Time for new strategies with your bond exposure?

OOC Garnier

The volatility that struck global fixed income markets in May and June should prompt investors to consider strategies that will reduce risk coming from their bond exposure, investment experts argue.

At the end of May, Federal Reserve chairman Ben Bernanke prompted a sell-off in both bond and equity markets when he said the central bank would look to ease the pace of its $85bn-a-month quantitative easing programme if the US economy continues to strengthen as expected.

A number of analysts have called the end of the three-decade-long bull market in bonds after arguing that yields are likely to rise significantly once the world’s central banks start to unwind their unprecedented stimulus.

Pimco’s Bill Gross, for example, has predicted that bond returns are likely to be in the 2.5 per cent to 3 per cent range in the near future rather than the double-digit gains investors have witnessed in the recent past. Over the year to date, US 10-year treasuries have lost about 6.7 per cent, while 10-year gilts are down around 1.6 per cent.

Killik & Co head of research Mick Gilligan says the decline in bond valuations and the rise in yields that came with Bernanke’s tapering comments should act as “a clear warning” on the risk of destabilisation when central banks scale back their highly stimulative monetary policy.

“There is therefore an argument for holding a lower allocation to the asset class than historical average weightings,” he says. “We believe there are a number of strategies investors should now allocate new monies to in order to reduce the risk of current fixed income portfolios.”

Gilligan says investors with the risk-tolerance and time-horizon to withstand higher volatility should consider lifting their allocations to equities. “We believe a defensive equity portfolio should deliver a greater total return than a bond portfolio over the longer term, given current relative valuations,” he adds.

Furthermore, the analyst points out that the London Stock Exchange’s retail bond order book has “developed significantly” since its launch in February 2010 and offers investors the ability to choose from a wide range of issuers and purchase holdings with lower denominations than those previously available. Investors willing to tolerate concentration risk could consider looking for individual corporate bonds here, he adds.

Gilligan adds that allocating to shorter-dated fixed income investments will reduce duration risk and offer a degree of insulation from central banks’ monetary policy moves, while noting that further diversification can be achieved through funds looking at alternative sources of income, such as residential mortgage-backed securities.

GAM’s Charles Hepworth, the investment director responsible for the firm’s DFM business, says the rise in bond yields after Bernanke’s comments “came as a surprise” to many market participants and has damaged the investment case for traditional fixed income assets.

“These developments reinforce our view that government bonds in the US, UK and Europe do not offer compelling opportunities. Furthermore, the recent strong correlation with equities implies these bonds are unlikely to serve their traditional purpose as a diversifier,” he explains.

Hepworth, who also argues that high-yield bonds are exposed to a “sharp pullback” after strong investor flows, says the increasing correlation between equities, bonds and commodities could mean absolute return products offer greater diversification than traditional government debt.

“With that in mind, we are overweight several absolute return strategies, including global macro, fixed income, FX and equity long/short,” he says. “Global macro strategies, for example, thrive in an environment of volatility and a resumption of higher cross asset class dispersion should be ideal for realising strong returns.”