Bonds are “rigged to be expensive” after years of low interest rates and quantitative easing (QE) measures from central banks but some attractive opportunities can still be found, according to Liontrust Asset Management’s Phil Milburn.
The co-manager of the newly launched Liontrust Strategic Bond fund said that starting with a blank piece of paper it is difficult to justify investing in bonds.
“Bonds are still expensive and are still rigged to be expensive but it is measuring how expensive and when you start to see value in the market [that is important],” he said.
Bonds have been on an extremely strong run over the past 10 years, with the Bloomberg Barclays Global Aggregates index up by 88.66 per cent, as the below chart shows.
Performance of index over 10yrs
Source: FE Analytics
As investors have sought out income in the low rate environment, bonds have risen to extremely expensive valuations while yields have fallen due to the inverse relationship with bond prices.
As a result, Milburn said he is running a lower duration portfolio to counterbalance this effect. When running models – before the fund officially launched - he had a duration of just two years at the start of the year.
This is opposed to an average for the Bloomberg Barclays Global Aggregates index and the peer group of 600 global bond funds available for sale in Europe of around 4.5 years.
Duration for the fund has slowly moved back up to 2.75 years of interest rate risk but remains some way off the average.
“So, we still have a beta to the market regarding interest rate risk duration of about 0.7,” Milburn said. “We still think the beta is expensive so running a low-beta strategy and prioritising high alpha opportunities within the fund or sweating the assets and making them work harder.”
He added that while the market is expensive, many investors will still see a need to own fixed income for diversification purposes.
“Yes it is expensive but people still have to own some so would you rather go with managers who say ‘no, they are not expensive, you are wrong’, or those that say ‘yes, you are right but you still have to own some so we will make it sweat as hard as we can’,” the manager said.
So where can investors turn to? Milburn said that starting over with a blank piece of paper, the only developed market country he likes is the US.
“Within the rates markets our very strong preference is for the US market and that is very simply because it is much further through the interest rate rising cycle than the UK, eurozone, Japan et cetera,” he said.
Indeed, the Federal Reserve (Fed) was the first to embark on an interest rate hiking cycle, resulting in the yield of 10-year US Treasuries more than doubling to 3 per cent over the last two years.
Chart of 10yr US Treasury yields
Source: Federal Reserve Bank of St Louis
“As Treasury yields have now gone through 3 per cent with the 10-year yields around 3.1 per cent as we speak, we have been adding a little but it is very much the case in the rest of the world there is very little value,” Milburn said.
This is also the reason the duration has increased slightly.
“The US market which is starting to reflect more of the interest rate rises so it is hard to be as bearish,” he noted.
The Liontrust Strategic Bond fund manager said rates are likely to peak at around 3 per cent – much lower than in previous hiking cycles – despite an expected four rate rises this year by the central bank.
“We still believe that we will see four interest rate rises this year in the US but next year it will start to get a bit trickier, particularly as the Fed retrenches on QE and starts to do a lot more of their payback via their ‘caps’ that they have been using,” he added.
In terms of the yield curve, Milburn said he has a preference for longer-dated bonds as yields are more likely to rise at the shorter end.
“What this is telling you is that, actually, rates are going to peaking at a lower level in the US and that there is a long-term growth and inflation problem,” Milburn said.
“I am a big believer that there is an inflation scare coming in the US because the labour market can’t continue to expand indefinitely without some wage inflation coming through; but it is a scare not a long-term problem because there continues to be significant offsets to wage inflation – namely technology and global outsourcing.”
Overall, the Liontrust manager has employed a mixture of both corporates and treasuries with a preference for the former, particularly quality companies, where he is looking for the cheapest level of debt.
Turning to the rest of the world, Milburn said
it will be harder for rates to rise as much as in the US, but that we are definitely on a tightening cycle.
Indeed, the European Central Bank (ECB), should stop its QE program later this year and investors should expect rates to rise eventually.
“If you are looking at forward-forward and saying that base rates are going to stay low forever – which I just don’t believe – then actually you could almost justify it [holding European bonds] now,” Milburn said.
“But if you say what real return do I need to invest in the bond market, at the moment the only market where you are getting any real return nowadays are the US.”
Milburn joined Liontrust from Kames, where he ran a number of fixed income mandates, launching the Liontrust Strategic Bond fund earlier this month.
Performance of manager vs peers since 2002
Source: FE Analytics
Over his career, the manager has outperformed his peers by 23.67 percentage points, as the above chart shows, returning 173.87 per cent.
Liontrust Strategic Bond, which he co-manages alongside David Roberts and Donald Phillips – a former Kames colleague – has a clean ongoing charges figure (OCF) of 0.7 per cent.