There is no bubble in the bond market which is about to burst, according to FE Alpha Manager John Pattullo, who has been adding duration – or interest rate sensitivity – in his £1.3bn Henderson Strategic Bond fund in the expectation of lower yields. 
Fears of a structural bear market in bonds have been ever present in the industry over recent years, but as an increasing number of fund managers position for such an outcome, yields on bonds have continued to fall.
This year has been distinctly different, however, as prices of perceived ‘safe’ developed market government bonds fell uncharacteristically as economic growth seemed to be improving, investors kicked-back against negative real rates in some parts of the world and, at the same time, there was a lack of underlying liquidity.
According to FE Analytics, UK gilts, US treasuries and German bunds have all posted losses since the middle of April.
Performance of indices since April
Source: FE Analytics
This has led many to believe that a bubble in bonds is about to burst, especially as there is talk of interest rate rises in the US and the UK. These fears have recently hit the mainstream media as well, with BBC’s Newsnight running a feature on the potentially dire consequences of a major back up in fixed income yields.
The likes of Nigel Green, founder of deVere Group, say investors need to act now to make sure their portfolios aren’t exposed to the threat of a fixed income crash.
“There could be a perfect storm brewing for many retirees, and those nearing retirement, which could lead them to potentially becoming unstuck in their retirement planning strategies. This is because the much-anticipated US and UK interest rate rises are likely to burst the bond bubble,” Green said.
However while Pattullo, who runs Henderson Strategic Bond with fellow FE Alpha Manager Jenna Barnard, says the recent falls were “frightening”, the fears over the future of bonds are overblown as he can’t see a reason why yields would spike massively from here.
“We have never bought the idea of being short bonds, as many believe is true, and that is because we still don’t think there is enough growth in the world,” Pattullo (pictured) said.
The manager says global growth is going to remain weak for a long-time to come (which in turn will make bonds attractive) as there is still too much debt in the system, over-capacity in the economy and an ageing global population.
He also says inflation, which if it were to ramp up would seriously hurt bondholders, is only going to remain low or fall further from here. Firstly, he says consumer price indices (CPIs) are set to remain weak thanks to the huge falls in the oil price both last year and over recent months.
Performance of indices since January 2014
Source: FE Analytics
Pattullo also says recent events in China are very deflationary for the global economy.
Fears over China’s slowing growth has been a macroeconomic headwind over recent years, but they have really come to the fore over recent months as the country’s authorities had to step in on a number of occasions to offset that trend and try to instil confidence in markets.
The most recent of those was the central bank’s decision to devalue the yuan, which prompted further fall in its equity market. Patullo says that not only are these developments bad for the Chinese economy, but also for the global financial system.
“China is a huge contributor to global growth and as a commodity importer, and it’s in a super down-cycle. Emerging markets, in general, are tethered to the commodity super-cycle and China has borrowed a lot and spent a lot on infrastructure, and that is unsustainable.”
“They have also decided to devalue their currency and that again is deflationary.”
With global growth set to remain weak and disinflation or even outright deflation on the cards, Pattullo says investors are wrong to be bearish on bonds. In fact, he has been upping his exposure to longer duration assets, or those which are more sensitive to interest rate movements, within his fund.
“No, I don’t think there is a bond bubble. If there is going to be no inflation, you should be buying 30-year gilts at 2.6 per cent. If you do think inflation is coming, then you shouldn’t, but I don’t really see where that inflation is going to come from.”
“I think a lot of our competitors are running short duration thinking bond yields are going to rise. We have been adding to our duration exposure as we think bond yields will actually move lower from their current levels.”
Nevertheless, many experts – such as Invesco Perpetual’s Martin Walker – say the biggest threat to investors is an unexpected spurt in economic growth which will cause inflation (which is currently running at 0.1 per cent in the UK) to surge higher.
They point to the fact that the falls in the oil price will soon be “anniversaried-out” of the CPI figures and that there is already signs of underlying inflation ramping-up, with data suggesting wage growth and falling unemployment in both the US and UK.
Pattullo says, though, that slowly improving labour markets aren’t strong enough to offset all the other deflationary forces facing the global economy.
There are others who believe that when the US Federal Reserve and the Bank of England do raise interest rates to curb potentially higher future inflation, it would cause a “brutal” and “devastating” sell-off in fixed income.
Again, however, the FE Alpha Manager sees no reason why the central banks would tighten monetary policy as with inflation so low, he thinks further quantitative easing could even be on the cards.
“They could have got away with it a few months ago but if they start raising rates now they could be making a mistake and look stupid. They are in a really tough place now as China is blowing deflation all over the world,” he said.
“The point is, there isn’t another China out there as the likes of India or Brazil aren’t going to be able drive global growth to the extent China did. I think it is quite amazing that we are talking about a lack of growth and inflation after $116trn’s worth of QE has happened since the crisis.”
While Pattullo is quite positive on bonds, he has performed well in 2015 despite the negative sentiment towards his asset class as all three of his IA Sterling Strategic Bond funds (Henderson Strategic Bond, Henderson Preference & Bond and Henderson Fixed Interest Monthly Income) currently sit in the top quartile this year.
This has added to the manager’s decent long-term numbers. For example, our data shows his Strategic Bond fund is firmly top quartile since its launch in November 2003 with gains of 95.59 per cent.
Performance of fund versus sector since launch
Source: FE Analytics
It is also outperforming its peers over one, three, five and 10 years having beaten the sector average in eight out of the last 10 calendar years.
The four-crown rated fund sits on the FE Select 100 as it is highly rated by our research team, who describe Henderson Strategic Bond as “very good option for those who want to make money from their bond allocation over the longer term”.
“This is a genuinely ‘strategic’ bond fund in that it is flexible and can use derivatives extensively,” the team said.
“The managers are very skilled in employing this freedom, although it does result in a fund that is a little more volatile than many bond funds. However, the managers have a bias to defensive sectors that should be more stable over the course of the economic cycle.”
While Pattullo is positive on bond yields, with his anticipation of a more difficult global economy, he expects default rates to pick up and admits that credit markets are showing late-cycle trends. However, he is offsetting that risk by lending to higher quality names in the high yield space, such as non-cyclicals that shouldn’t get “washed away”.
Henderson Strategic Bond has a yield of 4.8 per cent and a clean ongoing charges figure of 0.7 per cent.
