Are bond investors really doomed?
We’re on the cusp of a new bond age. Talk to investors on the street and they are ready to run for the hills. There’s virtually no ‘income’ left to be made in fixed income, a long slog of low interest rates ahead and a generally miserable outlook for bonds that don’t yield anything close to what they did in the ‘good old days.’
Maybe it is true that traditional bond investing is all but doomed, but we would argue that bond investors who can find managers that know the best buying opportunities will be very glad they haven’t bailed out of bonds.
At their core, bonds are simple, you have to remember. You lend money to a company or a government in return for an annual interest payment. You get your money back at the end of the term of the loan. For decades government bonds were a fantastic deal for private investors. Just look at UK gilts. Since 31 December 1985 they delivered annualised returns of 8.5%. That return rate beat out inflation which ran at an average 3.6%. Unfortunately, those days are gone and no one expects that rate of return to continue.
So what does the new bond age herald?
The main consequence of the financial crisis has been the need to pay down debt that had ballooned and that means deleveraging.
Central banks such as the Bank of England have helped borrowers to pay down that debt by keeping interest rates and government bond yields very low for a very long time. So low in fact most government bonds now yield less than the inflation rate. No wonder that investors buying government bonds locked into losing money in real terms are feeling rotten. Looking further forward, the next big move in interest rates (although it may be some way off) is for interest rates bond yields to move higher as the economic recovery gains traction, causing bond prices to fall.
So how can we be sure that bond investors won’t fall off a cliff? The answer is in the selection. There are three types of bonds that investors should look out for in the new bond age all of which, with careful selection, offer yields over 4.5%:
1. Bank debt. Banks are being forced to pay down existing lending books and to have higher capital buffers. You’ve got to make sure though that your manager is confident of the risk they are taking for the return on offer. Look for those buying the strongest credits in the so-called ‘subordinated’ debt markets where returns are high for those with good security selection skills.
2. High yield bonds. Some will argue that the high yield trade is played out, but don’t believe them. To judge whether high yield bonds represent good value, you have to look at default rates. If default rates increase, investors will lose money. However, with a moderately improving economic backdrop, we are predicting that default rates should not increase. Therefore yields on high yield of more than 6% compensate you for the risk of default and provide a lot more return than you could get in government bonds. Specifically, we’re buying the debt of US high yield companies that are displaying good behaviour, such as using new debt to pay back old loans.
3. Emerging market debt. This is a tricky area for investors because there have been significant losses year to date, but careful managers are finding good opportunities. Many emerging market countries have now had credit ratings raised (unlike many developed countries) and are managed on conservative economic principles. This makes sovereign emerging market debt a good buy, if your manager is highly selective and does their homework.
The days of buying a UK gilt or corporate bond benchmarked to a traditional index are over for many investors. Bond indices reward bad behaviour, in that they allocate more to those entities that have issued the most debt.
Not optimal in a world awash with debt. Looking forward, bond investors will need to think in a global, unconstrained approach, buying those bonds they like irrespective of sector of geography. With this approach the potential for yield and returns abounds.
Nicholas Gartside is portfolio manager of JP Morgan Strategic Bond fund and CIO at J.P. Morgan Asset Management.