How many times have you heard fund managers and asset allocation experts say in recent months that equities are cheap and bonds are expensive? Well, they’re not. “Equities are not cheap. They are not throwaway cheap or scarily cheap,” says John Patullo, head of retail fixed income at Henderson and co-manager of a string of Henderson funds, including its £1bn Strategic Bond fund and the £1.3bn Cautious Managed fund.
Of course, a bond fund manager would say that, wouldn’t he. But Patullo takes you back a year. The same voices were saying we were in a bond bubble. And what happened? “In total return terms we are up 15-16 per cent. There has been yet another year of extraordinary performance by bonds. And everyone is wondering if it’s a bubble.”
The truth is, Patullo says, that bonds are not driven by value. Their price is a function of the asset-liability matching models of their buyers.
He accepts that investment grade bonds are looking pricey, having enjoyed a remarkable run over the past year, but he’s still a major holder of high yield. Strategic Bond continues to yield 6 per cent, a level Patullo is confident he can maintain without taking excessive risk.
He adds he’ll tell investors when we are in serious bubble territory – even if they won’t listen. “I generally speak my mind. When we are bearish on bonds, we have no problems saying so, such as in 2007. We said then that bonds were not good value. Yet we still took in £100m that year.”
Inflation is the perennial enemy of the bond holder, but, in Europe the lack of it is alarming in itself. The lack of inflation is symptomatic of a lack of growth – and Patullo fears that a spiral of decline will hit sovereign bond holders.
He says: “How does a country pay off its debt when its economy is shrinking? How do you pay off your mortgage when your salary is falling? Throwing liquidity at the problem is only a short-term solution. There will need to be write-offs, and for bond holders to actually lose money.” You can assume from this that he’s not a holder of southern European sovereign debt. Italy, he says, has already had a lost decade akin to Japan. “Europe is tough. We like the core businesses in the core countries. There is still lots of nasty news to come from the periphery.”
Government bonds make up just 2.4 per cent of the Strategic Bond portfolio, compared with 43 per cent in high yield and 38 per cent in investment grade.
Was that Economist cover on the French economy, that caused such as stir in Paris, unfair? “Look, France is not growing but taking on more debt.” But he warns “being short on France is popular, but has lost you lots of money.”
Junk has enjoyed perhaps the strongest rally this year, but Patullo is wary of the triple-Cs, which make up less than 3 per cent of his portfolio. Yes, many appear to be stronger and issuing decent earnings. “But the earnings are coming from cost savings, not growth,” he warns. But neither is he at the triple-A end of the market either, with no AAA holdings and just 2.9 per cent in AA. The vast majority of the portfolio is in BBB and BB.
So what does Patullo like? Watching the telly. Well, Virgin TV, because of its pricing power. He’s overweight cable companies across Europe, as they have became better at pushing through price rises for the delivery of broadband services. He also likes food and beverage companies, some mobile, and healthcare.
“I have to pump out 6 per cent a year but I’m confident that it’s achievable, sustainable and reliable. But if you want 9, 10 or 11 per cent yields then you are only asking for it,” he says.
The big risk for investors, curiously, is that the US economy starts to perform rather better than most people think. The US is way ahead of Europe in dealing with a balance-sheet recession, having de-levered at a much faster pace than us.
If credit begins to expand in the US, we could start to see a rise in yields on US Treasuries which in turn will drag up bond yields across the globe.
He watches the Federal Reserve surveys on business lending very closely. “There is now evidence that individuals and corporates want to borrow again. The irony of the credit bubble is that once it has stabilised, people feel able to borrow again, but now at absurdly low interest rates. Commercial lending is picking up, and corporates are borrowing again. Credit is just beginning to grow. But there’s no evidence of that in Europe at all.”
That said, he thinks Europeans should thank their lucky stars that Mario Draghi replaced Jean-Claude Trichet as president of the European Central Bank. “He’s done a fantastic job” says Patullo.
Closer to home, he notes the IMF’s recent downward reassessment of the UK’s long term growth prospects, with trend growth expected at 1.75 per cent rather than the 2.5 per cent of the past. For now, bond investors can be confident that inflation will remain low, and probably so for five years hence. But further out, it’s a much tougher call. One gets the impression that although Henderson is confident that bond returns will be decent for the next few years, it won’t be that long before Patullo will say it’s a bad time to buy.
Patrick Collinson is the Guardian’s personal finance editor