A feature of markets in recent years has been the steep rise in yields offered on gilts and US Treasuries.
There has been some pull back, with the 10-year UK government bond presently (February 28) being above 4 per cent.
As the prevailing rate of inflation falls, certain parts of the government bond market now offer a yield thatcompares with inflation or surpasses it.
In such an environment, does a client need to worry about being diversified when it comes to fixed income?
An active and flexible strategy, able to tactically adjust positioning, can potentially generate strong risk-adjusted returns with a steady income stream in an array of economic environments.Nicola Mai, Pimco
Craig Inches is head of rates and cash at Royal London, and says the key to diversification may be around the duration of the bondexposurerather than the type of bond.
He says the yields on short-term bonds are presently such that even a material fall in yields would still mean they offer a better return than cash.
Inches adds that longer-duration government bonds are now at a level of yield that, even if bond prices fall from here –bond prices falling sends yields higher –the current yield may be high enough that it offers a cushion for any capital losses that occur along the way, that is,the income collected could be enough to see an investor in profit overall.
Nicola Mai, an economist at Pimco,says: “While fixed income markets have the potential to weather multiple macroeconomic outcomes, an active and flexible strategy, able to tactically adjust positioning, can potentially generate strong risk-adjusted returns with a steady income stream in an array of economic environments.”
David Roberts, bond fund manager at Nedgroup, says the landscape for bond investors will be radically different in the coming years, the determinant of returns being more likely individual bond selection than the duration, which has powered returns to date.
Duration is the measure of the impact that movements in the base rate have on the price of a bond.
Roberts says he believes that the era of very low interest rates and bond buying by central bankscreated fixed income markets where the only thing an investor had to get right was duration, by being either short or long, as individual bond selection was made irrelevant.
In that environment, an investor who was able to understand the drivers behind inflation and ratescould make money, almost regardless of the bonds they bought, but Roberts saysthat as those policies unwind, markets will change.
Time marches on
FrédéricTaché, head of fixed income at St James's Place, told FT Adviser that in general they prefer to see fund managers focused on getting duration right, rather than taking extra credit risk.
But he says the key lesson from 2023 was that bond markets were mostly in negative territory, until the final quarter, when a sharp shift in rate expectations caused a rally in bond markets andmany portfolios ended the year in profit.
Tache says if one believes that rates are likely to fall roughly in line with what the market expected at the end of last year, then the logical thing to do is buylong-dated government bonds, and nothing else.
But even since the start of 2024, markets have rushed to reprice bonds based on the view that central banks may not cut rates at the trajectory that was expected in the final quarter of last year.
This may be why investors who own either the UK bond market indexor the global bond market indexhave lost money so far in 2024.
Tachésays there is considerable risk attached to trying to second-guess how central banks will act, but also around how they will communicate before acting, with the latter also capable of moving fixed income markets.
With this in mind, he says it is justified to own a portfolio that is broader than just government bonds or cash, despite the intuitive appeal of owning those assets when rates fall.
Edward Harrold, fixed income investment director at Capital Group, says that if one had focused simply on owning long-duration bonds in anticipation of a recession and of rate cuts, “one would have missed out on a lot of returns, because assets which might not have been expected to do well in those market conditions, such as emerging market bonds, actually performed well”.
Kelly Prior, part of the multi-manager team at Columbia Threadneedle, says the options available to bond investors have expanded massively in recent decades.
She says that “at one time there were no high yield funds in the UK”,and thatthe advantage of owning a range of different bond funds is that“some will work in periods of time when others don’t.
"We own the Allianz Strategic Bond Fund, for example, and that has had periods where what they do hasn’t worked, but we are confident it will work when some of the other bond funds we have won’t”.
Her overall approach to building a fixed income exposure in portfolios is to “think about how particular parts of the bond market relate to the equity holding we have in a portfolio. So if we have a lot of growth equities at any one time for example, that would impact how the fixed income exposure is constructed.”
Stuart Chilvers, fixed income fund manager at Rathbones, agrees that one of the characteristics of fixed income markets right now is that at current prices, bonds do represent diversifiers in the event of certain economic conditions and market events, and that this was not the case prior to the pandemic.
His says his view is that owning just government bonds or long-duration bonds only offers diversification against a small range of the possible outcomes.
David Thorpe is investment editor of FTAdviser
