Bond investors face three significant challenges in the current investment environment, according to Liontrust Asset Management’s global fixed income team, although there are opportunities for those willing to look for them.
The first challenge, lack of yield, can be explained by looking at the UK government bond space.
During 2020, the UK government borrowed billions of pounds to offset the economic impact of Covid-19. This large-scale borrowing followed more than a decade of ultra-low rates, as well as quantitative easing (QE), in the wake of the global financial crisis.
“This all matters to investors because of the impact this has on bond markets and returns on investment,” the team said.
“First, the yields on government debt have tumbled since 2008 because of low interest rates, QE and investor demand for ‘safe’ assets.
“This means investors have made good total returns from government bonds over this period but yields now do not have much further to fall even though some countries have experienced negative rates.”
Currently, a 10-year gilt will provide a yield to maturity of 0.29 per cent – down from a range of 4 per cent to 5.5 per cent over the first eight years of the century, as the below chart shows – and is even lower when you take inflation into account.
And for some shorter-dated gilts, yields are already negative in nominal terms.
But while it might seem ‘logical’ for bond prices to fall and yields to return to more normal levels at some point, the team said, central banks still have significant powers to control and manipulate markets by bond buying.
And this is where investors face the second challenge, greater interest rate risk.
This can be seen in higher levels of duration – how sensitive a bond is to interest rate movements – more recently, with the Bloomberg Barclays Global Aggregate index (a composite benchmark of government and government bonds) increasing from 5.5 to seven years over the past decade.
“If a bond investor has lower duration than the market average – and bond prices generally rise while yields fall, then their bonds will rise by less; if market-wide prices fall, a lower duration portfolio will fall by less,” it noted.
“Going back to the rise in duration of the Bloomberg Global Aggregate Index, market-neutral bond investors now need to own bonds with an average duration of 7.5 years or risk their portfolios having different interest rate sensitivity than the market average.
“This means investors are having to take on more interest rate risk to match the index of government and corporate bonds.”
The third challenge to bond investors is how expensive these assets have become.
Nevertheless, there are opportunities for those willing to seek them out.
“Prices and yields for different areas of bond markets will not always move in the same directions at the same time,” the Liontrust team explained.
“Choosing the correct exposure to the yield curve is therefore very important. The same is true of choosing your allocation between government and corporate bonds and your credit risk – which governments and companies you are comfortable lending to at the available yield.”
The global fixed income team said one of the most powerful tools at its disposal is the ability to look beyond government bonds to the corporate bond market.
“For example, we hold Netflix in our Liontrust GF High Yield Bond fund and its 2030 bonds offer a yield of 3 per cent,” the team highlighted. “We recognise there are credit risks: before the crisis, Netflix still invested more cash than it generated because it is growing so quickly, and well-resourced rivals like Amazon, Apple and Disney ensure a very competitive market.
“Netflix, however, has more than 140 million subscribers who we think have a reasonable degree of brand loyalty.”
The team continued: “We also view content streaming as non-cyclical; customers will retain their £9 [per] month subscription during tough economic times, as shown by its subscriber growth during the pandemic.
“We think Netflix’s default risk is low and, if needed, the company could swiftly switch to cash generation mode by toning down its investments.”
There are also opportunities to be found by being selective and flexible, the team noted. However, there are also more idiosyncratic risks that investors need to be aware of, such as exposure to energy prices or financial services contagion.