Q And A: Bonds Are Boring Again

On gilts and inflation

“I think that quantitative easing has definitely had an effect. Gilt yields are lower than they would have been had we not had quantitative easing. It is one of a number of measures that governments have put in place over the last year to try to get the financial system working again. If quantitative easing did not exist, how high gilt yields would be is hard to say, but I am sure that they would be higher”.

“I think it is fair to say that the government and central bank agenda is, in a sense, inflationary. However, I also think that we are a long way from having an inflation problem of any kind. We have a big output gap; we have high and rising unemployment. I do not think that we are going to have a near?term inflation problem and I would be surprised to see short?term interest rates going significantly higher over the next 1.5 to two years. I think we are going to have low short?term interest rates for quite a while and that is certainly what central banks in general have been saying”.

“Obviously, if interest rates go up it can have a negative impact on corporate bonds and bond markets generally, but what corporate bonds have been all about over the last 18 months is really credit risk and the spread contraction between the yield on the bond and the yield on the underlying government bond. Hence it has been much, much more about credit than it has about what is happening to the underlying gilt market”.

“We do not think that there is particularly good value in gilts and I suppose over time there is scope for gilt yields to rise. We have been running relatively short duration portfolios and a significant portion of our portfolios are under zero to four years in maturity. Absent some sort of nasty sell off in government bond markets, which I do not predict, I think we can work our way through this”.

On future returns

“There is always the potential for money to flow between asset classes and the relative attractiveness of equities in my opinion has increased so that, as you said before, at the beginning of this year I thought you had a once in a career opportunity in fixed income, fantastic yields that you were able to lock into, i.e. equity?like returns from corporate bonds. From here, I think it is bond?like returns, in essence, from the bond markets, so people wanting equity?like returns may look towards the equity markets more”.

“I do not think there can be a strong rally in corporate bonds over the next year. This is not to say I think they will sell off, but I think we have had the big rally – depending on what part of the corporate bond markets you are looking at, up more than 20% so far this year, so we have had a significant rally that is not going to be repeated”.

“I think there are still lots of areas in my markets that are attractive, absolutely and relatively. I would include parts of high?yield in that; I would also include parts of the bank subordinated debt markets, financials, that sort of thing. I think, in general, though, the answer is no, we are not going to have the same kind of rally”.

Are equities more attractive now?

“A lot of investment banks are publishing on the relative attractiveness of dividend yields versus the underlying corporate bond yield for the same credit. In many, many cases, you are starting to find very, very good blue chip companies which are paying dividends that exceed their corporate bond yields. In that sense, therefore, I would probably agree that there is a lot of value in a lot of the equity market, but you are taking a different kind of risk. Therefore, for people who want relatively safe income and lower levels of volatility, by moving into the equity market to achieve that you are probably exposing yourself to more volatility, so it is attractive, but it is a different asset class”.

Bank debt as an investment

“We are definitely still very involved in subordinated bank debt, bank capital. It is one of the parts of the fixed income market that I think has the most value still. We have big positions and significant sector weightings in banks and I continue to think that that is one of the most attractive parts of our markets. Although we have made fantastic returns on those parts of the markets, I continue to think it is attractive because I think that the risk involved in being in that sector has come down a huge amount over the past year and will continue to decline. Therefore, within investment?grade credit I think it has a lot of value still”.

“The most significant value in credit markets continues to be in financials, so we continue to have significant positions in subordinated bank debt, both Tier 1 and lower and upper Tier 2. Outside of the banks, it is less obvious. There are parts of high-yield that continue to be interesting, such as parts of the insurance-company market and many of the very blue-chip, safe, household?name, investment-grade credits that are trading more or less fully valued now. While it is not a market where everything is cheap, there are definitely areas of the market that are still very attractive”.

“In terms of sector-positioning, the big positions are in banks and other financials, which make up about 50% of the portfolio. This is not dramatically out-of-line with the market, because these are big components of the corporate bond market. About 25% of that is subordinated bank capital and about 15% is Tier 1. We still have big positions, then, in bank debt. Outside of the financial and insurance-company sectors, we have about 8% each in utilities and telecoms, but again they tend to be big sectors of the bond market. I do not think that we are taking big cyclical or other sector bets”.

Index-linked gilts

“Index-linked is not really attractive to us. It is not really a market that we are ever significantly involved in. It is an institutional market. I do not think that the breakevens in terms of inflation rates are interesting for us, but there are very important pools of capital that have to be involved in that market. We do not have to be involved in it and rarely are. It would have to be a combination of us having a really big worry about inflation and finding that the breakevens were attractive”.

“The way that we would normally manage that risk would simply be to have lower-duration portfolios and to build up cash, rather than to try to finesse it with index-linked. I do not think that it is a big part of the market for us”.

“What the last year has all been about, really, is credit risk, credit spreads, and ensuring that you capture that. That was where returns were going to come from. We have had quite a negative view of taking duration risk and have kept it relatively modest. The modified duration on the Corporate Bond Fund is about six [years]. It could be lower, but we are not taking significant duration risk, and neither would I want to be making that a core feature in the funds for the foreseeable future”.

Summing up

“The background is pretty good now: the markets are functioning; liquidity has improved; the market is technically well-supported; and, by and large, corporate management is focused on improving balance sheet and credit risk. What is much more important, I think, is managing people’s expectations and saying, ‘Please do not expect to get the returns that you got so far this year out of this asset class again – this is not going to happen’. There is still a huge demand globally for income, because short-term interest rates are low, as are gilt yields. The other traditional sources of income, like bank dividends, which were always considered to be relatively safe, are no longer there. This is, then, a good asset class in terms of income provision”.