Bond managers have warned that the multi-decade bull market in fixed income is on the brink of coming to an end, but the latest figures show that UK investors continue to flock into the asset class.
Data from the Investment Association reveals that fixed income funds captured net retail inflows of more than £2bn in November 2017, making it the month’s most popular asset class. Equity funds took in £713m in fresh money over the month while multi-asset funds gathered £1.2bn.
The IA Sterling Strategic Bond sector was the best-selling peer group in the Investment Association universe after taking net retail inflows of £1.5bn; this followed £1.6bn of inflows in the previous month. IA Mixed Investment 20-60% Shares, IA Europe excluding UK, IA Mixed Investment 40-85% Shares and IA Global were the next most popular sectors in November.
Best-selling Investment Association sectors in Nov 2017
Source: Investment Association
The move into bonds comes despite signs that ultra-loose monetary policy environment of past decade is drawing to a close.
The Federal Reserve increased interest rates three times last year and unveiled plans to reduce its balance sheet while the Bank of England lifted its base rate once; investors expect both the European Central Bank and the Bank of Japan to ease off on their aggressive stimulus policies.
Meanwhile, inflation has continued to tick up in the UK, which tends to be bad for bond investors. According to the Office for National Statistics, the consumer prices index climbed to 3.1 per cent in November – this is its highest reading since March 2012.
Laith Khalaf, senior analyst at Hargreaves Lansdown, said: “It’s hard to fathom why bond funds have gained such popularity at a time of rising inflation and tightening monetary policy, both of which make wringing returns out of an already fully-priced fixed income market look like an uphill struggle.
“Portfolio rebalancing is one possible answer, as investors may have taken profits on equities and topped up their bond holdings to maintain their preferred asset allocation. In addition, after 10 years of ultra-low interest rates, perhaps some cash investors have finally given up the ghost and traded up the risk spectrum in search of a higher income.”
The move by UK investors towards bond funds coincides with some bond investors – including fixed-income veteran Bill Gross – warning that the bull market which has buoyed bonds for more than 30 years could be coming to an end.
In this latest outlook, Janus Capital Management’s Gross – who has been defensive for some time – is quite explicit in saying that bonds “are in a bear market”.
Gross noted that the yield on a 10-year US Treasury bottomed-out at 1.45 per cent in July 2016 and said, in retrospect, it should have been obvious that the asset class’s “time was up”.
“18 months ago, it was obvious to most observers that the economy, measured by nominal GDP, was not going to go much lower than 3 per cent and that the Fed was having second thoughts about quantitative easing. A 1.45 per cent 10-year was at that time set up for perpetual QE and the possibility of a deflationary collapse in the economy,” he said.
“Neither conditions prevailed, and so 1.45 per cent for [10-year treasuries] can legitimately be cited as the end of the bond bull market which began at 15.8 per cent in 1981 and provided prescient portfolio managers with the potential for huge capital gains and the moniker of ‘total return’, which previously had been the sole bastion of stocks and real estate.”
Performance of US treasuries over 20yrs
Source: FE Analytics
Gross added that it has still been possible to generate decent returns from bond portfolios over the past 18 months or so. Even index-tracking fixed income portfolios that included a small allocation to high-yield bonds could make a total return of around 5 per cent in 2017.
“Now, however, that 5 per cent number may be hard to duplicate. High yield spreads are compressed and not likely to provide future capital gains. And the situation in Treasuries, although standing as I write at 2.55 per cent, is not conducive to a ‘total return’ environment either,” he warned.
“We have begun a bear market although not a dangerous one for bond investors. Annual returns should still likely be positive, although marginally so.”
Concluding that “the bear bond market’s time has come”, Gross predicted that the yield on 10-year Treasuries will reach 2.70 per cent or more by the end of 2018 – leading to a “mild bear market” return of between 0 and 1 per cent for most fixed income portfolio.
Colin Lundgren, global head of fixed income at Columbia Threadneedle Investments, is another bond manager warning investors to expect lower returns from here.
Following on from a relatively strong 2016 and 2017 for bonds, Lundgren said “the best days for fixed income are likely behind us”.
He predicted that returns in 2018 will struggle to match those of previous years given a lower starting point for yields and risk premiums, expectations for low inflation and a less accommodating US Federal Reserve, and no extra risk premium for potential negative surprises.
He also argued that investor expectations of future returns from bonds might have swung too far. The manager noted that many bond investors have been calling higher rates since the global financial crisis only to watch them constantly move down but warned that they may have turned too sanguine in their outlooks now.
“As global financial conditions improved and central banks became less accommodative, investors show little concern that the environment might be changing,” he said. “They are not fearful of an acceleration in rate hikes or inflation. Simple but sage advice when investing: be greedy when others are fearful, and fearful when others are greedy.”
Lower yields mean less return opportunity
Source: Columbia Threadneedle, Bloomberg, Barclays
Lundgren explained that a “modest” 0.5 percentage point rise in interest rates would lead to price losses for US Treasuries that more than wipe out income return, given coupons are so low. At the same time, the yield premium on high yield bonds prices in a 1 per cent default rate, yet Columbia Threadneedle’s analysts forecast defaults between 3-4 per cent.
“Back-to-back years of strong returns in fixed income are a tall order, especially at current valuations. The upshot for 2018 may seem unexciting, but prudent bond strategies still seem likely to outperform cash,” he concluded.
“Our fixed income playbook calls for less interest rate and credit risk, and more diversification. Stay invested but temper your expectations, turn down risk and wait for better days and higher yields.”