks to keep it in check.
“The outlook for fixed income going forward depends more on the outlook for inflation and the global economy,” he says. “Inflation is much higher than government targets, as well as staying persistently higher than the same institutions.”
For Lowcock, the biggest risk to bonds is stagflation, namely low growth and high inflation. He notes high-yield bond issuers are more likely to suffer in this situation as they have less room to manoeuvre.
“Government debt remains low yielding, often negative and simply unattractive for investors, with the risk that should central banks lose control of inflation then yields could rise substantially,” he adds.
Like many participants, Lowcock says the fixed income market is at present waiting to see the direction of travel and what are the central banks going to do.
“The Bank of England may have no choice but to raise rates sooner rather than later. This could be bad for the bond market in the short term but may well quash the recovery and be short-lived as rising oil prices, removal of furlough and other Covid support payments hit household incomes.
“The US is likely to be more patient and introduce tapering before raising rates, willing to let inflation overrun for a while,” he says. “However, if inflation remains higher for longer we could see bonds begin to underperform – especially if the oil price remains consistently high as it will weigh on economic growth in 2022.”
