May has seen a sell-off in government bonds, in the UK, US and Germany. Yields had reached ultra-low figures and a correction was not unexpected. However investors are asking if this signifies the end of the bull market in bonds which has run for about 25 years. It commenced around 1990 when a secular long term trend of falling global inflation and interest rates started. Some of you will recall the double digit mortgage rates you were paying 25 years ago.
The sell-off in bonds does not appear to have been triggered by anything specific but investors are naturally concerned about the prospect that interest rate rises in the US will start shortly. The Bank of England is likely to follow suit shortly afterwards. Government bonds and investment grade corporates are especially interest rate sensitive as the value of the coupon, the rate of interest a bond pays is fixed, and its value therefore declines relative to cash when interest rates rise. A similar fall in bond prices is expected from rising inflation.
Clearly interest rate rises from historically low levels in the last six years is another step in the ending of “easy money.” The argument goes that bonds and other assets have risen indiscriminately on the back of loose central bank monetary policy including QE and low cost central bank finance, for example the UK’s Funding for Lending Scheme. Bonds have got drunk on liquidity and low interest rates but like all good parties it is coming to an end and a bar tab has to paid. Whilst the US is leading the way in normalising monetary policy, the “taper tantrum” in May 2014 caused by the Federal Reserve giving notice that QE was ending was the first ruction, there is clear divergence globally. In many economies interest rates have been heading south whilst money printing continues in Japan and Europe. This reflects the fact that in many parts of the world economic growth is anaemic.
Most fund managers would argue that equities have better investment potential than bonds but investors are still nervous with stockmarket indices reaching new peaks, valuations in some markets and sectors looking expensive, company earnings growth not keeping pace with stock prices and fears of a super taper tantrum and a Greek exit from the Euro. Whilst this in part a “wall of worry” syndrome, fundamentals do give cause for concern; there are systemic risks from a Grexit and potential for a major crash in the bond market. So how are investors positioning their portfolios in current market conditions? Here are a few perspectives from what I have been reading:
1. High Yield Corporate Bonds
This type of fixed interest is less interest rate sensitive than government gilts and investment grade corporate bonds. This is due to their high coupons which provide a cushion against rising interest rates and falling prices. In addition high yield bonds have shorter maturities or durations than gilts. Duration or interest rate sensitivity is a function of maturity date of a bond. Long dated bonds such as gilts have high durations and hence are more vulnerable.
For investors credit quality is the key issue with high yield bonds. In the US they are somewhat disingenuously referred to as junk bonds. Currently default rates are low and are expected to remain so in the early stages of global economic recovery. Smaller companies which are often issuers of high yield bonds historically underperform larger companies only in the late stages of the interest rate cycle as an economic slowdown approaches. We are at the beginning of the cycle so the outlook for high yield bonds is OK in my opinion. That said stock selection is key and I would not advocate the use of index trackers or ETFs.
2. Cash Weightings Rise
Fund managers fearing a crash have been increasing the cash weightings in their portfolios. Aside from this being a defensive measure, cash provides liquidity if investors sell up in their droves and gives scope for managers to add to their best investment ideas on the dips.
3. Targeted Absolute Return Funds
According to the Investment Association who monitor inflows and outflows of investor money in different sectors large allocations were made in April to cautious risk targeted absolute return and money market funds. This is a clear sign of investor sentiment being cautious.
4. Diversified Bond Portfolios
In a recent blog, M&G a leading bond fund manager argued (as others do) that flexible diversified bond portfolios are favoured for fixed interest exposure. This is because different types of fixed interest have different characteristics as noted above. They warned that interest rate rises or inflation could trigger further sharp falls in government bonds and the risks of this are high. Moreover the very low yields will not adequately compensate investors for capital losses. However M&G observed following negative returns from global government bonds the 12 months were great times to own them. There was a big bond sell off in 1994 but in the following year returns were 16.9%. I have always felt bonds have an inherent self-correcting mechanism. If prices fall, yields rise and this attracts buyers.
In another article I read, M&G suggested that UK inflation although muted now could rise in the medium term and the markets are underestimating the risks here with a pre-occupation on the short term. The bond markets are consequently pricing CPI inflation at an average of just 1.6% p.a. over the next five years. Inflation could surprise on the upside from UK wage growth, a falling pound and a recovery in oil prices. Index linked bonds offer attractive opportunities as an inflation hedge whilst a portfolio shorter dated inflation linked corporate bonds with low or negative duration provides protection against rising interest rates.
5. Investing in Earnings Growth
There has been a clear move in equity investment away from US equities. A six year bull run, a dip in economic growth in the first quarter, concerns about earnings growth, a strong dollar and high equity valuations have shifted sentiment from Uncle Sam. Of course the rest of the global equity market is not especially cheap, so where do you invest? Robin Geffen, a leading fund manager and CEO of Neptune Investment Management acknowledges this but observes equities are not worryingly expensive in the markets they specifically like. These are where company earnings have broadly kept pace with prices. For example in Japan the price to earnings ratio (P/E) ratio of the TOPIX* Index is a very reasonable 13.3. However the earnings per share (EPS) growth for the 2014/15 year has been a very strong 16.7%.
Geffen also observed that in a bull market it is not uncommon for the S&P 500 index to hit 50 new highs in a year and to sell on the back of a high being reached is not a great idea.
*TOPIX is the Tokyo Stock Price Index a broad based Japanese stockmarket index. I understand it has around 1,600 listed stocks.
This blog is intended as general investment commentary and principally reflects my own views. It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions.