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Why you’re wrong about rising interest rates and ‘expensive’ bonds

12 September 2017

BlackRock’s Ben Edwards outlines why investors should not give up on bonds as we could be settling into a period of lower for longer interest rates and yields.

By Jonathan Jones,

Reporter, FE Trustnet

Interest rates are not going to rise as the fundamental forces that have driven them lower over the past two decades remain firmly in place, according to BlackRock fund manager Ben Edwards.

This means that yields are set to remain low – but with money offering negative real returns people should not discount investing in bonds as they are not as expensive as one might think, the manager of the BlackRock Corporate Bond and Sterling Strategic Bond funds added.

“For me it is not ‘should I sell my bonds because rates are going to go up’, it is ‘is everything expensive and what is the catalyst to reverse that?” the manager said. “It is that finding a catalyst that I think people are struggling with.”

Edwards said that if investors believed interest rates have been driven lower by geopolitical events it would be relatively straightforward to reverse because issues such as tensions around North Korea can be resolved.

However, he said rates have been driven low by technological improvements, by low productivity and by changing demographics – things that are much harder to reverse in the short term.

If these factors can reverse, the manager said “we can find a reason for bond yields to rise, why the neutral rate should increase and why interest rates at the short end – money rates – should increase.”

Yet these structural changes are unlikely to reverse and if anything are more likely to increase further, Edwards said.

“People don’t see deflation driven by technology going away, they see it increasing. People don’t see demographics in the Western world increasing, in fact it is accelerating,” he noted.

“And they don’t see problems with productivity given the fact that we have underinvested massively since the financial crisis.

“These are the drivers of what has taken bond yields not low over the last two years but low over the last 20 years.



“All we need to do is find a reason for why they should reverse but the reality is they’re not – they are increasing – so is it very difficult to make the case that we should return to some normal period.”

The only reason investors have been wishing for interest rate rises is because they feel “uncomfortable”, Edwards added.

“The only thing that makes us expect interest rate rises to happen is because we are tired. We know that without further QE – and we know that is being backed away from by central bankers – it seems unlikely that we go through the lower levels and we want yields to go somewhere,” he said.

“So if it can’t go much lower and we know it is a low level it therefore must go higher. And we spend all our time trying to work out why it goes there.”

Indeed, the current expectations are that there is a 53 per cent likelihood of at least one rate rise by the August meeting of the Federal Reserve next year.

 

Source: CME Group

Meanwhile there is a 47 per cent chance of rates falling or remaining flat, according to the latest data from the CME Group, though this follows three consecutive rate rises from the Fed in the previous three quarters.

“What the real risk for me over the next 12 months is will the Fed hike without inflation,” Edwards said.

“Or globally will we move into a situation where there is monetary tightening even without inflation because they realise that it is not within their control.

“They realise that effectively the Fed has exported wage inflation to the entire world and they’re not in control of wages and therefore start focusing more on financial conditions and stability.

“It was clear from some members of the Fed that they see asset prices – and it is all asset prices – as having a destabilising effect on the economy.



“So whether you move to a situation where with a lack of deflation yet they feel emboldened to hike – that is my risk event. I think they are going to go very slowly – that has been their raison d'etre up until now – but it’s the risk that eventually they get too concerned.”

“But what if it just stays here for an extended period of time?” he asked.

At these levels, he said there has been opportunities for bond manager to find investments, despite many becoming frustrated with higher prices and lower yields.

“Ultimately equity returns have been fantastic, bond returns have been great and up until recently property investments have done alright as well. Even gold is going up. What’s not going up? It’s a very difficult position but while it’s happening investors are doing very well,” he noted.

Indeed, over the last 10 years, the MSCI AC World index is up 135.52 per cent while the Bloomberg Barclays Global Aggregates index has gained 118.87 per cent.

Performance of indices over 10yrs

 

Source: FE Analytics

“We live in a relative world of investing,” Edwards said. “There is cash that needs to be invested and you need to put it somewhere.”

As such, he disagrees with people who say that fixed income as an asset class is expensive, noting that it everything needs to be looked relatively.

“The question is not is fixed income expensive the question is it more expensive than everything else?” Edwards said.

He added that he has been asked recently if investors should continue to invest in fixed income despite low yields and noted that he has seen opportunities all the way down to the current levels and expects to continue to find new ideas.

“No one generally asks that question of the property market or the equity market, where we all know the reality of valuations and fundamentals that we all learnt in finance 101 in school: you discount the future cashflow by whatever the risk-free rate is plus whatever the credit premium or equity risk premium is,” he responded.

“The reality is then that low bond yields are making everything expensive. As investors we all feel beaten up by the market because it is being driven by powerful forces that are don’t make us particularly comfortable.

“Bond yields are low but I don’t think that makes them expensive, it just means that they are low. In the same way that PEs [price-to-earnings ratios] are exceptionally high. I have never had a problem with bonds all the way down to these levels.”

 

Edwards has run the BlackRock Corporate Bond fund since 2011, during which time it has been a top quartile performer in the IA Sterling Corporate Bond sector despite underperforming its Bank of America Merrill Lynch Sterling Corporate index by 3.49 percentage points.

Performance of fund vs sector and benchmark since manager start

 

Source: FE Analytics

The four crown-rated, £538m fund has a yield of 2.92 per cent and a clean ongoing charges figure of 0.57 per cent.

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