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Fixed income, what is it good for? Absolutely nothing?

22 November 2018

With bonds’ promise of inverse correlation not bearing fruit and little upside but plenty of downside for most corporate bonds, investors must look more widely for diversification and risk-off type assets, says Miton’s David Jane

With bond yields heading higher in most markets, leading to capital losses across the fixed income spectrum, it’s easy to question the role of the asset class. The Fed is seemingly committed to continued rate rises, and the ECB to withdrawing from QE, so rises in yields look set to continue. The equity market’s recent setback hasn’t seen a material fall in bond yields. If anything, the opposite has occurred. Bonds’ promise of inverse correlation isn’t bearing fruit.

The equity market has been fretting about an economic slowdown all year, but this hasn’t fed through into corporate bond credit spreads, implying the bond market is more sanguine about the economic outlook than equities. This is an unusual scenario, normally credit spreads would act as a lead indicator, suggesting that worries about the economy may be overblown. At the same time, spreads have little room to tighten further given they’re at historically low levels. The risk is that conditions deteriorate, leading to credit losses.

There’s been commentary on the high levels of corporate debt in the economy, reflecting a very long period of expansion, share buybacks and general optimism. While superficially this is the case, ultra-low interest rates have made this debt highly affordable – so debt service expenses are far from a problem.

Even with expected interest rate rises, on most realistic scenarios interest costs will still be very manageable for the average company. However, this average hides the fact that there are plenty of zombie companies already struggling to service their interest bill, despite a benign economy and favourable investment market. As interest rates rise, or if the economy takes a turn for the worse, investors will be less willing to lend to companies without the means to repay. This draws us to conclude there’s little upside and plenty of downside for most corporate bonds.

The historic purpose of bonds was as a low risk income generating diversifier, which performed well when equities were weak. This appears to be no longer the case. Most scenarios that are negative for equities are also negative for bonds, unless, despite the evidence, you continue to believe in the negative correlation of government bond yields to equities. If you do believe in this flawed relationship, you will need an awful lot of currently loss making long dated bonds to balance a small position in equity, a recipe for negative real returns.

Investors must look more widely for diversification and risk-off type assets in the current environment. While we can hold a position in short dated corporate bonds, expecting a small return from the income and our capital back from maturity, this is unlikely to generate much return. Ultimately, we must recognise it’s a strategy dependent on a continuing benign economy. As a result we’re always on the lookout for reasonably priced assets that can deliver a return that’s broadly uncorrelated to the economic cycle.

The valuation of all assets is a function of interest rates but we can find some protection from the main driver of interest rate rises, inflation. We currently favour lowly indebted infrastructure equities, particularly where they’re less economically sensitive. These assets can often grow revenues close to nominal GDP, giving some protection against rising interest rates, particularly if their debt is long dated. We have holdings in airports, railroads, pipelines and telecommunication networks. Clearly, each comes with a higher degree of equity beta than corporate bonds and has its own amount of sector specific risk, but as lower risk assets than mainstream equities, they can provide some buffer to equity volatility.

We have been building our position in REITS, although it’s still at a low level. Property is valued closely off interest rates and most REITS have significant amounts of debt, but rising inflation is a big driver of rents. We have also been increasing our exposure to gold, another risk-off inflation hedge. In some funds, this is through a direct gold ETF, in others via gold miners.

Diversification is very difficult to achieve at present, particularly in the simplistic approach of combining long dated bonds with equity. A more nuanced approach is required, considering the risks we’re trying to diversify away, and recognising that equity beta is much more unavoidable than it has been for some time.


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