The chart shows that Government Bonds, conventional and linkers, have been the safest of havens this year, posting strong returns. Last quarter though, it was corporate bonds, especially High Yield, which produced the best returns as spreads (the yield pick-up over Gilts, in effect the risk premium) tightened sharply after their big panic sell-off in March.

Income is going to be a scarce commodity for investors and we see credit markets as an attractive ‘halfway house’ for investors, especially in lower risk/reward profiles as there is a far greater degree of comfort in solvency and coupon payments from bonds rather than in earnings expectations and dividend payments from equity. Our preference is for investment-grade bonds; higher yields may be seductive but not at the expense of defaults and downgrades. It certainly helps that Central Banks are huge buyers of corporate credit as part of their QE programmes, protecting companies from default and thus underpinning the asset class. Thanks guys. A consequence of the Central Banks owning such a large proportion of global bond and credit markets, but caring little for the inherent value of the assets they are purchasing, is that the pricing in the bond markets is arguably losing touch with reality and a problem for ‘down the road’ as when, or indeed if, ever they begin to unwind their asset purchase programmes.

Can Fixed Income still play a role in portfolio diversification?

Government bonds proved their worth as a negatively correlated risk-off play at the start of this crisis, producing strong returns as equities crashed, but no longer offer the same protection going forward, with yields now virtually zero. These yields can become negative, as they have for some time in Switzerland, Germany and Japan. As such, Government Bonds can still provide portfolio insurance (prices rise as yields become ever more negative) but now only to a limited extent and the US and UK are more likely to target yield curve control at the long end of the market rather than allow yields to become negative. To achieve significant diversification in the event of an equity sell-off, duration will be your friend, the longer the better, and UK Gilts fit the bill with the average duration of gilts now being near 20 years and index-linkers 23 years. The danger of holding such long duration, is that if interest rates rise sharply there will be a significant loss of capital, though this is unlikely with the Bank of England buying so heavily in the market and we see Central Banks keeping 10-year yields at their current super-low levels for an extended period of time.

Corporate bonds add less diversification/protection to a portfolio in the event of a big fall in the equity market as spreads widen considerably as the risk of default is deemed to have increased, so prices fall. We increased the quality and duration of our Fixed Income positioning last quarter, not least in adding to the Troy and Ruffer multi-asset funds which we own on our lower risk/reward Model Portfolios and which are significant holders of UK and US Government and Index-Linked Bonds.

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