Flexibility in the bond market will be essential this year, says Darius McDermott, managing director, FundCalibre, which is where strategic bonds may win out
Prior to the onset of the pandemic, I was pessimistic about fixed income. The asset class always seemed to defy my expectations, but I was particularly concerned by the fact that around 30% of the bonds issued by governments and companies worldwide were trading at negative yields.
The old saying goes that ‘you never hear the shot that kills you’ and the speed of the March sell-off due to the pandemic saw bond prices fall to significantly low levels. However, as prices fell, yields increased, and significant opportunities arose for investors.
Fast forward to the end of 2020 and the last nine months have seen strong returns for fixed income thanks to support from central banks and governments. Since March, the average return from a fund in the IA Sterling Corporate Bond and IA Sterling High Yield sectors was 14.9% and 29.1% respectively*.
Valuations are now back to levels seen at the start of 2020, so it would seem we’ve come full circle over the course of the year with bonds looking expensive again.
The combination of many developed world government bonds having negative interest rates and many companies cutting or postponing dividends, means corporate and emerging market bonds are likely to remain popular as they offer a higher and more predictable income. However, the global economy is still in recession and second and third waves of the virus are weighing further on company balance sheets. In this environment flexibility is a necessity – and that is where strategic bond funds should flourish.
Risks
As we know, beyond credit risk, there is also interest rate and inflation risk for bonds. While interest rate risk is unlikely in 2021, we recently saw the 10yr US governments bond yields go above 1% – a direct result of the Democrats gaining control of the US Senate with President Biden committed to spending money – always a harbinger for inflation.
Effectively, this move means there is more inflation in the economy than the market has priced in, but I still believe it will be at a manageable level for the next 12 months. Jupiter Strategic Bond fund manager Ariel Bezalel says while some people are worried about the prospect of inflation, he believes many of the developed economies “will continue to face a cold world of sluggish economic growth”. Ariel also cites the increasing debt taken on board to meet stimulus and the deflationary pressures facing markets – namely globalisation, the relentless downward pricing pressures of the internet, ageing populations and falling fertility rates.
Ariel adds that central banks in Japan and the EU have both tried – and failed – to get inflation up to 2%, so why should it be any different in the UK or US? “Central bankers know precisely what to do about inflation, it is deflation that keeps them awake at night.”
The easy money has been made but opportunities remain
You have to balance the pros and the cons for the asset class and accept the easy money has been made. Corporate bond funds are now yielding circa 2-3%, so there is not a lot of compensation for the risk you are taking – although there is still some capital appreciation to be made by skilled managers – while the default concerns remain very real in the high yield space. Nevertheless, we are in the midst of major secular change for markets, which will bring about a number of opportunities.
A good example of this is Baillie Gifford Strategic Bond fund manager Torcail Stewart, who has talked about positively responding to mishaps, even in some of those sectors where a recovery can take longer, like hotels, energy and hospitality. He says the key is not to target the most distressed companies, rather those where liquidity is excellent, the long-term business model is sound and valuation compelling. Essentially, the survivors where long-term market share gains are likely.
The average fund in the IA Sterling Strategic Bond sector has now returned 16.6%* since the March low. I’d say anything between 5-8% would be a good return in 2021 as the market continues to recover. It’s now a very congested market and you want someone who can demonstrate not only strong bond selection but proactive asset allocation to take advantage of those opportunities.
The Jupiter Strategic bond fund is a good option, Ariel Bezalel is quite cautious in his approach and emphasises limiting potential losses in tough markets. The aim is to achieve a moderate income, but with the prospect for growth. Another is the TwentyFour Dynamic Bond fund, which traditionally offers one of the highest incomes’ in the sector.
Those looking for a punchier option may like Invesco Monthly Income Plus, which also has the ability to invest up to 20% in equities and currently yields more than 4%**.
*Source: FE fundinfo, total returns in sterling, 23 March 2020 to 31 December 2020
**Source: Fund factsheet, 30 November 2020
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
This article was first published in the February issue of Professional Paraplanner.
