The global bond sell-off could have further to run as investors continue to prepare for the post-pandemic future, warns AJ Bell’s Laith Khalaf, so now is the time to question what role fixed income is playing in portfolios.
Recent days have seen investors dump bonds, as eyes turn towards stronger economic growth as the world recovers from the coronavirus crisis. The moves in government bonds have been especially prominent in the US, where the 10-year Treasury yield has exceeded 1.5 per cent for the first time in a year.
In the UK, the 10-year gilt yield has more than tripled from 0.2 per cent to 0.75 per cent since 2021 began, putting it above pre-pandemic levels.
Khalaf, financial analyst at AJ Bell, said: “Bond investors have had a pretty rocky start to 2021 and if the global vaccine roll-out prompts a sharp economic recovery, price falls clocked up this year could be just the beginning.
“Yields have fallen to such record low levels that the bond market is like a coiled spring, ready to twitch into action at the first sign of inflation or interest rate rises.”
Indeed, bond prices across the board have been falling and all the major bond sectors have suffered from significant losses so far in 2021.
Bond sector performance year-to-date
Source: FE Analytics
Khalaf said lot of this move could be investors anticipating stronger economic growth and the risk of inflation down the line as vaccines are rolled out globally.
“Vaccines are literally a lifesaver, but for the bond market they spell trouble,” he said. “A recovering economy means central banks don’t have to offer as much stimulus and at some point this year they might even start gently whispering about when to withdraw QE [quantitative easing] or raise rates.
“Given how much the bond market has been propped up by central bank activity, kicking away this crutch will inevitably lead to a fall in prices. Markets will look to pre-empt central bankers and that’s probably why we’re seeing yields rising now.”
Khalaf said one issue is that investors will be less likely to buy bonds because they anticipate prices will fall, making the yield pickup in the future more than what can be bought today.
Institutions such as pension funds and insurance companies with regulatory or legal obligations may still buy these bonds, but they often hedge the risk to the downside.
“But there is one area where savers themselves are heavily exposed to bond market falls, just as they are about to retire,” Khalaf said.
“Many old company pension plans use a process called lifestyling, which automatically shifts pension savers out of equities and into bonds just as they are about to retire.
“This strategy has worked a treat as loose monetary policy has led to rocketing bond prices, but if that trend goes into reverse, pension savers will see big falls in their retirement pots, just as they are about to draw on them.”
He pointed out that so far in 2021, the average lifestyle fund has fallen by 8 per cent in under two months.
“For many savers, the decision to default their money into these funds was made by someone else, a long time ago,” Khalaf added. “Few probably appreciate the risks that have been assumed on their behalf.”
He said the moves being seen in the government bond market are “a reminder of the price falls that bond investors might face when the QE music stops, and the low yields currently on offer don’t offer a great deal of compensation for that risk”.
Despite the sell-off bond markets are seeing, Khalaf believes the asset class still offers diversification in the event the re-opening of global economies fails to meet expectations.
He said investors should consider one of the three potential reasons why they have an allocation to bonds – but keep in mind that there may be alternatives to pure fixed income funds.
The first reason he outlined is diversification. “Bonds still offer diversification from equities and if risk appetite wanes, bonds funds can be expected to do well when equities fall,” he explained.
“This still holds true today, though with bond prices already so high the upside is much more limited than the downside.
“The benefit of holding both bonds and equities together is these assets minimise portfolio volatility, though this may come at the cost of longer-term returns.”
Instead of managing the bond-equity split themselves, Khalaf suggested investors consider a multi-asset fund which does it for them, such as the Personal Assets Trust or Rathbone Total Return.
He said: “These funds won’t shoot the lights out when risk appetite is high, but they are run by managers with experience in making allocation calls between shares, bonds, and other assets like gold, and who run their funds pretty conservatively.”
The second reason investors may want bonds is for the income. “The income produced by a bond portfolio has fallen in line with loose monetary policy and has already pushed many income seekers out of the bond space,” Khalaf explained.
For long-term income investors who aren’t phased by market volatility, he highlighted the £1.5bn City of London investment trust which currently yields 5.25 per cent.
“The investment trust structure means manager Job Curtis can hold back some of the portfolio’s dividends in good years to pay out in fallow years, providing a smoother income stream for investors,” he said.
“Those who prefer to hunt for income in the bond world might consider higher yield bond funds like Baillie Gifford High Yield Bond fund, but these come with added equity-like risk.”
The third reason investors may want bonds is for some market protection. “Some investors choose bonds because they have low volatility and are generally considered safe,” Khalaf said.
“However, one has to question whether a high allocation to bonds right now is actually an accident waiting to happen; pension lifestyle fund investors fall into this bracket.
“For those who are thinking about buying an annuity with their pension, a lifestyling approach using bonds still hedges their bets on annuity rates, so might not need to be tinkered with.
“For those who are looking to just draw their pension as cash, gradually switching into cash rather than bonds might be a better idea.”
For investors who plan to continue to add to their pension and receive income, Khalaf said investors could consider switching to a portfolio of income funds such as City of London Investment Trust, Evenlode Global Income or Man GLG UK Income
“A mix and match approach to cash, annuities and investment income requires a combination of strategies,” he finished.