Bonds have partied hard for more than three decades so it is understandable they are looking a little tired, says Gill Hutchison, but what does this mean for diversified portfolios and mixed-asset funds?
We have heard the ‘end of the bull market in bonds' story many times over - indeed, the end seems to have been coming for an awfully long time. Still, without wishing to get too hung up on these well-rehearsed arguments, it is worth pausing for a moment to contemplate what this means for diversified portfolios and mixed-asset funds.
Notwithstanding a few bumps in the road, fixed income markets have had a pretty continuous party through the 1980s, 1990s and into this century. Not surprisingly, then, bonds have been getting rather tired. The 10-year gilt yield touched a whopping 16% in 1981 - now it stands at a measly 1.12%.
My late father, who invested through the wealth-eroding, inflationary horrors of the 1970s, would have been flabbergasted to see what has happened over the decades since then. The real surprise for those who remember life with candles and flared trousers is that fixed income holdings have been such a wonderful boon for investment portfolios.
Most would agree bonds are unlikely to achieve rip-roaring returns from here on. Apart from the obvious mathematical limitations - there's only so low yields can go - the economic backdrop is suggestive of the need for higher interest rates in Europe as well as the US.
Consequently, investors with fixed income exposure need to be prepared for the likelihood of a muted, if not negative, outcome from their holdings in the next phase of the market cycle.
Thank you, Mr Bond …
From a performance perspective, such a change of fortunes would be a big deal for mixed asset funds. The five-year, annualised return from UK gilts is around 5%, while both sterling investment grade and high yield bonds have delivered an annualised return of around 7% (source: Morningstar, to 27/03/17). Wow, what a run!
Meanwhile, here are the scores on the doors for the Mixed Investment sectors (again annualised, looking over five years): 0-35% Shares delivered around 5%, 20-60% Shares achieved around 6.5% and 40-85% managed 8.5%. Looking at these returns, we can appreciate quite how important the bond contribution has been.
… but not goodbye
So, if bonds are not going to pull their weight to the same degree in the future, will equities take up the slack? The textbooks would suggest they should, based upon a normal cycle - economic growth accelerates, interest rates move up, companies benefit from increased economic activity and push through price increases as inflation rises.
We know, however, that this has been no ordinary cycle. Bond and equity markets broadly benefited from the era of extraordinary monetary policies in the same fashion - after all, low bond yields and lacklustre equity earnings mattered little against a tidal wave of liquidity looking for anything with a cashflow.
Now, interest rates are barely off the starting block for this monetary cycle and yet equities and credit are displaying late-cycle characteristics. These and other issues are extremely vexing for professional investors. In short, there is no playbook.
Back to the basics
The good news is that diversified portfolios make as much sense in this muddled world as they always have done. Equities are alluring when the momentum is behind them, but high-quality bonds still provide an all-important counterweight in the event of economic disappointment, political mis-steps, terror risks and anything else that jumps out at us from leftfield.
More simply, equities may just run out of steam and then we will be reminded that technicals can work against us on the way down as dramatically as they work for us on the way up.
Looking at things through a more positive lens, if we have indeed achieved economic escape velocity and companies are entering a new era of prosperity, risk assets should respond in kind and make up for at least some of the relatively poor returns from bonds. Bonds may be a disappointment, but at least you have the insurance policy in place.
In the meantime, we should thank Mr Bond for a wonderful contribution to our portfolios and prepare ourselves for something that may look rather different in the future.
How bonds are used in mixed investment funds
Fixed income allocations can be used for different purposes in mixed investment funds, depending upon the mandate and objectives. Managers often have a bias to the way in which bonds are deployed and, in very simple terms, they are:
* Bonds as a diversifier: For some managers, the fixed income allocation is as much about offsetting equity risk as it is about generating an income. Managers of the following funds, all featured within The Adviser Centre, consider the bond allocation in these terms: AXA Framlington Managed Balanced, Fidelity MoneyBuilder Balanced, Investec Cautious Managed and Jupiter Distribution.
* Bonds as an income generator: Funds that have a focus upon the delivery of a higher income typically incorporate more credit risk within the bond allocation. In this way, investors gain in terms of yield premium, but lose in terms of risk diversification.
These funds - again, all featured within The Adviser Centre - invest with income as a priority: Artemis Monthly Distribution, Invesco Perpetual Distribution and JPM Multi-Asset Income. Income is also a priority for the manager of M&G Episode Income, although his distinctive value-biased and high-conviction approach makes this a more nuanced proposition when it comes to the role of fixed income in the portfolio.
Gill Hutchison is research director at The Adviser Centre. To access the firm's free-to-air fund research and consultancy service, please click here.
The Adviser Centre will also be presenting at Professional Adviser's Multi-Asset Roadshow, which visits Birmingham, Bristol, Harrogate, London and Manchester between 25 April and 4 May 2017. For more details, please click here. To register your place, click here
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