The current backdrop for fixed income
Many of the recent comments around fixed income have referred to the impact on the asset class of global monetary tightening. For example, the US Federal Reserve (Fed) and Bank of Canada (BoC) have already raised interest rates, the Bank of England (BoE) have followed suit and, in January, the European Central Bank (ECB) will begin tapering their huge quantitative easing programme. This synchronised activity may well push up government bond yields, but we believe that those who focus on a struggle for fixed income in this environment have misunderstood the sheer variety of investable assets, as well as the impact loose monetary policy has had across the spectrum. The era of super-loose money policies has benefited all kinds of asset values; bonds, shares, housing, antiques etc. and so all kinds of asset values will be squeezed as policy inches back towards normality. In such an environment investors should continue to focus on sound investment principles such as diversification and choosing good quality assets.
Have bonds been the biggest beneficiaries of the last 10 years?
Corporate bonds have certainly been one of the beneficiaries of low interest rates as investors have chased yield. Much like government bonds, yields have significantly compressed in the corporate space too, with the iBOXX £ Corporate Index now yielding less than 3%.
Source: Markit, semi-annual yield for the iBOXX Sterling Corporate Index, as at 30/09/17.
But bonds have not been alone. Whilst the iBOXX Sterling Corporate Index has returned 84.8% over the last ten years, the FTSE All-Share Index is closing fast with a 75.2% gain, and a whole host of other asset classes have seen their values rocket over the last decade. Even the price of an average pint has risen by more than 50%!
What does this tell us?
For nearly a decade, super-loose monetary policies around the globe have ensured that the tide has been coming in and the price of many assets has gone up substantially. However, in 2017 there has been a growing awareness among policymakers that the era of loose money has gone on for too long and may be counterproductive. A particular issue has been the price of residential housing, where the prolonged period of low interest rates has pushed up prices and contributed to problems which it will take a generation to resolve. In 2017, we have therefore seen a kind of slack tide, with the makers of monetary policy taking tentative steps toward tightening. This has created a more nuanced market in bonds where yields have risen and fallen as markets swung between optimism and pessimism about interest rates and quantitative easing (QE). This ‘slack tide’ has required a more considered investment approach, given the greater volatility we have seen in government bond yields and has had an impact across all asset classes.
Looking forward, the global economy is now firing on all cylinders, and we expect to see synchronised monetary tightening. However, central bank committees are famous for their risk aversion and will not want to be blamed for disrupting economic growth. Therefore, any rise or tightening measure will likely be gradual and spread over the medium-term.
Are there still risks for some bonds?
Of course, parts of the bond market are very expensive, but then so is everything! We like to think of fixed income returns as asymmetric, which means that either the risk is skewed more heavily to the upside or downside. In fixed income, the risk is skewed to the downside, because your return is capped yet you could lose all your money investing in a bad company. Therefore avoiding losers is more important than picking winners! Our credit process, for example, is central to avoiding problem companies. To illustrate this, the CF Canlife Corporate Bond Fund and CF Canlife Short Duration Corporate Bond Fund had no exposure to recent banana skins such as Provident Financial and Co-op Bank.
This approach is not just centred around the worst case scenario though, it is also useful as a risk/return measure. For example, we are currently cautious on bank additional tier-1 (AT1) bonds as we believe the apparent fixed income return is outweighed by equity-like downside risk. Instead, we are more optimistic on the insurance sector – which trades at very attractive spreads.
Another area of interest is collateralised bonds. Following the financial crisis, collateralised became a dirty word, but when used in the right sense it is actually a good thing. When you lend a company money, you want some collateral to back that loan up. An under-rated area in the sterling market is bonds backed by portfolios of pubs. Despite worries about smoking bans and changing consumer habits these bonds often have good cash flows and are backed by collateral in the form of a diversified portfolio of assets with good alternate uses.
The UK continues to be the recipient of Brexit-related uncertainty, but as recent data shows, is nevertheless still delivering economic growth. Supported by a global economic recovery, monetary tightening is inevitable, but it will have an impact across the asset class spectrum – it is not just fixed income that will be impacted by this ‘new normal’. Furthermore, central bank sentiment shifts are likely to continue to create swings between excessive optimism and pessimism in the markets, which should provide opportunities for active investors. Against this backdrop, bonds retain solid defensive characteristics and should remain a useful component of a properly diversified portfolio.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate.
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