The first nine months of 2022 have been nothing short of horrible for investors who have simply been unable to find a safe hiding place for their assets.
Having seen three consecutive quarters of losses from both equities and bonds, questions have once again been raised about traditional asset allocation. A fact that is highlighted by the 12 per cent to 13 per cent losses seen across the Investment Association Mixed Investment sectors year-to-date.
The suffering in the bond market has been particularly noteworthy. On my whistle-stop tour of the sector, I have had many a manager point to this as the worst bear market for bonds in recorded history.
You can understand the logic of some raising their cash weightings, despite the impact of inflation.
Investor fears that central banks would once again fall behind the curve in terms of managing inflation saw longer-dated securities sell-off first, only for the hawkish move from policymakers to quickly place pressure on the front end of the yield curve as rate hikes became imminent.
Inflation and interest rate concerns
The Federal Reserve and the Bank of England are now expected to have rates at 4.5 per cent in time for Christmas, while markets in general are pricing in a peak of 5.25 per cent for UK base rates longer term, having been more than 6 per cent following the now infamous “mini” Budget.
You can understand the logic of some raising their cash weightings, despite the impact of inflation. You now have a real yield on a risk-free asset, and the opportunity to invest in a number of asset classes at distressed prices when the opportunity finally appears.
But there are a few other areas of interest for risk-averse investors – in particular, short-duration bonds (two to five years), many of which are starting to offer attractive yields of 6 per cent to 7 per cent.
Will interest rates reach the levels markets are predicting to counteract the threat of inflation?
The question is all tied into interest rates, namely, will they reach the levels markets are predicting to counteract the threat of inflation?
I would like to take a trip back to 2006 as an example. The market was super-optimistic back then, yet rates peaked at 5.25 per cent.
We are currently in the face of a huge cost of living crisis, it is a huge economic concern, so the argument is, how can rates reach those levels in the UK based on these concerns? If the markets come to this conclusion, bonds should go up.
Stephen Snowden, co-manager of the Artemis Target Return Bond fund, says the threat to the mortgage market and consumer spending means rates are unlikely to go past 4 per cent, making short-dated investment-grade bonds an extremely attractive option.
He says yields would have to rise from 6 per cent to 9 per cent in short-dated investment-grade bonds to lose money in the next 12 months – this would be worse than the peak yield of 8 per cent during the global financial crisis, meaning we would need to see greater losses on this occasion.
The falls seen in bond prices means bond yields on UK corporate bonds have now risen to 7 per cent, roughly matching what the markets are forecasting for inflation in the next 12 months.
Market pricing in too much
However, Snowden says the attraction for this 7 per cent yield comes in the longer term, with inflation forecasted to fall to less than 4 per cent in 12 months and 3 per cent in the following 12 months after that.
Stuart Steven, co-manager of the Liontrust Sustainable Future Monthly Income Bond fund, concurs that the market has priced in too many interest rate hikes, given rates are ineffective at reducing supply-side inflation.
A short-duration bond makes far more sense as you are getting up to a 7 per cent yield.
He says: “Retail sale volumes are already contracting and the slow pass-through of rate hikes (due to fixed rates and term funding) will likely result in a greater economic slowdown if the BoE hikes as much as the market expects.”
There is evidence of this opportunity growing in other parts of the world too.
Janus Henderson portfolio managers Daniel Siluk and Jason England say the repricing of markets has increased the asset class’s capability of fulfilling its core tenets of generating income and providing diversification to riskier assets – characteristics that have been lacking since the global financial crisis.
Although yields are at improved levels, they say the maturities are not distributed in a normal manner – citing the inverted US and Canadian yield curves as an example.
The pair add: “We believe that the combination of flat-to-negative yield curves, along with elevated economic uncertainty, supports an overweight higher-quality, shorter-dated securities at the expense of the longer-dated bonds that we believe remain vulnerable to additional bouts of volatility.”
I will not disagree that it is a calculated risk, but the argument is starting to look very compelling.
The pair say the worst-case scenario would be a wage/price spiral taking hold or supply chains remaining impaired, meaning inflation and bond prices would start rising again.
In a nutshell, if rates do rise one or two more times – most of which is already priced in by markets – and you buy, for example, a 30-year long duration bond, should interest rates fall by 1 per cent you will make a lot of money. But the level of uncertainty does remain rife, so if rates rose by 1 per cent, you then open yourself up to a significant capital loss.
By contrast, a short-duration bond makes far more sense as you are getting up to a 7 per cent yield on some bonds over a period that is less sensitive to interest rate risk.
I will not disagree that it is a calculated risk, but the argument is starting to look very compelling.
Funds to choose from
Artemis Target Return Bond: This fund is a ‘steady Eddie’ targeted absolute return fund, with a heavy emphasis on controlling risk. It targets an annual return of at least the BoE base rate plus 2.5 per cent after fees.
Snowden is one of the one most experienced fixed income managers in the UK, and he has a great long-term track record. The fund has a solid, flexible process, combined with a tight risk management.
SVS Church House Tenax Absolute Return Strategies: A defensive offering that has a blend of asset classes and is currently well protected from an inflationary environment with a considerable weight to floating rate notes.
The duration on the bond allocation of the portfolio currently stands at four years.
TwentyFour Absolute Return Credit: Invests predominantly in investment-grade bonds that are due to mature shortly. It has been designed to be easy to understand and does not ‘short’ stocks or borrow any money to boost returns.
The fund currently has a modified duration of one and a half years.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre
