Is the traditionally ‘safe haven’ bond market now a risk?
The year 2016 was unprecedented for investors and 2017 is set to be a challenging one to navigate amid the impact of Brexit, Donald Trump, lower interest rates, rising inflation and the unpredictability of European politics.
As investors sought to protect their portfolios by allocating to the traditional ‘safe haven’ asset of bonds in the run up to the momentous events, fund managers now predict an end or ‘mean reversal’ of its bull market run and they question whether this asset class actually poses more of a risk than retreat.
For the past four years, the UK has been in a deflationary environment and the primary trend was to invest interest rate-sensitive assets, such as bonds and ‘equity surrogates’ which also benefit from falling bond yields.
This stable trend meant that such assets were given the irrefutable reputation of being safe. However according to Marcus Brookes, head of multi-manager at Schroders, there’s a good chance that 2017 is the year that exposes this safe asset as a risky investment.
“Our outlook for the coming year is heavily influenced by the likelihood that inflation now surprises on the high side for at least a few quarters.
“This prospect has already instigated a significant rotation within the equity market and a sell-off in fixed income (i.e. bonds).
“There is a window of opportunity between now and the next recession to benefit from a period of mean reversion, as the extreme crowding in bonds, bond proxies and yield plays dissipates and owners of those assets suffer drawdowns.
“Quite simply, we believe the short-term losses that investors have suffered in recent months have the potential to build and ultimately become quite substantial.”
Brookes says that higher inflation is not great for zero-yielding cash, but is even worse for long duration bonds. As a result he argues investors need to watch these markets closely, particularly if corporate and low-grade bonds join the deterioration in government debt.
For Gary Potter, co-head of the F&C multi-manager range, the overriding message for long-term investors is to stay committed, diversify and don’t chase phantom fashion.
But he does believe we are at a critical point in a political and economic cycle and seismic shifts will start to manifest in the investment world, particularly a mean reversion out of bonds.
“We’ve seen mass rebellion against the political elite and rebellious votes for Brexit and Trump.
“The seismic shift of inflation systems because of sterling should mean bond yields are likely to rise.
“A huge amount of money in the last five to six years has gone into bonds and my view is that there’s a strong possibility of a rotation out of fixed income and we find ourselves thinking that the last five to six year trend might also be going into reverse.
“It won’t happen overnight, but could be in three to four years,” Potter says.
What alternatives could investors consider?
As an alternative in an environment of rising bond yields, Brookes says investors can benefit across multiple asset classes, but he says they have exposure to a combination of absolute return funds as well as gold “which has historically been a useful diversifier during periods of higher inflation”.
Hartwig Kos, vice CIO and co-head of multi-asset at SYZ Asset Management, says that although inflation-linked bonds are designed to hedge the inflation risk, they should be considered carefully as the real return might be negative.
Instead, commodities such as oil and industrial metals, will also benefit from rising inflation.
“Gold, which has to be considered as an alternative currency, will also be favoured in our allocation. Unhedged gold positioning should perform well, especially if currency depreciation is the main driver of inflation (as it is the case in the UK with the sharp depreciation of the pound).”
For Potter the rotation out of bonds will be combined with outperformance in emerging markets and a significant comeback of active management.
“People have been piling into low cost trackers as they’ve been brainwashed into thinking that’s the only way to make money and there was the regulatory framework for this.
“Trackers aren’t bad but we believe active management will make a significant comeback in relative performance.
“In emerging markets, their outperformance peaked on 7 April 2011 and since then there have been much better places to be.
“But if the growth continues, we suspect EMs will start to outperform.”