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Bond investors: make sure you’re being paid for taking risk

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Written by: Paloma Kubiak
18/01/2018
The fixed income sector has continued to attract investors despite the prospect of rising interest rates and inflation. But investors need to make sure they’re properly compensated for taking risk.

The bond market has been in a near 30-year bull run and statistics from The Investment Association reveal the £ Strategic Bond sector has been the best-selling sector in each of the four months to November 2017.

In this month alone, the total net retail sales for fixed income came to £1.9bn, helping the sector swell to a total fund holding of £199bn.

According to Adrian Lowcock, investment director at Architas, bonds “may seem an odd asset class for investors to buy” as the prospect of rising interest rates present a headwind for bond funds.

But he says: “With equities seen as expensive, interest rates still at low levels and importantly below the rate of inflation, bonds offer income seekers a relatively attractive return at present, particularly for more risk averse investors.”

Both rising interest rates and inflation are seen as bad for bond investors. As interest rates rise, bond yields should also rise, causing the price of the bonds to fall and vice versa.

For those already holding a bond, you would expect to see the price fall, while for those looking to buy then you will be able to buy the bonds cheaper and with a more attractive yield.

Inflation erodes the value of the repayments received on the bond.

However, Kelly Prior, investment manager in the multi-manager team at BMO Global Asset Management, says bond markets haven’t been worrying about inflation or central banks raising rates, and as such, it’s an interesting and opportunistic time for investors.

“In 2017, you would have made money no matter which bond sector you were in, but I don’t think at the start of the year this would have been predicted.

“Sterling high yield bonds returned 6.14% in 2017 – investors have been paid for taking risk in bonds.

“Historically, (high yield bonds) is one of the most volatile asset classes but the key thing here is that there’s been no volatility. In contrast, the safety associated with gilts/government bonds have given less return (1.68%) and more volatility so 2017 has been quite an unusual year.”

Prior says currency also mattered in 2017: “Historically we thought that the currency of a central bank should be stronger when raising rates but this hasn’t been the case in 2017. We’ve seen some of the historical relationships break-down so managers have taken advantage of this by taking different currency options.”

When it comes to inflation, Prior says there’s nothing really to see in the bond market. “Central banks have been raising rates but bond markets aren’t worried about inflation – it’s a very benign environment. This is a very interesting area going forward – to see how the curves of the different markets will behave as we potentially start to see a bit of inflation creeping in and how markets will respond to that. At the moment, there’s nothing in the curve so this is an opportunity for investors”.

‘Lending money is a binary thing’

Looking at the risk vs return scale, Prior says when using duration as a measure of risk, for example, lending for longer means there’s greater risk for investors.

“Yield is a measure of return for lending. Over a 10-year period, in November 2008, we had less, lower risk, so lending for seven years (as an average for the index) paid just over 8%. But fast forward to August 2017 where the lending average was nine years, and investors have been paid significantly less – under 3%.

“Investors are taking on more risk and are being paid less for it. Make sure you’re being paid if you’re taking the risk,” she warns.

She says that while it’s not “new news” that the quality of issuance of bonds has been coming down, BMO care about quality and they don’t want to be just chasing the bonds with the highest income.

“We want to know managers are lending to good quality companies that are doing something sensible with the money rather than lending to people with lose covenants who will issue more debt underneath you and so suddenly the bond becomes less valuable.

“We need to exploit the yield curve and less volatility but make sure you’re being paid for the risk. If you see a headline duration figure for a fund, it doesn’t mean anything as you need to think about which country or curve is achieving that duration. Central banks are doing very different things, for example a six-year duration on a fund but it’s coming from Australia. You need to understand which curve you’re exposed to. Thinking about that is crucial,” she says.

Prior adds: “As a bond holder, you’re lending your money to a company or government – make sure there’s asset backing – something behind that so you get your money at the end of the term. Make sure you’re compensated for taking the risk in the meantime. Sometimes we forget that. It’s a binary thing lending money so you need to make sure you have enough behind you.”

Ideas for bond investors

Lowcock says managers have plenty of tools to diversify and profit from falling bond prices so investors shouldn’t ignore the asset class.

“Given equities are not cheap, bonds do offer better protection in falling markets and should be used as part of a diversified portfolio,” he says.

He suggests the following funds:

Kames Strategic Bond: The managers believe they can generate an attractive return through a flexible approach to fixed income markets. The team are well resourced and take a macro view when looking at bonds. They are fairly tactical and are willing to exploit sell-offs in sectors although they do take long-term views when investing. The fund should prove more defensive than some of their peers.

TwentyFour Dynamic Bond: This fund is run on a team basis with each member having specialisms in fixed income. The investment committee establish the bigger picture view of the world leaving the managers to decide how and when to reflect this within the fund. The fund can go anywhere in the fixed income space and as such could be considered a best ideas fund.

Royal London Sterling Extra Yield: Manager Eric Holt runs this fund from a bottom up perspective and prefers to conduct his own fundamental analysis instead of relying on rating agencies in order to identify undervalued assets. There is a focus on un-rated investments which are often ignored by other managers and differentiates the fund to other UK Corporate bond funds, but also means this fund is riskier and more akin to a high yield bond fund.

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