Paul Read, fixed income manager at Invesco Perpetual, says 2017 has been good for many of its portfolios, with the firm’s exposure to corporate hybrids, subordinated financial bonds, high yield and US dollar-denominated bonds all delivering outsized returns.
“However, as a consequence of this strong performance, we now start 2018 with many areas of the European bond market looking expensive,” he says.
“That said, a number of the factors that helped drive returns in 2017 remain in place. The demand for income remains very high and the ECB is still a dominant force in European credit markets. Although it is tapering its asset purchases, it is doing so very gradually and any actual hike in European interest rates still looks some way off. Amid improving economic data, ‘animal spirits’ are also high. Meanwhile, companies have been able to take advantage of low yields by refinancing debt at more attractive terms, so there is currently little pressure on default rates.
“This mixed backdrop of positive fundamentals but expensive valuations leads us toward a more balanced investment outlook. It is difficult to see a scenario in which yields move meaningfully lower, and so income is likely to be the main component of return in 2018.
“Overall, it is difficult to see bond markets repeating the kind of performance we have seen in 2017. Our focus is therefore defensive, and we are taking relatively ‘safe’ income where we can while waiting for better opportunities to add exposure.”
For Rush at Iboss the risk/reward outlook for bonds looks to be poor both in absolute terms and relative to history.
“We do however believe that bonds still have a place as the defensive portion of a portfolio,” he says.
“For that reason, we continue to hold a wide selection of bond funds but with a bias toward short-dated funds and cash for their defensive qualities but no explicit allocation to gilts, global emerging debt or high yield (other than through our strategic managers), preferring instead to take risk where the risk/reward profile is more positive in the medium term, i.e. some equity markets.”
Looking back at 2017
Despite a lacklustre year for returns, investors flocked into fixed income funds in 2017 with some £11bn (€12 bn) invested into the various Investment Association sectors until the end of October.
Indeed, while there is no available data yet for net fund flows in November and December, the £10.96bn invested into fixed income funds this year eclipses the £3.99bn raised throughout the entire of 2016 as investors seemingly adopted a defensive stance.
Taking the lion’s share of the bond inflows this year has been the IA Sterling Strategic Bond sector, attracting £5.77bn, of which £3.6bn came in between August and October. The next best seller was the Global Bonds sector, with net inflows of £1.56bn, followed by the Sterling Corporate Bond sector, which attracted £1.43bn of inflows.
While most investors will have used bonds as a defensive option, it’s worth looking at the returns given back and it was the Sterling High Yield sector, attracting £368m throughout the year, which ranked highest with a 5.88% return over the year to 19 December according to FE Analytics.
The next best sector was Sterling Strategic Bond, which registered a 5.09% fund average gain, followed by the Global Emerging Market Bond peer group, where the average fund was up 4.88%. Bringing up the rear were UK Index Linked Gilts, where the average fund was up just 0.52%, followed by UK Gilts which rose 0.89%.
With a return of 9.47%, the £550m Schroder High Yield Opportunities Fund took top spot in the High Yield sector, with no funds in the 30-strong peer group experiencing a negative return.
Turning to the larger Sterling Strategic Bond sector, where 83 funds reside, it was the £117m Tideway Hybrid Capital Fund which produced the strongest return, rising 16.72%. In top spot in the Global Emerging Market Bond sector was the $356m Luxembourg-domiciled GAM Multibond Emerging Markets Opportunities Bond Fund, which has gained 12.65% so far in 2017.
Ben Yearsley, a director at Shore Financial Planning, says that in his view the popularity of bond funds in 2017 is a reflection of risk reduction, profit taking and the fact many markets are at all time highs.
“Interestingly though, is it really reducing risk by going into bonds?” he says. “With a rising rate environment bond returns could well be lacklustre. I’m pleased the Strategic Bond sector is the main beneficiary, this is the main sector we use, as managers have the most flexibility to navigate choppy markets ahead.”
Within the bond holdings across Iboss’s range of Oeics, Chris Rush, senior investment analyst, says it has opted to introduce a heavy short-dated element through passive funds.
“We use the L&G Short Dated Sterling Corporate Bond Index, Royal London’s Short Duration Global Index Linked and the Vanguard UK Short-Term Investment Grade Bond Index which, muck like cash, should offer downside protection in the event of an equity market sell off or a rise in interest rates,” he says.
“These short-dated bond funds sacrifice a bonds maturity premium and therefore, whilst correlated with other corporate bond funds, provide lower volatility and potentially lower risk.”