Low yields and rising correlations with stock markets make fixed income an unattractive diversifier from more risky equities, according to Ben Willis, head of research at Whitechurch Securities.
Bond funds have traditionally been seen as the primary diversifier from equity markets thanks to their ‘contra-cyclicality’. More simply put, when one goes up the other goes down and vice versa, which helps to soothe volatility.
Performance of indices over 20yrs
Source: FE Analytics
However, Willis((pictured) says he and the Whitechurch Securities team are minimising holdings in bond funds and instead looking to two popular portfolios to offer a similar performance.
“We continue to have limited bond exposure and where we do hold bonds we maintain a preference for corporate over government bonds. Although corporate bond yields have also reduced, at current levels they still look attractive relative to the yields on government debt,” he said.
“With the correlations increasing between traditional asset classes, we will continue to seek out alternative areas that can improve diversification. The demand for bond substitutes is leading to a greater choice of ‘absolute return’ funds that aim to generate a positive return irrespective of market conditions.”
“We use these funds to reduce cyclicality and spread risk in portfolios. However, if investing in these funds it is important to be selective and understand the wide ranging differences in risk and reward profile that these funds can offer.”
Absolute return funds seek to make a positive return over a given period regardless of market conditions and Willis is opting for two in particular to replace the function of bond funds across his portfolios.
These are the £9bn Newton Real Return fund, headed by FE Alpha Manager Iain Stewart, and the £5bn the Invesco Perpetual Global Targeted Returns, run by David Millar, Dave Jubb and Richard Batty.
“In these extremely volatile periods, funds such as Newton Real Return and Invesco Perpetual Global Targeted Returns have been particularly impressive in producing steady positive returns year to date,” he said.
A recent FE Trustnet study found Newton Real Return has been one of the most consistent absolute return funds of the last decade. It has made a positive return in nine of the past 10 calendar years and in its only down year – 2009 – it was just saw a small fall of 0.35 per cent.
Stewart, who has headed the fund since 2004, has an investment process that aims to generate returns of cash plus 2.5 per cent while maintaining a volatility between that of equities and bonds.
This has worked well over the manager’s tenure with the fund ahead of the FTSE All Share index in terms of total return with much lower volatility.
Performance of fund and index under Stewart
Source: FE Analytics
The portfolio is a mixture of high quality defensive equities as well as government, corporate and index-linked bonds. There are also some commodities, infrastructure and floating rate notes as well as index futures and options to hedge against equity market risk and cash.
The fund has a clean ongoing charges figure (OCF) of 1.11 per cent and yields 2.12 per cent.
Invesco Perpetual Global Targeted Returns, launched in September 2013, aims to deliver equity-like returns of LIBOR plus 5 per cent with less than half the volatility of equities over three-year rolling periods.
The strategies employed in the fund are very different to Newton Real Return, which results in a low correlation since launch between the two.
It has made a very strong start since its launch, delivering 14.32 per cent – just a touch less than the return of the MSCI World index.
Performance of fund and index under manager tenure
Source: FE Analytics
Presumably, this has been a key driver of the fact that it has been the biggest recipient of inflows in the past 12 months in the entire Investment Association universe – £3.7bn – our data shows.
It has a clean ongoing charges figure of 0.87 per cent and a small yield of 0.88 per cent.
While fixed income remains unattractive, Willis adds, bond markets have been doing well of late as fear of a global recession began to rise, leading to further falls in the yields of major government bond markets.
“Gloomy economic data saw central banks maintain a stimulative stance. The US Federal Reserve indicated that there would be immediate rate rises if US growth comes under pressure, whilst the European Central Bank indicated it would ease further and the Bank of Japan has moved to negative interest rates.”
In February 10-year gilt yields fell from 1.6 per cent to 1.34 per cent, whilst in the US 10-year treasury yields fell from 1.95 per cent to 1.74 per cent as expectations of further US interest rate rises continue to recede.
“Continued yield compression means that the bond conundrum remains one of the greatest challenges for investors as we move through 2016. Even more than ever, government bonds appear to offer ‘return free risk’ at these current levels.”
“We continue to believe that interest rates will be lower for longer and don’t expect the bond bubble to burst in the foreseeable future, just that returns will be uninspiring and not worth the risks attached.”
