Calling time on the 30-year bond bull market?
Bonds took a bit of a tumble last week when Mario Draghi, president of the European Central Bank, hinted at scaling back the bond purchases the bank has been making as part of its quantitative easing programme. This news, coupled with signs of rising interest rates from both the US and the UK, was enough to see yields rise and some negative returns. After enjoying a 30-year bull market in the asset class, is time finally being called?
Three themes that could push yields higher and returns lower
Bonds are expensive – there is no doubt about that. And any increase in yields could very possibly deliver more negative returns. According to Chris Iggo, head of fixed income at AXA Investment Management, there are three macroeconomic themes that could force bond yields higher, or at least increase volatility.
The first is the normalisation of monetary policy – basically the central banks raising interest rates (albeit very slowly) and no longer buying bonds themselves. As Chris pointed out recently, central bankers appear to believe that they are winning the war on deflation and also that they need to restore some firepower in readiness for the next recession. With interest rates in developed markets already at rock bottom or even negative in come cases, a good analogy is that policy at the moment is a bit like driving a car without the spare wheel!
The second of Chris' themes is the economic cycle. There is optimism about the global economy and it is expected to remain reasonably strong going into 2018. Europe in particular is finally showing signs of a strong recovery. Bond yields remain much lower than the rate of nominal global growth and that gap could close.
The final theme is politics. The last few years have seen a discernible increase in what is described as “populism”. It manifests itself in a desire for change, a reaction against “elites” and growing opposition to globalisation. In the end money talks and we are likely to see some combination of increases in public spending and more progressive taxation. Chris suspects this means higher budget deficits as well and the consequent increase in public debt that goes with that.
Picking the right bonds will be key
So in this environment should investors still consider investing in bonds?
They still have a part to play in diversifying a portfolio and they can still produce an attractive income – a much sought-after commodity these days. Given the very strong structural factors and the likely slow pace of monetary unwind, a good active bond fund manager should be able to mitigate many of the risks.
But care will need to be taken. If you find a manager that can navigate the changing environment, the silver lining is that valuations will improve in the bond market in general and if more volatility returns to all markets, their diversification benefits will once more come to the fore.
Four corporate bond funds to consider
I like four very differently managed corporate bond funds that could be worth a look. Each is run by very experienced managers who are well aware of the risks in their asset class right now.
The first is Rathbone Ethical Bond. It invests in quality investment grade bonds and has a higher income target than most of its peers, currently yielding 4.2%. It is also one for the more ethical of investors and its exclusions are simple: no mining, arms, gambling, pornography, animal testing, nuclear power, alcohol or tobacco, which rules out about one third of the index. All positions must also have at least one positive environmental, social or corporate governance quality.
The second is M&G Strategic Corporate Bond fund. This fund aims to maximise total return (the combination of income and growth of capital) and is part of a suite of bond funds run by one of the largest bond teams in London. It invests mainly in investment grade bonds, but up to 20% may also be held in high yield bonds, government debt, convertibles and preference stocks.
The third is Royal London Corporate Bond fund. The manager has proved adept at delving into parts of the fixed income market where others fear to tread and identifying bonds that offer superior risk-adjusted returns. The process is risk aware and concentrates on avoiding losers rather than picking big winners, with the goal of providing an attractive and stable yield over time (currently 3.43%).
The final fund is Invesco Perpetual Corporate Bond fund. Invesco has one of the best fixed interest teams around and the fund is managed by some of the most respected managers in the industry. It has been positioned very cautiously over the past few years, as the managers are so cognisant of the risks they face.Over the longer term, it has an excellent track record and is typically one of the less volatile funds in its sector.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius's views are his own and do not constitute financial advice.