Can bond investors still expect positive returns in a world of negative interest rates?

David Roberts

Bond investors have had a great few decades. Bond prices have risen almost inexorably since central banks tamed inflation in the 1980s. For most of this period, yields fell, meaning investors benefited from capital gain as well as enjoying high levels of income from their assets.

 

As the chart below shows, anyone lending to a G7 government back in 1995 could expect to receive annual income of around 7%. And with average inflation of little more than 2%, this gave a nice, real income of 5% per annum. That’s normally the way with bonds – when investors lend money, they expect to get back enough income to compensate them for inflation at the very least.

 

That remained the case until 2011. The Global Financial Crisis (GFC) of 2008-9 led to aggressive central bank policies, including quantitative easing (QE) and so called NIRP – Negative Interest Rate Policy – when banks were charged for putting funds on deposit with certain central banks.

 

The intention was to stimulate the economy, persuading (or forcing) banks to take money away from the central banking system and lend more at lower costs to companies and individuals. Did it work? Well, the jury is still out.

 

However, one consequence was that the level of income paid to bond investors collapsed. Indeed, for several years now that income has often been below the level of inflation, meaning bond investors lose money in real terms. Given prices are close to all-time highs, offsetting those losses with capital gains is incredibly difficult.

 

10 year average G7 bond yield

 

No income, scant chance of capital gain – no point owning bonds?

 

For those fund managers who follow the direction of the market, making money in 2021 could be a challenge. In market parlance, the “beta” could well be negative as post-viral inflationary pressures lift economies and threaten us with higher interest rates – remember those?

 

However, there are many ways to make money from bonds and avoid (or at least reduce) exposure to market direction. For us, such “alpha” sources come in three categories:

 

  • Rates
  • Allocation
  • Selection

 

Rates

Rather than worry about the direction of the entire market, experienced fund managers can often spot opportunities within the market. There is a tonne of jargon around this type of thing – we talk of curve trades and cross market relative value.

 

Perhaps an example serves us best. Canadian and Australian economies share many similar features – they are commodity rich and to an extent dependent on large geographical neighbours for trade. In each case, their sovereign bonds are rated AAA – as good as it gets.

 

Yield spreads between Australian and Canadian government bonds

 

You might think choosing the bonds of one of these countries and not the other wouldn’t make much difference. But in October 2019, we were paid 0.5% a year more to own Canadian bonds than Australian ones. By June 2020, this had flipped round and we were paid nearly 0.5% more to own Australian bonds. This doesn’t sound much – however this move in yields meant Canadian bonds had risen in price by nearly 10% compared with Australian ones. Most of us would take that.

 

By putting your clients’ cash into Canada and then sell Australian futures (both AAA sovereign bonds), this removes much of the market direction, i.e. the interest rate exposure. Pick the right one and you make 10% more than the other without taking much of that expensive market beta.

 

Allocation

The global bond market is huge and full of possibility, from low risk but low return sovereign debt to more aggressive but rewarding high yield. The price of these different asset classes can move at greatly differing speeds. Many modern bond funds can allocate between different parts of the bond markets.

 

In our Liontrust Strategic Bond funds, we can own from zero to 40% in high yield bonds. Normally, our exposure is around 20%, but when we believe there are great opportunities for clients we can move up towards the 40% limit. And that’s what happened in March 2020 as coronavirus was spreading across Europe – prices fell, value increased.

 

The chart below shows the leading proxy for the US high yield market. In the space of a few weeks, the price of the index fell from around 109c to 87c – a mark-to-market drawdown of 20%. For us and others, this was a great opportunity.

 

US CDX High Yield Index

 

At the same time as high yield was falling, government bonds moved higher in price. For us, it was a simple decision to sell some of the government bonds to buy high yield.

 

Just as in 2009, monetary authorities acted quickly to shore up the system. That put a floor under the market and prices have since risen back towards February 2020 levels, giving our investors a nice excess return from this asset allocation decision.

 

Selection

Another great and oft-forgotten way to make money in bonds is simply to buy the right ones – especially when it comes to company debt! As I have said, bonds come in many different guises, some risky, some less so, some from well-known companies, some from less well-known ones.

 

Running a core portfolio as we do, there are a few quick tricks we use to decide which parts of the market to invest in. One of these is to avoid rapidly growing companies executing a high risk/high return expansion. If a company grows rapidly, it is the shareholders who reap most of the benefit. Bond investors generally receive a fixed rate of return and don’t often get to participate in the upside but this fixed rate is generally much better protected during a downturn. Small, start-up capital intensive businesses or sectors are therefore often best avoided – leave those 100% gains or losses to our equity colleagues. So too are private companies or ones where the managers have little “skin in the game”.

We often talk about Netflix as our ideal bond investment. The company is huge with lots of equity holders to lose their money before us if it ever got into difficulty. Bond liquidity is excellent. It is in a growth sector but unlike many others it has fantastic, diverse, regular income and the ability to turn how much money it spends on products on and off. Perhaps most importantly, it is still run by its founder. We like this alignment of interest.

 

Strategic Bond Funds

Bonds are now very expensive. It will be difficult to make a lot of money from them in the next few years. This means investors in bond funds will have to think very carefully. Will the winning recipes of the past decade still be successful? Can we still rely on chasing market direction when yields on many bonds are negative or below inflation? It seems unlikely.

 

Some strategic bond funds can and often do own equities or speculate on foreign exchange to chase extra returns. We don’t do this. At the risk of stating the obvious, we think bond funds should own bonds. We believe there are enough opportunities in bonds to generate annualised returns of 4% to 5% without the need to take risks in different asset classes.

 

At a time when bonds look really expensive, how are we positioned? Our philosophy is to use our given flexibility to add risk when the rewards for clients justify the risks. We don’t believe in chasing the market simply because others are doing so.

 

Liontrust GF Strategic Bond Fund

 

As the table above shows, we currently have less than one third of our possible exposure to interest rates/government bonds. Importantly, we pre-define our range and communicate this openly in advance to all clients. No black boxes, no secrets. Our core positions at present are those cross-market and curve trades we mentioned: we own Australia and not Canada.

 

When it comes to investment grade bonds – names such as Apple, Credit Suisse or GlaxoSmithKline – we can own between zero and 100%. We move this weight depending on value for investors. As the market plunged in March 2020, we increased our weight from 45% to 70%.

 

In high yield, it’s the same story. First, we limit our maximum weight to 40% – if we were to own more than this, we’d just be a proxy high yield fund and not a true strategic one (of course we do have a pure high yield vehicle, if that’s the risk you want). The asset class has rallied hard from its pandemic-induced lows and in aggregate we are back to neutral. However, selected sectors and bonds are still worth considering: Netflix again, why not. Indeed, Netflix is one of less than 20 high yield bonds we own from a potential universe of more than 1,000.

 

Bonds for the coming decade

Bond markets have flown high for more than a decade and anyone with a lot of market direction should have done well. Our strategy is designed around core, conservative risk, not just the chasing of market direction. With bond markets looking very expensive, it is highly possible we will see negative returns from the market for those taking directional risk. However, concentrating on relative value rates, value driven asset allocation and solid sector and stock selection could be a more sensible strategy for bond investors over the next 10 years.

 

For a comprehensive list of common financial words and terms, see our glossary here.

 

Liontrust Insights



Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, February 2, 2021, 11:26 AM