The bond bull market
We have often talked about the extraordinary bull market we have witnessed in bonds in recent history, with 10-year UK gilt yields falling from 15% in 1974 to just 1% today. However, the long-term data shows that – although 2016 and 2017 have seen the lowest yields in the history of the UK gilt market – they are not that anomalous. Indeed, the incredibly high yields of the 1970s and 1980s look to be the anomalies in this context. Nonetheless, what is currently keeping yields at such extraordinarily low levels?
Source: Bloomberg & Canada Life Investments, annual yields as at 31 December 2016.
When will the normalisation come?
For years market participants have speculated that we are about to enter a normalisation cycle, with US Federal Reserve (Fed) futures pricing showing a steep lift in expectations along the curve, whilst actual rates have remained at rock bottom. There has been an inflection of late however, with the Fed hiking rates twice in the last six months. Despite this, we have still yet to witness a persistent rise in yields, as although US treasury yields spiked to around 2.6% at the start of this year, it has since fallen back to 2.2%. Yields have been further compressed despite the widely-held agreement that the Fed will be embarking on further hikes later this year.
US interest rates influence much of the rest of the world from a cost of capital perspective. However, they are currently the only major developed market on an interest rate rising cycle. Typically, when the US leads, others follow, but this has not been the case in the era since the financial crisis. As a result, when global investors see they can achieve a 2.6% yield in US treasuries, a wave of new money flows in, compressing the yield once more. In addition, an interesting paper from a group of researchers at the New York Federal Reserve earlier this month highlights the rising premium for the liquidity and safety of treasury bonds as putting a long-term downward pressure on yields.
What can we expect going forward?
In the UK, gilt yields have similarly remained stubbornly low, having peaked at 1.5% in January and fallen back towards current levels. However, we must be cognisant that interest rates cannot stay this low forever and an increase will impact some fixed income investments more than others. At Canada Life Investments, the CF Canlife Corporate Bond Fund is positioned with a shorter duration than the benchmark, whilst 30% of the £26 billion we manage in individual bond mandates is specifically in shorter duration securities. As an example, the CF Canlife Short Duration Corporate Bond has a modified duration of 1.97 years.
Despite the somewhat uncertain outlook, we believe that our conservative, low-risk style that concentrates on credits with strong fundamentals will continue to perform. Although Sterling credit spreads are not cheap, they are not overly rich, and we believe opportunities remain in certain sectors.
Source: Bloomberg & Canada Life Investments, as at 13 April 2017.
With a team of 30 credit analysts based in Europe and North America, we focus on fundamental credit research, believing this is the best way to add value for clients and generate superior returns. Having managed fixed income assets for more than 50 years, our view is that the avoidance of bad credits and downside risk protection is critical to long-term success.
The securities within our portfolios are ultimate the biggest driver of returns and what we are paid to do as active managers is to select these credit opportunities on behalf of our clients. An example of one of our shorter duration positions is a holding in Fidelity International (FIL). The bond is a BBB+ rated bullet, maturing in 2020. We purchased the position in October 2016, at a yield of 2.11%, representing an attractive 1.98% spread and comparing well with other similar instruments. We view FIL as a cash generative, globally diversified business that maintains a strong balance sheet. In addition, its family ownership is a positive as it helps maintain a long-term strategy for the firm. This combined for a positive internal credit assessment and its inclusion within the CF Canlife Short Duration Corporate Bond Fund.
The value of investments may fall as well as rise and investors may not get back the amount invested.
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CLI00794 Expiry on 2 June 2018