Fixed income, what is it good for - absolutely nothing (Edwin Starr - sort of)

With bond yields heading higher now in most markets, leading to capital losses across the fixed income spectrum, it is easy to ask the question set out in the title. The Fed is seemingly committed to continued rate rises, and the ECB withdrawing from QE, rises in yields look set to continue.

The equity market’s recent setback has not seen a material fall in bond yields. If anything, the opposite has occurred, so bonds’ promise of inverse correlation is not bearing fruit.

The equity market has been fretting about an economic slowdown all year, but this has not fed through into corporate bond credit spreads, implying that the bond market is more sanguine about the economic outlook than equities. This is an unusual scenario, normally credit spreads would act as a lead indicator, suggesting that worries about the economy may be overblown. At the same time, spreads have little room to tighten further given they are at historically low levels. The risk here is that conditions deteriorate, leading to credit losses.

There has been some recent commentary on the high levels of corporate debt in the economy, reflecting a very long period of expansion, share buybacks and general optimism. Whilst superficially this is the case, ultra-low interest rates have made this debt highly affordable – so debt service expenses are far from a problem.

However, we are expecting interest rate rises going forward. On most realistic scenarios, interest costs will still be very manageable going forward for the average company. However, this average hides the fact that there are plenty of companies who already struggle to service their interest bill (known as zombies), despite a benign economy and favourable investment market. As interest rates rise, or if the economy takes a turn for the worse, investors will be less willing to lend ever more money to companies without the means to repay. This draws us to conclude there is little upside and plenty of downside for most corporate bonds.

As a consequence, multi asset funds have for some time had a problem from a portfolio construction point of view. The historic purpose of bonds was as a low risk income generating diversifier, which performed well when equities were weak. This appears to be no longer the case. Most scenarios that are negative for equities are also negative for bonds, unless, despite the evidence, you continue to believe in the negative correlation of government bond yields to equities. If you do believe in this flawed relationship, you will need an awful lot of currently loss making long dated bonds to balance a small position in equity, which is a recipe for negative real returns.

Investors must look more widely for diversification and risk-off type assets in the current environment. While we can hold a position in short dated corporate bonds, expecting a small return from the income and our capital back from maturity, this strategy is unlikely to generate much return and ultimately, we must recognise it is a strategy dependent on a continuing benign economy. Hence, we are always on the lookout for reasonably priced assets that can deliver a return, either from income or capital that is broadly uncorrelated to the economic cycle and ideally protect against rising inflation.

The reality is that the valuation of all assets is a function of interest rates but we can find some protection from the main driver of interest rate rises, inflation. We currently favour lowly indebted infrastructure equities, particularly where they are less economically sensitive. These assets can often grow revenues close to nominal GDP, giving some protection against rising interest rates, particularly if their debt is long dated. We have holdings in airports, railroads, pipelines and telecommunication networks for this purpose. Clearly, each comes with a higher degree of equity beta than corporate bonds and has its own amount of sector specific risk, but as lower risk assets than mainstream equities, they can provide some buffer to equity volatility. Outside these areas, we have been building our position in REITS, although it is still at a low level. Clearly, property is valued closely off interest rates and most REITS have significant amounts of debt, but rising inflation is a big driver of rents.

We have also been increasing our exposure to Gold, another risk-off inflation hedge. In some funds, this is through a direct gold ETF in others via gold miners.

In conclusion, diversification, particularly from fixed income is very difficult to achieve at present, particularly in the simplistic approach of combining long dated bonds with equity. A more nuanced approach, considering the risks, (economic growth, inflation, political, sector) we are trying to diversify away, recognising that equity beta is much more unavoidable than it has been for some time.



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Source for information: Miton as at 07/11/2018 unless otherwise stated.

The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.

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