Equity markets have been in the forefront of investors’ minds over recent months as higher levels of volatility have tested sentiment after a prolonged period of relatively stable positive returns. Whilst much has been written on equity strategy, it is important to remember that for portfolios managed with a medium level of risk fixed income constitutes over a quarter of the assets - and well over a third for a more cautiously positioned portfolios.
Here we outline our key themes for fixed income this year.
Government bonds generally look unattractively priced…
After years of easy monetary policy and low interest rates, government bonds in developed economies look expensive relative to their pre-financial crisis history. As central banks begin the slow normalisation of monetary policy, yields on government bonds are likely to rise, resulting in capital losses for investors. This is starkly evident in the graph below, where small rises in yields correspond with steep falls in price.
Should we be concerned about rising bond yields?
UK gilt yields vs. potential losses
Source: Cazenove Capital. Bloomberg. 12th February, 2019. Past performance is not a guide to future performance.
As a result, we continue to see little value in having significant exposure to conventional government bonds within fixed income allocations.
The one exception to this is in the US, where a faster pace of interest rate normalisation by the Federal Reserve in recent years has resulted in more attractive valuations. We therefore see greater merit to tactically holding some US Treasury exposure as a hedge against further equity market volatility.
…but we remain happy to hold inflation linked government bonds
Whilst in the near term inflation in developed markets has been relatively subdued, we are conscious that there remains the potential for an increase in inflationary pressures in both the US and UK. Therefore whilst we remain underweight in government bonds on valuation grounds, we do see merit in carrying an exposure to inflation linked government bonds as a hedge against this scenario.
In the US, the oil price remains a key driver of inflation, with recent weakness offsetting pressures from rising wages to keep headline inflation under control. We have seen a signs of an oil price recovery at the start of the year, and a continuation of this trend will likely contribute to building inflationary pressures in the US.
Our view however is that oil price movements will remain volatile and accordingly our conviction on the direction of inflation is lower than it has previously been. We have consequently marginally reduced our exposure in models at the start of the year.
Within the UK, whilst there remains a meaningful probability of a hard or no deal Brexit, there are notable diversification and inflation protection benefits of holding index linked gilts. In the event of a hard Brexit, we would likely see a devaluation of sterling against other major global currencies, with the resulting impact on import prices being inflationary. However as the inflationary outlook continues to be dominated by the potential outcomes of ongoing political negotiations, we took advantage of a period of strong performance towards the end of last year to reduce exposure.
Overall we are reducing risk within fixed income
Earlier last year we became concerned that fixed income markets had grown too optimistic on growth and were underestimating the potential for inflation, despite a deterioration in a number of economic indicators and a notable increase in geopolitical risks.
Whilst we were happy to remain invested in equity markets, the decision was made to reduce risk levels by increasing the overall credit quality of fixed income allocation through a reduction of high yield and lower quality credit exposed strategic bond funds. Credit spreads seemed to us too low for the risk, especially in lower quality corporates. Whilst one could argue that following the sell off in the fourth quarter there were attractive short term value opportunities in high yield, at this stage in the cycle we are happy to maintain a relatively cautious stance and are more minded to continue to improve overall credit quality.
In the UK, we see better relative opportunities in short dated corporate bonds. In the current market environment it is possible to buy bonds issued by high quality investment grade names with maturities of about a year paying yields of around 1.5%. To receive a comparable yield from UK government bonds, one would need to hold 15 year long gilts, therefore taking significantly more duration risk (meaning a small increase in interest rates can cause significant capital losses). Our investment thesis is that the Bank of England will be able to raise interest rates a few times once there is more visibility on the UK’s final trading arrangements with its European neighbours, at which point government bonds may look more fairly valued and we can consider adding more UK government bonds to our portfolios.