While he believes it is still possible for certain parts of the fixed income market to deliver a positive return in 2014, it is unlikely to be the more conventional government and corporate bonds, which will suffer as interest rate expectations rise. Investors have to look to less well-known, or less liquid parts of the fixed income markets to diversify their portfolios.
This sentiment is echoed by other high profile managers such as Bill Gross of Pimco. He believes investors should own bonds with less duration and shorter maturities, that way, when the market goes against them, there is not as much to lose. Instead of looking to longer maturity bonds during the year to generate higher income and capital returns, fixed income investors can add value through credit spreads, volatility sales, yield curve positioning and currency-related characteristics, he says.
He believes that total return bond portfolios should float above water in 2014 and total return for bonds could be in the region of 3-4%.
Some types of bonds appear to be more suitable for the environment in 2014 than others. For example, convertible bonds are generally less interest rate sensitive than other types of bonds and also benefit from a rising equity market as the option to convert to equity becomes more valuable. Although this part of the market remains relatively small and there are only a handful of funds, it can offer a means to retain exposure to fixed income at time when interest rates are likely to rise.
Floating rate notes are also likely to benefit from a rising interest rate environment, as the coupon is linked to Libor. Again, the market is relatively small and illiquid, but a number of funds offer exposure in a closed-ended format. Smouha says that this type of bond offers the double benefit of a high coupon up front that will then reset at a higher rate when interest rates finally move.
Smouha has also done well buying the junior debt of highly rated companies. This will be lower down the pecking order in the event of a default, but he reasons that if the company is high enough quality and he has done his credit research correctly, the bond is unlikely to default anyway. He can benefit from the pick-up in yield. This is particularly true, he believes, in the banking sector, where a range of bond-holder friend activity is taking place.
Strategic bond fund managers may look at these kind of areas, but many will stick to more conventional bonds. Although economic growth is not yet fully established and inflationary risks remain muted, investors need to be alert to the risks inherent in their fixed income portfolios. There is a place for fixed income in this type of climate, but it has to be the right kind.
