Evidence of bubbles and rotations out of the asset class suggest a hard year ahead for bond managers. Rathbones' Bryn Jones explains where he is finding value...
Over the course of the year, investors are expected to gradually 'rotate' into equities as strong performances in fixed income markets have precipitated several headlines about bond bubbles.
Despite the significant contraction of spreads in certain bond indices over the last year (the Iboxx Non-Gilt index, for example), there is still value in some areas.
Furthermore, as the hunt for yield abounds, we believe that increasing the quality of ones’ portfolio, versus chasing scarce yield, will become more of an issue as the year progresses. We have already started to switch out of some lower-rated investment grade names and begun to de-risk.
Why this'll be a tough year for bond managers
Time to de-risk?
Talk of a bond bubble is somewhat misleading. Many companies have been deleveraging and cleaning up their balance sheets and, therefore, fundamentals should continue to support tighter credit spreads. However, we also believe it may be time to take profits, focus on ‘quality’ and limit any potential downside risk.
For example, in investment grade credit, we have looked at the spread conversion between BBB issues (the low end of the rating spectrum for investment grade securities) and A rated issues (or better).
Spreads have reduced considerably in some cases, and we think this represents an attractive opportunity to take risk off the table and improve portfolio quality.
In those specific cases, we are sellers of BBB-rated bonds and buyers of higher-rated issues.
In the high yield space, we favour short duration assets, especially European high yield, over US high yield. There is under-valuation in the European peripheral bond market, but this is an area we view with a great deal of caution.
For the first time in its history, the US high yield market is yielding less than the earnings yield of the S&P 500 index, which suggests that some US bonds are now fair- to over-value. In Europe, however, the spread differential is wider and, as demand outweighs supply, we believe that there remains some opportunity for contraction.
This is a space where we would look to add.
Gilts have little intrinsic value and low nominal spreads look very vulnerable. We use our exposure to gilts with longer durations as a hedge against our risk positions, and have added to our exposure as yields breached above the 2% mark.
We think there are still some opportunities in the subordinated financial space that can provide a hedge on rising gilt yields. Indeed, we have seen some interest in lower tier two securities issued by the banks. In some cases, the banks have not called these securities, meaning the coupons are now floating.
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