Posted inAnalysis

Back into bonds?

Risk and Reward

A lot has been made recently of both wealth managers and fund managers increasing cash holdings in their portfolios to act as a cushion against a potential downturn in equity markets.

A recent Legg Mason study found a third of wealth managers, who together manage in excess of £100bn, revealed they are holding cash across their clients’ portfolios to protect against an imminent correction.

Others, however, have been less inclined to bump up the cash. Rathbone Global Opportunities lead manager James Thomson said he has “never been so invested” after reducing the portfolio’s cash weighting to 0.64% from 1.10% in October.

This view is reinforced by the latest Bank of America Merrill Lynch (BoA ML) fund manager survey which found the average cash balance held by global managers fell to 4.4% in November from 4.7% in October – the lowest level since October 2013 and below the 10-year average of 4.5%.

Not all about cash With cash clearly dividing opinion, bonds, particularly strategic bonds, appear to be re-staking their claim as defensive asset class du jour in certain portfolios as fears of an equity correction loom.

“You can suddenly go really defensive but then the danger is that spreads stay the way they are. That is why we are still overweight high yield.”

According to the latest Investment Association sector flows data, strategic bonds are continuing to dominate the pickings. During September, the sector accumulated net inflows of £985m – the third month in a row the sector has topped the rankings.

This acceleration in flows is perhaps unusual given it occurred at a time when investors were expecting a rate rise from the Bank of England. However, the flexible nature of strategic bond funds means they should protect against volatility, hence their appeal.

For Torcail Stewart, manager of the Baillie Gifford Corporate Bond fund, the economy’s lights are flashing green as deflationary pressures continue to dampen rising inflation. If there is a correction, Stewart believes it will be behavioural.

He explains: “With high-yield markets having done as well as they have of late, psychologically some managers still have the global financial crisis in mind so think there will be a correction. But if you look at the global economies, the US, Europe and China, everything is flashing green, the economies are all motoring quite strong and the other peculiar aspect is inflation is trending down.”

Stewart says to the end of November his strategic bond fund has seen AUM boosted by about £170m year on year, although he is quick to point out this has been a steadily ticking up since the start of the year rather than a sudden rush into the asset class.

In terms of portfolio make-up, at the start of the year the fund was 40% in high yield but that has progressively reduced to 34%. Meanwhile, exposure to investment grade, single-A and above, has grown from 19% of the fund to 26% over the same period.

Not too defensive

As for defensive plays, Stewart says the fund is “keeping some powder dry” through holding short-dated treble-A rated supranational bonds that offer liquidity, and short-dated bonds where the likelihood of call is high.

However, he also warns of being too defensive, noting that between 2004 and 2006 spreads were roughly 10% lower than they are today and stayed at that level for a long period.

He explains: “You can suddenly go really defensive but then the danger is that spreads stay the way they are. That is why we are still overweight high yield by a small portion because we could be in an environment where spreads stay low and continue to grind lower slowly – ie they continue to rally – but we think you may well get a correction before that.”

Diversification: the only defence

Andrew Herberts, head of private investment management at Thomas Miller Investment (TMI), says the firm’s managed portfolios are neutral, if slightly underweight, bonds and he has taken some of the interest rate sensitivity out.

He explains: “If you bought bonds now as an insurance you will pay a premium because as the economy continues to grow and central banks normalise rates, your capital will erode and you don’t have the income cushion, so it is more difficult to get into bonds as insurance.

“The only defence at the moment is diversification,” he adds.

While somewhat reluctant, because it is outsourcing asset allocation, Herberts says TMI has started to use strategic bond and absolute return funds because they can access scale. In addition, because they are unitised, they offer some client protection that TMI cannot.

“That flexibility is worth buying in as we can’t do it,” he adds.

Sebastian Cheek

Sebastian joined Last Word Media in 2017 as editor of Portfolio Adviser. He previously spent 10 years as a journalist and editor in the UK institutional investment sector, most recently as editor...

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