The majority of fixed income investors have been hit with capital losses at points over the last 12 months with bond yields trending higher in the expectation of a normalisation in US monetary policy.
Bonds, such as gilts and treasuries, have performed better in 2014 than they did last year but Coombs – who is head of multi-asset investment at Rathbones – says that the asset class will serially underperform over the coming three to five years and is holding high levels of cash to mitigate that risk.
“One thing people forget is that you are getting higher duration, lower credit quality and lower nominal yields than history in the bond market,” Coombs said. “At some stage, someone is going to look at this in five years’ time and say, “what were we doing?” The average rating on a bond fund is BBB, you have ridiculously low nominal yields, almost negative real yields and higher duration. What were we thinking? Bubble?”
The FE Alpha Manager added: “So, yes, we are very low fixed income.”
A number of experts have warned that a multi-decade bull market in bonds is coming to an end. For instance, FE Alpha Manager Marcus Brookes is also holding a very high level of cash across his Schroder MM funds as he warns that the asset class is so expensive that it can no-longer be viewed as a safe haven.
Prices on fixed income assets have already begun to fall over the last 12 months.
Performance of indices over 1yr
Source: FE Analytics
The initial sell-off in May was sparked by Fed Chairman Ben Bernanke warning the market that he would consider tapering quantitative easing.
Bonds have performed much better so far in 2014 as investors have been concerned about the immediate outlook for equities, but the majority of experts believe that this is nothing more than a pause in a largely downward trend.
Coombs agrees and says investors will have a very painful, and long, period of capital losses in the asset class from here.
“I think another thing about bond markets that people are getting wrong is that most people are looking back to 1994 as the last bear market in fixed income,” Coombs said.
“You have got to remember, yes that was a grim year for bonds when the Fed raised interest rates and shocked the market, but nominal yields were north of 5 per cent.”
“Even though you had capital losses, your income more or less offset that, meaning that you would have had a flat return which wasn’t great, but not disastrous.”
Both bonds and equities were hit in 1994 when Alan Greenspan raised rates unexpectedly with FE data showing that both the US treasury market and the S&P 500 delivering a negative return that year. However, Coombs says this time the outlook is far worse.
Performance of indices in 1994
Source: FE Analytics
“Now your nominal coupons are so low, with gilts at 2.5 per cent and US Treasuries about the same, you have even less cover than you had in 1994,” Coombs explained.
“This bear market could be much worse than 1994, it just might not be quite as quick. It may be a very nasty two or three years, whereas 1994 was more like an equity correction.”
“This could be a much nastier bear market that keeps eroding capital, not a shock or V shaped recovery like in 2009 when you made money very quickly on the way back up.”
As head of multi-asset investment at Rathbones, Coombs manages their Multi Asset Strategic Growth, Total Return and Enhanced Growth Portfolios which have proved popular with advisers due to their risk and volatility targeted mandates.
His high weighting to cash has helped him protect capital during this so far turbulent year.
For instance, cash makes up 20 per cent of his Rathbone Multi Asset Total Return Portfolio and it has delivered a positive return in 2014 while global equity markets have fallen.
While Coombs is very bearish on traditional fixed income assets such as government bonds and investment grade corporate credit, he thinks investors who are piling into high yield for carry are making just as big a mistake.
It has been by far the best performing area of the bond market over recent years. According to FE Analytics, the average fund in the IMA Sterling High Yield sector has delivered a similar return to the FTSE All Share over five years, but with half the volatility.
Performance of sector versus index over 5yrs
Source: FE Analytics
A number of experts have warned investors about the now very low yields on poorly rated credit and Coombs agrees that the outlook for high yield bonds looks uncertain.
“Is there a danger in high yield? From a default perspective, probably not and that is because we are in an economic recovery but in terms of return for risk employed, it is very, very poor. On a risk reward basis, it is totally unattractive. Would you enter high yield now? No.”
The manager says that high yield, as an asset class, isn’t too affected by changes in interest rates. However, given that nominal yields are so low, he says high yield is as susceptible to a rate hike as he has ever seen.
He says he understands the reasoning behind buying high yield now because he doesn’t expect defaults to rise at any stage in the immediate future, but he warns that the asset class now carries a huge amount of risk.
“With nominal yields so low, there is not much protection for the coupon. Unfortunately, a lot of strategic bond managers are overweight high yield over investment grade and on a relative basis that looks good because of the carry.”
“Also, with interest rates not expected to rise significantly because inflation is falling, you could get trapped into saying high yield is still good value. If interest rates stay low and inflation falls to 1 per cent, than yes it looks alright.”
“However, the problem is you are priced for perfection. It looks like 2007 at the moment, or much worse.”