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24th September 2016
Why low returns may finally burst the bonds bubble

the times in article

These investments have always been considered a safe haven, but there are threats on the horizon.

There is no sign of a let-up in private investors’ seemingly insatiable appetite for bond funds. In July they snapped up a net £1.1 billion of them, more than they put into funds holding shares, property or cash, according to figures from the Investment Association, the industry trade body. In contrast there was a net outflow of £2.2 billion from equity funds.

However, some experts are questioning whether we are coming to the end of the long bull market in bonds — interest-bearing IOUs issued by companies and governments. They face a double threat in today’s ultra-low interest rate environment. On the one hand investors are tiring of the poor yields they are receiving on some bonds, with ten-year government bonds paying a miserly 0.8 per cent. Meanwhile the prospect of rising interest rates could deal a savage blow to bond prices, since they tend to fall when rates rise. We look at the factors that will determine whether investors should ditch bonds or stick with them.

Are bonds still a safe haven?
They have never been an entirely safe haven, according to Brian Dennehy, of Fundexpert, the fund research group, says: “The value of bonds gets eaten away by inflation and you also have the possibility that a bond may default on its interest payments or return of capital at maturity. Corporate bonds are more likely to default than government bonds or gilts, but even governments sometimes default on their repayments, as holders of Russian and Argentinian bonds have discovered.”

David Jane, of the fund group Miton, adds that if you buy an individual bond and hold it to maturity then, barring defaults, you will get your money back at redemption and will have had regular interest payments. However, he adds: “Many people don’t hold to maturity and if they want to make an early exit, they may have to accept a capital loss. Bonds are, generally, less volatile than shares, but that doesn’t mean they don’t exhibit volatility.”

Chris Bowie, a bond fund manager at TwentyFour Asset Management, says corporate bond funds are more of a safe haven than gilts because they tend to have shorter time spans to maturity, which means they tend to be less badly affected by rises in interest rates.

Are bond yields so low that they are unattractive?
It depends what type of bond you are talking about. Mr Dennehy says that about 30 per cent of all government bonds across the globe are on negative yields. Even where government bonds are not on negative yields they offer pretty paltry returns, says Mr Jane. “Ten-year UK gilts are yielding about 0.8 per cent annually, so once inflation rises above that you will be receiving a negative real yield.”

Corporate bonds issued by well-known, financially solid companies, known as investment grade bonds, typically yield a bit more than gilts, at between 1 and 3 per cent. This could mean that, after deducting annual charges and allowing for inflation, you might be able to achieve a real positive return. However, as Mr Jane says: “Many people would not be impressed with a return of 1 or 2 per cent and so might be tempted to buy higher-yield, lower-quality corporate bonds.”

He says there are plenty of bond funds with a mixture of investment grade and riskier high-yield bonds that have a yield of between 3 and 4 per cent.

Are rising interest rates a threat?
They are more of a threat in some countries than others, says Mr Dennehy. “In Europe and the UK the central banks have still got your back, meaning that you can invest in bonds for the foreseeable future with a reasonable level of certainty that the value of your bond holdings won’t be damaged by a sudden jump in interest rates. In the US there is no such security and the 30-year bull market in bonds looks as though it is coming to an end sooner over there.”

Mr Bowie is more upbeat. “Interest rates on both sides of the Atlantic will remain low by any historical context, so I think the risks to bonds are well contained.” However, he says: “If the government announces a big boost to the UK’s infrastructure in the autumn statement, and companies start issuing corporate bonds to finance these projects, the sheer weight of supply of new bonds could mean the issuers have to raise interest rates to tempt investors.”

Are there still reasons to invest?
Yes there are, says Mr Jane. To start with, he says, there is a range of bonds on offer, so there is likely to be something for everyone. “On the government bond side there are bonds issued by the world’s wealthiest countries such as the US and UK, but also by emerging economies such as Ghana and Colombia. When it comes to corporate bonds, you can choose anything from the largest companies with big cash piles, such as Apple, to distressed US shale gas companies.”

One of the places he is finding value at the moment is bank bonds, which investors have marked down because banks at present have to hold more capital, reducing the amount they can lend. Another is mortgage-backed securities, to which people tend to give a wide berth, irrespective of a bond’s quality, because they act as a reminder of the financial crash of 2008.

Mr Bowie says: “We have found that short-dated, higher-quality corporate bonds have delivered excellent returns in each of the past 16 years. You can still obtain yields of 3 per cent on some. If you can tolerate a bit more risk, then we like the least risky higher yield bonds, which offer rates of 7 to 8 per cent.”

Mr Dennehy adds: “People have been predicting the bursting of the bond bubble for several years but bonds have proved remarkably resilient. If you look at the performance of the seven different bond sectors over the past seven years — 49 discrete periods — there were only six periods out of 49 where bonds returned a loss.

“Having said that, you cannot expect such a strong performance to continue indefinitely and the prevalence of negative interest rates indicates that we are much nearer the end than the beginning of this extraordinary period.”

The experts’ picks
Brian Dennehy selects Fidelity Moneybuilder Income fund and M&G Global Macro Bond fund. “Ian Spreadbury, the manager of the Fidelity fund for the past 21 years, is a safe pair of hands. The fund has made money every year since 2008. The current yield is 3.45 per cent. The M&G fund can make money either from the bonds or the currency it holds. The key is being with a manager who is adept at adjusting the mix. We expect continued sterling weakness and this fund will benefit.”

Jason Witcombe, of Evolve Financial Planning, goes for Dimensional Global Short Dated Bond fund. He says: “We favour bonds of short duration [less than five years] because this tends to reduce price fluctuations. Over the past 12 months the total return [income plus capital growth] on the fund was 3.5 per cent.”

Hannah Edwards, of BRI Asset management, likes Muzinich Global Tactical Credit fund and Jupiter Strategic Bond fund. She says: “The Muzinich fund invests in corporate bonds offering different risk levels. The current yield is 3.8 per cent and the total return over the past year has been over 7 per cent. The Jupiter fund aims to hold a variety of high-yielding assets and bonds with the aim of producing a high income and some capital growth. The yield is 4.6 per cent and the fund has returned 103 per cent since 2008.”