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The ‘million-dollar question’ bond investors keep asking

03 September 2020

BlackRock’s Ben Edwards explains why he has been reducing exposure to developed market government debt and what has made him start worrying.

By Rob Langston,

News editor, Trustnet

Investors looking for real returns from their bond portfolios may need to bide their time in corporate credit markets as ultra-low rates continue to have a significant impact on developed market government bonds, according to BlackRock’s Ben Edwards.

One of the more difficult decisions for Edwards – co-manager of the £78m BlackRock Sterling Strategic Bond fund – has been where to find the bonds capable of delivering a 5 per cent upside over the next year.

He said: “I do constantly wake up every morning [and ask myself], ‘Where’s the best risk?’ or ‘Where’s the best place to allocate risk to try and make another 5 per cent over the next 12 months?’

“And I suspect that that next 5 per cent is more likely to come from credit risk than it is from interest rate risk.”

Having started the year more defensively positioned with high levels of cash, said Edwards, the fund was well-placed for the coronavirus-fuelled recession that hit markets this year. Although he said this was more down to warning signs around the bond market ahead of the Covid-19 pandemic.

He said: “Global credit markets, like some other markets, were in a state of fairly significant dislocation that drove even the very best and highest quality companies’ debt to much cheaper levels.

“Once the policy action was in, once central bankers stepped in to support the market in a meaningful way, once fiscal authorities did the same: then, obviously, that was the best place to capture that value.”

And now the manager has come full circle, with the corporate credit no longer as cheap as it was at the height of the sell-off and back to trading at fair value.

Edwards said: “We’ve got 20 per cent in developed market bonds and cash, not because we think government bonds are going to make us a lot of money going forward, but because, ultimately, we want to have that liquidity to inject when we see value in the corporate credit market.”

Indeed, the BlackRock Sterling Strategic Bond manager is bearish on the prospects of government bonds and what he calls the ‘million-dollar question’ – the impact of ultra-low interest rates on the economy

The manager said it is “pretty clear” that rates are likely to be at zero or near-zero for as long as many fund managers or analysts can project, but people are divided about what will happen.

“You could split the market into those that think that the blow to the economy are problems that are Covid-related – the lockdowns, the increase in unemployment, the loss of businesses – is basically going to drive some sort of deflationary funk,” he said.

“And effectively what you end up with is some version of what we’ve had in the past, which is very low growth, very low inflation and central banks stepping in to make most assets look better than they are.”

Edwards continued: “And then the other side is that the huge increase in the money supply by central banks is going to finally let the inflation genie out of the bottle and we’re going to get high levels of inflation that has eluded us for decades.”

However, the fund manager said from a risk allocation perspective it’s a much simpler choice.

“We’re not trying to pick an outcome and then and put all of our chips on black,” he explained. “We’re just trying to work out where the risk-reward is shifting to. And for us, the risk-reward is shifting clearly towards owning less government bond risk, it’s towards owning less duration risk.”

While duration (or interest rate risk) as a trade has worked “phenomenally well” for investors over the past decade – generating equity-like returns with lower volatility – it’s unlikely to perform as well in the years ahead, said the BlackRock manager.

At the same time, expectations of medium-term inflation are increasing due to the mix of monetary and fiscal stimulus enacted to support economies through the pandemic, which would have a negative impact on low-yielding government bonds.

“The combination of those two things is – the probability of positive returns going down and the probability of negative returns going up – means that we should have less of that risk in the portfolio, that’s a no-brainer for me,” said Edwards.

“I don’t need to really hang my hat on the deflationary funk or the genie-out-of-the-bottle scenario to know that the right thing to do from a portfolio construction point of view is to reduce duration.”

Indeed, when it comes to inflation, one thing that Edwards has been thinking about is the level of complacency among central bankers.

“When everybody tells me not to worry is usually about the time I start to worry,” said the manager. “And what’s interesting now is there’s a kind of cacophony of voices basically telling us: ‘Yes, what we’re doing is unprecedented. Yes, we don’t know what the side effects will be. Yes, there are concerns for the future. But don’t worry about it now.’

“Now, I’m not disputing that the first thing to do is to support the economy. But that doesn’t mean to not worry at all or think about the risks or position for the thing that comes next.”

Edwards said while it may not be a problem this year or next year the prospect of higher inflation shouldn’t be completely discounted because if bond markets are forward-looking then they will look toward the risks that come about from the policy response.

Performance of fund vs sector under managers

 

Source: FE Analytics

Under Edwards and co-manager Simon Blundell, BlackRock Sterling Strategic Bond has made a total return of 24.33 per cent since May 2016, compared with a gain of 20.87 per cent for the average IA Sterling Strategic Bond peer.

The fund has an ongoing charges figure (OCF) of 0.60 per cent and a yield-to-worst of 2 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.