One consequence of central banks slashing interest rates around the world, is that companies and governments who need to combat the economic effects of coronavirus are able to borrow cheaply.
However, the consequence for bond investors is that in aggregate, bond yields are likely to remain low, with passive investors bearing the brunt of the risk, several bond managers have told Trustnet.
Passive bond index investors faced a duration of about five years and an average yield of 5.6 per cent 20 years ago, but passive corporate bond investors today face a duration of roughly eight years and a yield just above 2 per cent.
This has made the trade-off between return and risk “pretty unfavourable”, according to Jeff Keen, head of fixed income at asset manager Waverton, who believes “the sensitivity of investing in fixed income generally has gone through the roof”.
“This is because when bond yields move around, that generates most of the return rather than the carry from the bonds you own,” said Keen.
“If you’ve got 2 per cent per annum, that’s roughly 16 basis points per month. Those 16 basis points can be wiped out very easily by a one basis-point move in the underlying yield of those bonds. “If the yield goes from 2 to 2.01 [per cent], you’ve just lost all the income collected from that one month.
“It’s a very dangerous fixed income market and being in a passive vehicle is not the way to go.”
He continued: “What’s more, if you were to buy an equity index, [with] the market-weighted share of each company you get a bigger share of the best companies, the companies that are performing best are driving performance.
“But when you buy a bond index it’s very different because you are buying a much larger allocation to the heaviest issuers of debt. It’s actually the companies that are issuing more debt like financials, automakers and utilities, which is very different to what you see in equities.”
Peter Doherty, head of fixed income at Sanlam and manager of the £163m Sanlam Hybrid Capital Bond fund, agreed that passive investment grade credit bond funds are taking on significant duration and inflation risk.
The manager said although a passive bond investor does benefit from a very diversified portfolio – ie: not much idiosyncratic or credit risk – “you are getting systemic risk of reflation, or rise in rates, or anything pushing up yields”.
He explained: “You will be offside for quite a long time because your carry isn’t anywhere near enough to make up for capital loss in the event yields go up a bit.”
Compensation for interest rate risk
Source: Bloomberg Barclays
Doherty added: “If you own an eight-year duration fund with a two per cent yield, you only need 25 basis points of increased yield and you’ve lost a year’s income.”
“Let’s say you have a 100 basis-point increase in yields – e.g. the inflation genie comes out of the jar and we get 100 basis points – at that point your fund is yielding 3 per cent, but it will take you more than three years to get back to zero from your carry.
“If you’re matching liability that’s one thing, but if you are taking that from a total return view, then it is super risky,” he said.
Doherty said: “What I don’t understand is, you buy the index and think it only has a 0.3 per cent cost, the reference securities and behaviour is very similar to our fund, but over four years you get half the return, and that isn’t right.”
Keen, who runs the £325m Waverton Sterling Bond fund, mitigates duration and inflation risks to his fund through inflation-protected bonds and various option strategies that passive vehicles like exchange-traded funds (ETFs) typically can't buy.
He said: “We look a little bit off the main track - for forgotten issuers, slightly smaller issues on occasion, sometimes unfashionable sectors - to really try and find those opportunities that will generate more income and less duration.”
Donald Philips, fixed income manager and co-manager of the £345m Liontrust Strategic Bond and $93.6m Liontrust High Yield Bond fund, said that with very low yields and high interest rate risk, “there’s never been a worse risk-adjusted potential in the investment-grade space”.
He said: “Many corporate bond funds that are calling themselves stockpickers are matching the duration of an index. So they’re running 7 or 8 [per cent] duration, and I would include them [with] the ETFs [exchange traded funds] that are running risks against duration.
“I think the risk lies is the attitude of ETF managers and high yield bond funds that have 200 or 300 bonds in the portfolio.”
He explained: “They tell their clients they take small positions in each issuer to reduce the impact of a default on the fund, while we have 1 or 2 per cent positions where a default may cause us problems. We differ, in that we are completely happy to completely ignore certain parts of the markets, [and] not owning certain sectors.”
“An ETF or a large 200-300 bond fund will have probably close to neutral index weights and that’s where the negative selection of the market kicks in – i.e. in sectors that have been large borrowers, such as the US shale market.
“I think the risk lies in the energy sector where the accumulation of many companies has taken the index weight to something like 13 per cent, so a manager running pretty close to index neutral will have 13 per cent in energy.”
“So periods such as April and indeed five years ago when the energy market runs into problems, what you end up seeing is a liquidation and crystallisation of losses.”
He said the same argument could be made for many other sectors such as retail, for example.
“A good active manager five years ago would have wanted to trim bricks & mortar retailers, while an ETF will have just accepted the index weight,” he said.
Finally, Philips said there should be some consideration from a societal perspective in today’s environment where there is a greater focus on ESG (environmental, social & governance) issues.
He concluded: “We should be here to actually allocate capital in a society in an efficient and responsible way that benefits everyone at the end of the day, but ETFs are just buying whatever’s available.”