Investors are susceptible to making “dangerous” fixed income investment decisions if they focus on the asset class’s recent strong performance as a move away from loose monetary policy means the upside for long-dated corporate bonds is limited, warned Janus Henderson’s Nick Watson.
Given stretched valuations in various areas of the fixed income market, the co-manager of the Henderson Multi-Manager range wrote in his latest Investment Insights blog that it is vital for investors to get under the bonnet of any fund they choose to invest in.
“We recently visited an independent financial adviser who focused almost exclusively on past performance when selecting his fixed income holdings. This had led the adviser to invest clients in long-dated corporate bonds funds, a high beta approach to credit investing that has performed incredibly well through the QE-driven bull market,” Watson said.
“We are not licensed to give advice, but reflecting upon that meeting, we would like to explain why our own approach to fund selection within fixed income differs.
“The upside for long-dated corporate bonds appears limited to us given the historically low yields on offer and an improving economic backdrop.”
Indeed, the strong performance of bonds over recent years has pushed their yields to all-time historic lows.
From 2008 until the end of last year for instance, 10-year gilt yields fell 71.8 per cent while the FTSE Actuaries UK Conventional Gilt Over 10 Years index returned 110.74 per cent, predominantly through price increases.
This meant that, despite government bonds traditionally being dubbed as ‘safe’ income plays relative to high-growth high-risk equities, 10-year gilts significantly outperformed the FTSE All Share over this time frame.
Performance of indices from 2008 to 2017
Source: FE Analytics
This trend appears to have come off the boil year-to-date though, as the FTSE All Share has outperformed the 10-year gilt index by 6.76 percentage points with a return of 5.83 per cent.
“The low growth, low rate, low inflation, and high QE environment that has propelled high duration long-dated bonds to current levels is ending,” Watson warned. “Global growth is positive and resilient, central banks are moving away from near-zero interest rate policies, inflation is normalising, and global markets are starting to look beyond QE for the future drivers of returns.
“In this environment, the high sensitivity to interest rates that has supported returns of high beta fixed income on a global basis throughout central banks’ QE experiment would become a significant headwind to total returns.”
Given how significantly the backdrop is changing, the manager said this is a prime example of why it is dangerous for investors to base their investment decisions on past performances.
Rather than focus on historic absolute returns that have been achieved through potentially misallocated capital, he urged investors to dig deeper into the fundamentals of the investment vehicles – and the broader asset class - they are buying.
“We think there are opportunities within fixed income for those investors who are prepared to be nimble and active in the face of continued economic growth and inflation normalisation,” Watson continued. “This can take the form of identifying the most appropriate area of the fixed income universe to invest in then, secondly, identifying the best instrument to reflect that view.”
For instance, the manager increased the funds’ weightings to US high-yield bonds at the start of 2016 and, as the asset class rallied off the back of rising oil prices and strong economic activity, he was able to take profits and reallocate some of the capital elsewhere.
One fund in this market area he favours is AXA US Short Duration High Yield Bond, which has been headed up by FE Alpha Manager Carl Whitbeck since 2010. Over five years, the £963m has underperformed its average peer in the IA Global Bond sector by 10.26 percentage points with a total return of 13.94 per cent.
What should be noted, however, is the smooth ride that it has given investors over this time frame – the fund has achieved almost half of the maximum drawdown of its sector average at just 3.76 per cent, as shown in the below graph.
Performance of fund vs sector over 5yrs
Source: FE Analytics
The manager achieves this through a highly-diversified portfolio, with its top holding – a bond from drugstore chain Rite Aid Corp – accounting for a modest 1.2 per cent of the overall fund.
“The fund offers an attractive near 4 per cent yield with only approximately 40 per cent of market volatility,” Watson said.
Another area of focus is strategic bond funds, where the manager likes the combination of TwentyFour Dynamic Bond and PIMCO GIS Income. The former is £1.5bn in size and has an average quality rating of ‘BB’, while the latter is $39bn in size and has a notable overweight to mortgage-backed securities.
Over five years, TwentyFour Dynamic Bond has outperformed its average peer by 16.71 percentage points with a total return of 45.86 per cent but has done so with a significantly higher drawdown of 6.35 per cent (its average peer’s drawdown over this time frame is 3.69 per cent).
In contrast, PIMCO GIS Income has achieved a very similar return to its average peer since its launch in November 2012 but has done so with a drawdown of 3.26 per cent. The funds have respective yields of 5.02 and 2.7 per cent.
“TwentyFour and PIMCO offer very different and complementary exposures from their actively managed portfolios,” he explained. “TwentyFour currently favours key positions in European financials, while PIMCO has a more cautious outlook, with exposure to US mortgage-backed securities alongside some emerging market debt and US high yield.”
“We think that an active and nimble approach to fixed income investing is necessary in an environment of positive growth and normalising economic conditions. We continue to focus on identifying what we believe to be the right parts of the bond asset class and the right funds to implement these views.”