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Lower for longer: finding value in Bonds

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Understanding Asset Classes: know what you have, and why you have it

This article forms the first in a series on asset classes. It’s easy to break down portfolio structure to simply diversifying between defensive and growth assets to deliver the appropriate balance of risk and return for your client’s chosen risk profile. But in this series, we dig deeper into our expectations of each class, and how we use those key characteristics in our different solutions.

Looking backwards, fixed interest has been a great place to invest money; equity level returns but without equity level risk. Essentially, a great risk/return trade off. Or, to be slightly more technical, the asset class has offered very good risk-adjusted returns. Given the breadth of the fixed interest market, that is undoubtedly a bit of a generalisation, but to add some colour, UK Corporate Bonds provided an annualised total return of 6.10% over the last 20 years compared with 4.83% for the FTSE All Share. And with less than half the volatility.

Quantitative squ-easing

Why not just hold bonds and be done with the equities altogether, then? The problem with this seemingly rational logic (given the numbers quoted above) is that falling interest rates have been a key driver of returns historically and there’s a limit to how long that can continue. The yield on a 10-year UK Government Bond in 2000 was over 5% and at the time of writing, the same investment provides a mere 0.13% per year. Falling yields also lead to capital appreciation for bond holders, as their ‘locked in’ income stream becomes more valuable. So, with yields this low and interest rates seemingly at rock bottom, (I will save a discussion of negative interest rates for another time), has all value been squeezed from the bond market?

Playing the field

The journey down in yields has been a good one for Passive fund investors in particular. Broad market exposure and a generally higher sensitivity to interest rate changes – relative to Active managers – has offered a meaningful tailwind to returns. But Active managers have more levers to pull, which is particularly important when the interest rate lever is already at max.

Credit quality, sector, country: an Active manager can vary these aspects of a portfolio. The equivalent Passive manager is matching the holdings of its benchmark index – with positions generally weighted based on the size of bonds within the market e.g. indebtedness. To give an obvious example, going into this year with less money in transport sector bonds and more in healthcare would’ve offered some protection as markets fell. And some of the price dislocations and stretches in value experienced since the Feb/March sell-off offer even more opportunity for Active managers to add value, in our opinion.

Finding Conviction

With this in mind, we’ve increased Active exposure to UK Corporate Bonds and Global Strategic Bonds within our PIM Strategic Conviction portfolios. In this solution we have flexibility to vary the amount in Active or Passive funds, at an asset class level. The ability for an Active Corporate Bond manager to have discretion over the type of company they lend to is particularly important for us given the current economic uncertainty. The same is true for a Global Bond manager, where the opportunity set is even greater.

The benefits that fixed interest brings to a multi-asset portfolio can’t be understated. Often a large proportion of a lower risk client’s portfolio, the asset class can provide a regular income stream through contractual coupon payments and a return profile that offers a hedge against falling equity markets. With returns quite unlikely to match that of the last 20 years, an Active manager’s ability to navigate the market is an additional benefit we hold in high regard.



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