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Is the bond fund exodus set to continue?

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After a dismal 2013 for fixed income, will investors return to bond funds? We ask the experts for their views...

Bond funds suffered a shoddy 2013. They took in no new money and, according to the Investment Management Association (IMA), experienced their first year of net outlfows since records began in 1992.

One reason for the flight from bonds was a response to fears about the US central bank tapering its asset purchasing scheme.

Investors were also encouraged to move into riskier assets such as equities thanks to a more positive economic outlook. IMA data showed equity funds took by far the largest share of investors’ money in 2013.

However, 2014 has brought with it fresh stock market volatility and a grim start for equities globally, with bonds looking like the better investment.

Fears over a crisis in the emerging markets because of a slowdown in China’s growth rate and volatility in emerging market currencies have boosted bond markets, as investors seek comfort in so-called ‘safer’ assets.

As a result over the past few weeks, there has been talk of an ‘unrotation’ or a reversal of the ‘great rotation’ if you like, with investors returning to bond funds.

However, not everyone believes an ‘unrotation’ is underway.

David Coombs, a multi-manager at Rathbone Asset Management, who remains bearish over the outlook for bonds, says any sign of a possible reversal in flows is unlikely to set a trend for the coming year.

“Of course it is possible that there is reversal of the ‘great rotation’, but I suspect not though given bond markets are not showing great value,” he says.

“I think it is more likely that people will sit on cash and wait it out. I suspect the flows coming out will go back into equities eventually.”

Coombs thinks investors will only start to look at bonds seriously if 10 year gilt yields rise above 3% (they are currently yielding 2.6%).

However, strong economic data over the next few months, and the UK unemployment rate falling below 7% will push up bond yields, making them more attractive, he predicts.

Richard Troue, investment analysts at Hargreaves Lansdown, agrees that looking ahead to 2014, there is less value in the bond markets.

“The ‘spread’ (the difference in yields) between investment grade bonds and 10-year gilts remains very low. The same is true of the spread between high yield bonds and 5-year gilts. This essentially means that investors are being paid very little extra yield for the additional risk of lending to companies, and it affords investors little protection should anything go wrong,” he says.

Coombs adds that investors holding on to their bond allocation should also be prepared for volatility as a result of rising interest rates and inflation.

Rising interest rates means that bonds held now will not be worth as much in the future.

However, Troue does not see rates rising before the 2015 general election and says bonds could therefore continue to perform well for a while yet.

“In the short term I do not anticipate a dramatic fall in bond prices, but interest rates will rise at some point presenting a challenge for bond investors,” he says.

Given these uncertainties, Troue currently prefers more flexible strategic bond funds where the manager has the flexibility to invest across the entire fixed-income spectrum.

“The Invesco Perpetual Tactical Bond fund is one of my favourites, where the managers have no constraints over the geography, sector, or credit quality of bonds in which they invest,” Troe says.

It is worth noting that general consensus in the investment universe is that equities are likely to have another good year, albeit possibly with the same levels of volatility as 2013. Star manager Richard Buxton predicts the FTSE 100 to reach 7,500 by the time the year is out, and experts still prefer equities over fixed income, especially with a backdrop of consistent economic recovery.

The key message for investors is to diversify portfolios, especially as equities come under pressure, and government bonds or gilts do better in comparison.

Nick Gartside, chief investment officer of fixed income at J.P. Morgan Asset Management, says: “A balanced portfolio means you’re never left in a circumstance where all of your assets are going in the same direction at once.”

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