After three years of strong returns fixed interest funds could be taking a turn for the worse. Cherry Reynard assesses whether it is still worth investing in the sector
IT IS DIFFICULT to find people who are kind about the current fixed interest market.
And that includes many fixed interest managers.
After over three years of strong returns, it is difficult to see how the sector can generate much capital gain from here.
With a diminishing chance of capital gains, investors are left relying on the potential income stream.
Would advisers be better off looking elsewhere for income? Say, for example, property? Or are there still reasons to invest in fixed interest? It has certainly been a purple patch for fixed interest.
The average UK corporate bond fund has generated 32.6% over three years.
This puts the asset class equal with its equity peers with significantly lower volatility.
The UK All Companies sector has produced 30.3% over the same period, while the UK Equity income sector has generated 33.9%.
Equity volatility has averaged 3.5 to 3.9, while corporate bond volatility has been less than half that at 1.2.
But if the past few years have taught us anything, it's that past performance shouldn't be taken as a guide to the future.
UK corporate bonds were the top-selling sector again in May with net sales of £127m.
The top-selling equity sector was Global Growth, which recorded net sales of just £51.5m.
Are those still investing in fixed interest now hitting the top of the market? As a rule, bonds favour misery - they flourish best in an environment of deflation and falling interest rates.
Deflation increases the value of the coupon.
Falling interest rates means that the coupon on a corporate bond has greater value.
But while this is an overall rule, different types of bonds perform better in different types of economic environment.
Jonathan Platt, head of fixed interest at Royal London Asset Management, divides fixed interest into four different areas - government bonds, 'real yield' or index-linked, investment grade bonds and high yield.
The government bond market is driven by interest rates, which are in turn driven by inflation and the strength of the economy.
Platt adds: "These tend to do well when economic growth is slowing. However, recently government bond markets have done well despite strong growth because inflation has been well-behaved." Index-linked bonds, as the name suggests, give some protection against rising inflation.
The performance of these depends on the level of 'real' interest rates.
Platt says: "The performance of these bonds looks at the rate of return on other assets. For example, if the rate of return on equities is fairly low, then real yields will also be quite low." Investment grade bonds introduce an element of credit risk - in other words, the risk that the company might go bust.
Investment grade bonds perform well when growth is strong, inflation is low and interest rates are low, as has been the case over the past five years.
There are two environments in which this type of bond will not do well - in a recession, or when companies are growing strongly.
In an environment of strong growth, companies will tend to be more adventurous, spend more money and increase the debt on their balance sheets.
As the main concern for a corporate bond holder is that a company has enough cash to pay the interest on the bond, they will do better when companies are paying off debt and have strong balance sheets.
Corporate bonds, like Goldilocks, prefer an environment that is not too hot and not too cold.
Shrinking market High yield incorporates a number of different types of bond.
First, there is emerging market government debt.
This market is smaller than it used to be following the accession of countries like Poland and Hungary into the European Union.
Then there are high yield corporate bonds, which have seen strong growth in issuance over the past 10 years.
The UK and European markets are still dwarfed by the US, but these markets are developing.
This type of bond tends to provide a return of 2.5% to 3% over government bonds.
Because there is more credit risk, these bonds tend to do well when the markets are more tolerant of risk.
This is usually when PLUNGE? uity markets are rising.
Platt says: "For these bonds, there is less underlying interest rate risk and more specific credit risk." What is the current outlook? Platt says: "We have had an extended period of benign conditions - corporate profits have been OK, interest rates have been low. Real interest rates have also been quite low. There have been lots of savings and this has driven down yields. All fixed interest assets have given a good return." Corporate bonds have also been pushed higher by the new solvency requirements on life companies.
Asset/liability matching has forced many life offices towards the corporate bond market in favour of equities, driving prices higher.
But can it last? Spreads over government bonds are at historic lows and look unlikely to come in any further.
The bond markets were knocked at the start of the year by the decision to downgrade General Motors, but have bounced back since then.
There is also plenty that could unsettle the market - companies are no longer focusing on improving their balance sheets, but are under more pressure to increase dividends.
Default rates, previously at historic lows, have been rising and are likely to rise further.
Difficult times Marino Valensise, head of fixed income at Barings, says: "The good times are over and it will be difficult to repeat the performance of the past few years. Yield used to provide a cushion, but at 3%-4% that cushion is now very low. The junk bond market used to have a 10% yield, but it has done so well that it is now around 5-7%. This is not enough to compensate for the additional risk." Valensise has two favoured areas - inflation-protected bonds and emerging market bonds.
On the former, he says: "The coupon is higher and if inflation goes up, it follows. They are issued by the government so there is no credit risk. In the emerging market area, some of the economic numbers are better than those in developed markets. These are not overpriced." Richard Woolnough, manager of the M&G Corporate Bond fund, says he is managing the current situation by favouring sectors not exposed to a weakening UK economy.
He says: "We like utilities, telecoms and the commercial property sector. The commercial property sector has been re-arranging its balance sheets ahead of the introduction of Real Estate Investment Trusts (REITS). We like defensive sectors and those companies that are looking after their bond holders." Woolnough says that managing the downside risk is particularly important in the current environment.
He adds: "It is very different ing a bond manager. Equities can find stocks that will double in price. With an investment grade bond, the most outperformance is 1-2%, but your money can still go to zero. We need to concentrate on the downside risk and at certain times it matters more than at other times. At the moment, the shrewd stockpicker will avoid those stocks that look cheap but have the potential to go wrong." But all the managers agree that many investors, particularly institutional investors, are still under-allocated to corporate bonds, which pro- vides some stability for the asset class.
Valensise says: "There are still very powerful forces pushing investors to buy more bonds - both regulatory and legal. So they have to do so, despite the fact it is not very attractive at the moment and there is very little value." A broad mandate To determine whether a retail investor is under- allocated, advisers or trustees need to look at risks and liabilities.
Valensise recommends a broad mandate in the current environment.
He says: "There is a high correlation between the breadth of mandate and the value a manager will add." How do you pick the best manager for each type of fund? Valensise says managing each type of fixed interest requires a different skill.
He adds: "For government bonds, you need to be a good forecaster of interest rates and inflation. If you are good at defining the credit worthiness of an asset, it may be best to play in the junk bond market." Woolnough says: "On the gilt side, you need a team with a strong macro background.For high yield, you need a good team of credit analysts." It seems very unlikely that fixed interest will outperform equities over the next few years as it has since the start of 2000.
Fixed interest has its place as a provider of income and as a portfolio diversifier, but there is little value in the majority of the sector at the moment.
While there is still sufficient demand from institutional investors to provide support to the market, investors should pick their fund managers with care and opt for those with maximum flexibility.
Coupon: The interest payment made to bondholders Credit risk: This is the risk of a company going bust and therefore the bond going into default.
Default: This is when the bond issuer cannot maintain interest payments or repay the face value of the bond on maturity.
Duration: This is the lifespan of the bond.
A bond's duration determines its sensitivity to interest rates moves.
Investment grade: These are high quality bonds, rated BBB/Bbb or above by rating agencies Standard & Poor's/Moody's.
Spreads: This is the extra coupon on a corporate bond over a government bond.
This compensates the investor for the credit risk.
Sub-investment grade/junk/high yield: These are lower quality bonds, paying a higher coupon.
They are rated below BBB/Bbb by the two rating agencies.
Yield: This is the fixed annual coupon value divided by the price paid for the bond.
When the price of a bond rises, the yield falls and vice versa.
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