How long do you see the current preference for bonds over equities persisting?
Until equities start performing. We saw 30-odd years where investors never really believed in bond markets because of their experience in the two decades prior to 1980. It took people a long time to overcome that aversion to fixed income and, by the time they did, yields in the UK had fallen from 15 per cent to 4 per cent.
Now investors have an aversion to equities and plainly that is equally wrong because some of the global dividend yields you see look great opportunities. I am by no means suggesting investors sell all their equities and buy fixed income – on an absolute valuation basis, you must think equities are starting to look attractive.
But it will take a long while before people fall back in love with equities and, while inflation is relatively low and central bankers are keeping yields down artificially, you could argue there will be no reason for people to move out of bond funds. When you are getting 0 per cent from your bank, 3 or 4 per cent from a corporate bond fund is going to look attractive in relative terms.
For UK investors, having some flexibility now seems sensible – if I do see the end of the world coming for bond markets, for example, I can use say, gilt orUS treasury futures to go negative duration and so still make money – as does gaining some global currency exposure.
What worries you about sterling?
UK investors have so little exposure to overseas bonds, which in recent years has been fine. Sterling has appreciated 15 per cent since 2009 so the fact there is a UK bias in the retail bond space has worked very well. The UK has very low interest rates, QE, good credit valuations and a strong currency but I just feel there is a good chance it loses its AAA credit rating because austerity is not working.
People look at the eurozone or the Great Depression and feel relieved the UK is not doing that badly. It is not – it is doing worse. At the same time, it has a huge current account deficit. Over the last 40 years, every time that deficit has reached around 3 per cent, sterling has depreciated at least 20 per cent against our trading partners – and we are back there now.
As a result, investors may well start seeing a good portion of returns from bond funds coming from sterling depreciation rather than, say, the capital gains from government bonds that have helped drive returns for the past two years. It is probably time for investors to start looking elsewhere.
What areas do you currently find attractive?
High-yield is our preferred place to be. If you look at the high-yield default rate right now, it is about 2 per cent a year yet the markets are pricing in anywhere up to 7 per cent annual default rates in the high-yield market. While it is very possible the default rate does edge up, it is not going back to peak levels.
Also, from a bottom-up perspective, high-yield companies have already borrowed money for five or 10 years forwards as they were worried the market was going to be closed to them following the credit crisis. They just do not need any cash so, without wanting to tempt fate, there is not much else that could make them go bust over that period. As a result, we have more than 20 per cent of the fund in high-yield bonds in Europe and also the US, where the stronger economic outlook makes it our preferred area for credit.
We also like some residential mortgage-backed securities or covered bonds – AAA-rated bonds issued by, for instance, UK banks. When they were issued, they were more than 200 – and in some cases 300 – basis points over government bond yields for a AAA-rated asset with security of the property underneath.
We also own index-linked corporate bonds, which is a good area to get credit risk because they are slightly less liquid but offer compelling yield. For instance, Tesco has a five-year inflation-linked bond maturing in 2016 – I could either buy a traditional Tesco bond at a little more than one percentage point over gilts or I could get this at two percentage points over gilts. It looks much better value than the ordinary bonds.
What about emerging market debt?
On the whole, we have negative views for two reasons. First, we see China as a bit of a credit bubble. The authorities have unleashed credit on the population as a way of stabilising growth around 8 per cent a year. People would love it to grow at 10 per cent but, with the resulting wage growth meaning China is no longer the cheapest place in the world to do business, the reality is it ought to be growing at 5 per cent. It will be a slow pull-down that may involve some bubbles bursting, which is not great news for the emerging markets that provide it with cement, copper and other raw materials.
Second, I look at my competitors in the global bond space and there are some huge funds with 80 per cent of their portfolios in local currency emerging market debt. Five years ago foreigners owned 30 per cent of Peru’s bonds but now it is 60 per cent and the same thing is happening across emerging markets. Valuations have moved stupidly – Brazilian government bonds now yield just one percentage point more than US government bonds – and everything is out of whack with the economic fundamentals.
When this sort of ‘hot’ money starts leaving again – as we saw with the Asian crisis in 1997 – it can have some significant impacts on both economies and asset valuations. So while we like Mexico, we have negative positions in Brazil, Russia and elsewhere. That makes us very different from our competitors in the global bond space.
Julian Marr is editorial director of Adviser-Hub